June 2008

ALPHA SOURCES: Trade Secrets

Alpha investors seek returns that are uncorrelated to indices. Ironically, a new range of index products could imitate this cheaply. But will disclosure scupper them? Angele Spiteri Paris investigates 
tradesecrets.jpgActive exchange-traded funds (ETFs) are something of an oxymoron. ETFs are passive index trackers, but lately product providers have found ways to extract active, or index-beating, returns from them.

Active ETFs offer all the advantages of their passive counterparts ­­– a broad investment universe, equal fees for all investors, and so on. But they also offer cheaper access to active management and, potentially, a source of alpha.

Optimism for the area is in no short supply. Gary Gastineau, principal at ETF Consultants, claims that five years from now, the active ETF market will be well on its way to surpassing the passive section by assets under management.

Frank Henze, head of product development at iShares, the largest ETF provider and part of Barclays Global Investors (BGI), says that not only will active ETFs offer access to traditional asset classes, but also to much sought after alternative instruments.

Cliff Weber, head of development and strategy at American Stock Exchange (Amex), says creativity in the market will lead investors and traders to develop all kinds of strategies that haven’t yet been anticipated.

Winning argument
At face value, the argument for active ETFs – principally that active returns can be gained for a cheap, passive price – is in no doubt a winning one.

But the major concern regarding this new breed of funds surrounds a reduction in the transparency of stock holdings. The holdings of an ordinary ETF are obvious: it’s the index that it replicates, and this transparency has been a main selling point.

However, in the active structure, a provider has the discretion to overweight or underweight particular stocks in the index according to the degree of risk and expected return. The issue of disclosure of these positions is crucial to the ability of active ETFs – as with any active investments – to offer benchmark-beating returns and a form of non-correlation, or alpha.

In the US, the Securities and Exchange Commission (SEC) has not made the launch of the active ETF market simple, exactly because of disclosure.

“The SEC was not ready to compromise much on this and wanted to make sure investors were getting as much information as they should,” explained Sonya Morris, senior analyst at Morningstar.

Invesco Powershares was the first to launch active ETFs in the US and has four funds currently trading. Tim Mitchell, head of investing institutions at the firm, says disclosure concerns can be overcome.

“The benefits of an active approach may greatly outweigh the increased opacity of the portfolio, especially when compared to mutual funds. Therefore, this is still a huge step beyond what exists in the active mutual fund space.”
According to Gastineau, of ETF Consultants, the issue of transparency could prove to be an even bigger worry than it has been made out to be, but he is positive that this could be overcome.

In a paper on the subject he said: “The manager of an actively managed ETF needs to offer no more information on his portfolio composition and portfolio changes than the manager of a conventional mutual fund.”  

Disclosure fears
It is understandable that providers of active ETFs are not keen to fully disclose the holdings of their funds. Like for true alpha investors, it is for fear of traders front-running them and driving up or down equity prices.

Weber, of Amex, explains: “Active managers attempt to outperform the market by using their expertise in picking stocks, recognising macro or industry trends. Often, implementing their strategies or turning over their portfolio holdings can take many days, or longer. If other market participants are made aware of their trading activity, it will likely adversely impact the performance of the fund as these other investors attempt to trade ahead of the fund and earn a quick profit, or mimic the fund’s strategy in their own portfolios.”

One Powershares fund discloses its portfolio holdings every day. But this, according to Henze of iShares, results in a fund with a weak source of alpha.“At BGI we believe alpha generation is a scientific way of analysing markets,” he said, “Therefore you cannot give away your ideas by publishing what is in your fund.”

ETF Consultants’ Gastineau also agreed that increased disclosure was not absolutely necessary. “More frequent disclosure is not essential. An investment process that requires the maximum permitted portfolio confidentiality can work well inside an actively-managed ETF,” he says.

Daniele Tohme Adet, head of ETFs and indexed funds development at BNP Paribas Asset Management, comments: “Full disclosure is a solution but within ETFs it is difficult to follow up as the end investor is somewhat out of reach.”

It must be said that convenience of running an active ETF with full disclosure means there are no transparency concerns and market makers can price the fund with ease.

The ‘blackbox’ approach pioneered by Bear Stearns, on the other hand, could be seen as a more efficient way of generating alpha, but inevitably throws up trading issues. The actual Bear Stearns active ETF seems to have sunk without a trace amid the bank’s problems, but the method it put forth had redeeming features.

The obvious downside to this approach is that, like with an active fund, market makers would have difficulty pricing an active ETF, which would result in spreads widening. This could in turn wipe out any outperformance.

“The quest is to combine both,” says Henze of iShares “You must be able to deliver high-quality alpha through the market-making mechanism of an ETF without distorting your cost.” He claims the only way of doing this is to work closely with market makers to enable them to price the particular product effectively.

Proxy portfolios
Another solution suggested by the market was for the manager to create a proxy portfolio, one that mimics the holdings of the actual fund and can be fully disclosed. It would provide market participants with information on how the fund is expected to behave, thus allowing for competitive secondary markets in the fund shares without the exact holdings being disclosed.

Morris, of Morningstar, says that the idea of building a proxy portfolio could work in the bond arena, but was unsure of whether it would be a viable solution for equity funds.

According to Weber, of Amex, proxies could be the solution to disclosure. “We think this approach best balances the marketplace’s desire for information about the fund holdings so as to price and hedge shares in the secondary market, with the investors’ desire to maximise fund performance by preserving non-transparency,” he says.

In spite of this, the proxy portfolio solution will not eliminate concerns about spreads. This is because market makers will make an allowance for the fact that proxies will not perfectly align with real portfolios and therefore spreads would still be wider than desired.

Invesco’s Mitchell recognises the concern surrounding disclosure. “I completely understand the point. If you don’t know what is in a fund you cannot price it and if you can’t price it, you cannot have an active market in it,” he says.

He explains how one of the Invesco Powershares funds tackles this problem in a way so as to not discourage investors. “Trading in one of our active ETFs does not take place every single day. Instead, trading is only carried out on a Friday,” Mitchell says.

This results in a portfolio that is static between Mondays and Thursdays, thus allowing market makers and investors to know the full holdings of the fund. The only day when this will not be possible will be on a Friday. Mitchell therefore hoped that people would simply alter the way they trade to adjust for this fact.

Morningstar’s Morris, however, expresses concern about whether this scenario would be viable as the fund develops. “This idea could work, but one issue worries me. If a fund grows large, or even medium sized, then it could have trouble bidding a full  2008 funds europe a stock in just one trading day.”

With four funds launched, Invesco is currently the largest player in the active ETF market. It has been a struggle getting there. “My colleagues in the US were in discussions with the SEC for a long time to get this to go through.”

The project had been on the drawing board for a couple of years, but getting over the regulatory hurdles “is proof and recognition of the strength of the ETF structure”, Mitchell says.

ETFs in Europe
Launching an active ETF in Europe, however, should not prove to be as problematic. Ucits III rules cover both ETFs and mutual funds and therefore managers should be able to move into the space with greater ease.

Henze explains: “In the US an ETF runs on an exemption from regulation. There is no regulation governing ETFs as such. In Europe the regulation is much more open and modern.”

Tohme Adet, of BNP Paribas, agrees that European regulation is very aware of innovation. However, there is a caveat. “Products still have to be transparent to fit in with the ETF eligibility in most European countries,” he says. “However, as long as the active index’s strategy is clear and transparent and communication to the investor is straightforward, then the regulator is open to new vehicles.”

© 2008 funds europe

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