WASHINGTON - Actively managed exchange-traded funds, which would compete directly with mutual funds, are moving closer to fruition.
The Securities and Exchange Commission issued a "concept release" earlier this month, asking for comments about how to regulate actively managed ETFs.
So far, the only ETFs that have been traded in the United States have been index-based funds.
ETFs are mutual funds that trade like stocks on exchanges, changing price throughout the day. They increasingly are seen as competitors to standard mutual funds.
Index-based ETFs have become popular because of their low costs and tax efficiency.
Sales of ETFs this year are expected to be just less than $42 billion, slightly down from last year's volume but up from only $6.4 billion in 1998.
The number of index-based ETFs had grown to 78 by the end of 2000, up from 30 at the end of 1999. Assets held in the funds had increased 86% to nearly $63 billion, from less than $34 billion over the same time.
As it studies the comments - which will be accepted until mid-January from the industry and the public - the SEC will explore setting up a pilot program to trade actively managed ETFs.
Release details concerns
The SEC's release, which had been expected for some time, details the agency's concerns.
A chief issue to be addressed is how investors and market makers would price the funds, because fund managers could change their investments during the trading day, said David Smith, associate director of the SEC's division of investment management.
"We're interested ... in the operational aspects of an exchange-traded fund - how it's run day to day, including transparency," said Mr. Smith, adding the SEC also wants to examine "how investors of all types - retail and institutional - would use an actively managed product."
So far two companies have applied to offer actively managed ETFs to the public: Rydex Funds of Rockville, Md., and ProFunds of Bethesda, Md., Mr. Smith said.
Officials at Rydex would not comment on the issue, and Michael Sapir, chairman of ProFunds, was unavailable to comment.
Both companies are noted for their sector funds and offerings targeting market timers.
Boston-based State Street Global Advisors is the largest ETF manager, with $42 billion in assets and a market share of about 45%. Gus Fleites, director of exchange-traded funds at State Street, said his company plans to offer actively managed ETFs. But he acknowledges there are significant regulatory challenges.
Because the composition of index-based ETFs changes infrequently, investors and market makers know what the underlying asset value is. If the funds trade at a premium or a discount, market makers will step in and trade the funds until the price matches the net asset value. If active managers made their holdings public on a daily basis, traders front-running the funds could harm investors.
But, Mr. Fleites said, "there are a number of ways of satisfying the market-making community and the investor community, to tell them how a product may behave without having to actually disclose what's in it."
He suggests active ETF managers be required to disclose such factors as the size of the securities they are trading, the concentration of funds in particular market segments and industry sectors, and whether they trade stocks with high or low price-earnings ratios.
The managers should "describe the portfolio in as much detail as possible so investors and traders can get comfortable with how the fund is going to behave, without disclosing the actual holdings in the fund," said Mr. Fleites.
Germany began trading in actively managed ETFs earlier this year. Managers of those funds are required to disclose portfolio holdings to a few market makers, who are charged with ensuring the funds trade at fair prices.
But that approach is not expected to be acceptable to the SEC. "You'd basically be giving a monopoly to one or two firms," said Mr. Fleites. "In the U.S., the approach has always been much more open."
Joseph Keenan, vice president and global product manager of exchange-traded funds at the Bank of New York Co. Inc., which manages about $35 billion in ETFs, said the industry "has been anxiously awaiting this concept release."
"This is part of an evolution of the ETF product in general," Mr. Keenan said of actively managed ETFs. He argues that even index funds involve some stock picking, because they do not buy all the stocks being tracked. "If you optimize (by choosing the stocks to represent the index), are you not already making an active management decision?"