Institutions' resistance to active ETFs may ease

Five years after the launch of the first active ETF — a short-lived short-duration bond fund from Bear Stearns — and one year after Pacific Investment Management Co. listed an ETF version of its Total Return Bond Fund, the case for active ETFs remains a difficult one.

Pension funds, endowments and other large institutional investors, in particular, are far from convinced. Using passively managed ETFs primarily for manager transitions and liquidity, they would need to transform their views on ETFs in general to welcome active ETFs into the fold.

The environment challenges a recent McKinsey & Co. forecast that actively managed ETFs could reach $500 billion in assets by 2020 — a far cry from today's $12.5 billion.

For long-term (or short-term) active strategies, pension funds have been better served by institutional funds, commingled trusts or separate accounts in which they can exercise significant discretion on price and strategy.

But two trends are emerging that could bring institutional participation in active ETFs closer to reality.

The first involves the ongoing reform for the $2.65 trillion in money-market mutual funds. Onur Erzan, a New York-based partner at McKinsey and lead author of “The Second Act Begins for ETFs,” sees the discussion of floating net asset value for money-market funds as a half-step to ETF conversion and intraday liquidity.

Of the 56 available active ETFs, the four largest are fixed-income funds. Active equity ETFs continue to be a much harder argument.

Both asset managers and institutional investors are worried about front-running or cherry-picking of their investment strategy.

But a second trend that could alleviate some concerns comes in the recently accelerated pace of exemptive relief approvals from the U.S. Securities and Exchange Commission. In order for an asset manager to offer an exchange-traded fund, it must first apply for relief from certain provisions in the Investment Company Act of 1940.

A 2011 proposal by BlackRock Inc. for non-transparent active ETFs and a more recent filing from Precidian Funds both suggest paths to keep ETF intraday pricing fair for all market participants while moving disclosure to quarterly from daily, the current requirement for active ETFs. Neither filing has yet been officially noticed by the SEC.

“Each of these proposals is trying to solve the same challenge,” said Michael Mundt, a partner at Stradley Ronon Stevens & Young LLP in Washington.

“Is there a way to protect portfolio management while providing enough transparency so that market makers can make efficient markets?” asked Mr. Mundt, who left the SEC in 2011 after almost 14 years. During his tenure as a regulator, he helped draft the active ETF concept release in 2001 as well as the 2008 ETF rule proposal and oversaw the office approving exemptive relief.

Chris Hempstead, director of ETF execution services for WallachBeth Capital LLC, New York, affirmed that quarterly disclosure would present a challenge for market makers. “It's hard to hedge a product when you haven't seen the holdings in a few months,” he said.

Indeed, no name-brand equity manager or firm has followed the lead of PIMCO, although several have cleared the initial regulatory hurdles to do so. Moreover, Ben Johnson, head of passive research for Morningstar Inc., Chicago, points to a successful equity manager like Bruce Berkowitz of Fairholme Capital Management who indicated in February that he's considering a move to more patient capital in a non-'40 Act structure.

“There will be focused opportunities where active ETFs make sense,” said Shundrawn Thomas, Chicago-based managing director of Northern Trust's ETF group, FlexShares, but issuers will have to “really clarify the value proposition.” Several advantages of passive ETFs, such as transparency, liquidity and total cost of ownership, do not necessarily translate to active strategies.

If anything, the most significant impetus to figure out active ETFs is the potential to expand into new channels and new customers for asset management firms. Their distribution model is changing with the shift to fee-based advisory for retail clients, said Mr. Erzan of McKinsey.

Yet Mr. Erzan acknowledges the wider challenges of the institutional market for active ETFs, particularly the customization in mandates and the constraints of the ETF structure.

Many industry observers, however, point to the initial skepticism around index equity ETFs in 1993 and, later, fixed-income ETFs in 2002, as an indication that “the pent-up potential for active ETFs,” as Mr. Johnson of Morningstar put it, could very well be relieved by the brand, resources, marketing and distribution strength of an industry leader.