ETFs vs. Mutual Funds (III)-Actively-managed funds

Similarities between actively-managed ETFs and mutual funds

Actively-managed ETFs have been allowed by the SEC since March 2008.  Like actively-managed equity mutual funds, they fall into two types:

1.  quantitative funds–that is, the fund sponsor creates a set of decision rules that are implemented without exception, typically by computer.  The set may be simple, like:  own equal dollar amounts of each of the 100 largest-capitalization stocks in the S&P 500.  Or the rules might be more complex, with constraints on allowable book value, historical growth rates, consensus earnings estimates and other variables.  There will also doubtless be a sub-rule dealing with borderline cases, to prevent having to trade in and out of a stock that flip-flops between #100 and #101.  Otherwise, the “active” here consists in executing the rules.

2.  “traditional” actively-managed funds–which make use of the subjective judgment of portfolio managers.  These managers are supported in larger organizations by a staff of, among other possibilities, in-house securities analysts, quantitative analysts or an investment committee that creates an “approved list,”  which specifies the only securities the manager is allowed to have in his portfolio.  Discretion given to the manager in forming strategy and selecting stocks runs the gamut from the manager having total control, on the one hand, to being more or less a client relationship manager for a portfolio structured completely by computer or investment committee, on the other.

You can find the general structural similarities in my earlier posts on ETFs vs mutual funds.  The differences?

Differences

In the ETF world, quantitative portfolio concepts dominate. In the mutual fund world, the reverse is true.  Since the history of actively-managed ETFs is so short, and has played out in a vicious bear market, it’s hard to know whether ETF investors simply aren’t interested in traditional active management or whether their choice is mostly a function of stock market conditions.

The main issue for actively-managed equity ETFs, as I see it, is the transparency requirement.  ETFs disclose their entire portfolios every day, usually on their websites.  Mutual funds disclose their holdings once every three months in an SEC filing, although many fund groups disclose the general portfolio composition and the largest positions more frequently on their websites.

EFT disclosure has several implications:

1.  Established money management firms will typically run similar portfolios for many institutional clients and possibly several mutual funds.  Buying a position in a new stock may take, say, ten days.  In order to treat all clients equally, the firm will allocate the stock it has bought on a given day to all clients, in proportion to their size (and at the same average price).  If the firm also manages an ETF, it has to disclose the fact that it is buying a new stock at the end of the first trading day.  Any market professional who knows the firm’s habits will instantly understand that there are nine days of buying left to go–and may act against the buying firm’s interest.  This is a problem.

2.  The firm may decide not to enter the ETF business as a result.  It might try to change its behavior, as some ETF managers have done, buy trading less often and buying more aggressively during a single day.  More recently, however, according to the Wall Street Journal, ETF managers have been disclosing to potential buyers that they may elect to buy for the ETF after they have bought for other clients.

3. ETF market makers can have a significant information advantage over active-ETF traders.  It’s a relatively simple matter to set up a continuous intraday NAV calculation for any actively-traded ETF.  So market makers will always have this information at hand.  Will individual investors take the trouble to do the same?  My guess is that most won’t.  If so, actively-traded ETFs should have relatively wide intraday deviations from NAV, making them potentially attractive for market makers.  On the other hand,

4.  volume in actively-traded ETFs can be very thin. Market makers, who trade with individual investors at a premium or discount to NAV, can offload their exposure at NAV to the ETF.  They must do so in so-called “creation units” of 50,000 shares each.  But, for example, the Grail American Beacon Large Cap Value ETF, which launched last Tuesday, had traded fewer than 7,000 shares through Friday.  At this rate, the earliest a market maker could deal with the ETF would be around the Fourth of July.

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