Exchange-traded Funds have traditionally been considered as purely passive, beta-indexing tools for basic market exposure. But with the rise of active management in ETFs, they may start competing with traditional active mutual funds.

ETFs

An ETF is simply a wrapper, a structure around an investment philosophy, process, and portfolio of holdings. However, with increasing investor demand and improved regulatory guidance, there is a potential for actively managed ETF’s to explode.

Actively managed ETFs provide investors access to some of the industry’s best money managers via a low-cost, tax-efficient and transparent product structure that also permits for trading intraday through investors’ brokerage accounts.

In a recent collaborative study arranged by the leading global provider of investment and fund processor SEI Investments Company (NASDAQ:SEIC) with the leading website of financial advisors ETF Trends, an attempt has been made to highlight the potential of actively managed ETF’s.

Creation/ Redemption Process Of Actively Managed ETFs

Actively managed ETF’s come with an innate creation/redemption process that provides for a potentially more tax-efficient product than mutual funds. They are also required to disclose holdings on a daily basis. However, the actively managed ETF’s consist of only 56 ETF’s controlling $12.6 billion in assets under management, as of March 13, 2013. This pales in comparison with the broader all-inclusive exchange-traded product market that encompasses 1,443 U.S.-listed products with $1.46 trillion in assets under management. PIMCO’s Total Return Bond ETF is by far the world’s largest actively managed ETF’s.

However, the number of actively managed ETF’s has been increasing ever since its launch in 2008. Besides increased interest from pension funds, endowments and other large investors set to fuel active ETF space. The regular institutional participation in active ETF’s would also get strengthened with the regulatory scrutiny over the $2.65 trillion money-market mutual funds and discussion about a floating-rate net asset value.

The advisor of the actively managed ETF may buy or sell components on a daily basis without adhering to an index, in an attempt to generate alpha, similar to any actively managed mutual fund. The inner workings of ETF’s are different from mutual funds in that the product has a built-in creation and redemption mechanism to produce or destroy ETF shares at NAV.

However, active ETF’s face some challenges. The creation/redemption process requires the ETF to disclose daily the underlying basket of securities. This requirement poses a major challenge for active ETF managers and is generally considered the main difference, and potentially competitive disadvantage, vis à vis mutual funds which are only required to reveal holdings quarterly.

Recently the SEC has lifted its ban on derivatives that permits portfolio managers to use futures, options and swaps in strategies designed to exploit perceived market inefficiencies and for hedging purposes. This initiative is likely to result in an increase in the number of active ETF launches. The SEC’s actions also make it more appealing for traditional mutual fund companies to enter the ETF space through active offerings.

Sensing the opportunity, PIMCO, the trillion-dollar asset management firm most well known for its bond mutual funds, has launched its own series of actively managed and indexed ETF’s.

Despite its attractiveness, due to the long SEC approval process, new actively managed ETFs have been slow to come to market. The SEC’s Division of Trading and Markets has made sponsors wait between 6 and 18 months to approve their 19b-4 applications, which is required for an actively managed ETF to be listed on the NYSE Arca or NASDAQ. In comparison, plain-vanilla, beta-indexing applications entail 9 to 12 months of SEC review.

Though the active ETFs are still in the nebulous stages, active management may represent the next growth phase in the ETF industry. Adding wind to the industry’s back, the SEC’s lifting of restrictions on derivatives in active ETFs may be the catalyst behind a new wave of active offerings.

With asset management industry known for its innovation and ingenuity, one can expect strong growth and creative solutions through active ETF offerings in the coming years.