Actively Managed ETFs get Big-Name Backing By Rachel Konig Beals for Reuters

CHICAGO (MarketWatch) — Actively managed exchange-traded funds may have gotten the headliner needed to push this sleepy category into the investing mainstream.

Bill Gross and his bond-fund-giant Pimco in early May added a third actively managed ETF to their roster. This offering follows their actively managed Pimco Total Return ETF BOND -0.0095% .

What should investors make of frontier-market exchange-traded funds? Is the proliferation of leveraged ETFs hurting the market? MarketWatch’s Chuck Jaffe asked these questions of three ETF experts at a recent Investing Insights panel discussion.

The ETF, a twist on Gross’s flagship Pimco Total Return Fund PTTAX +0.09% , is drawing a robust following in its short two-month run. It had more than $800 million in assets under management as of mid-May.

The actively managed ETF sub-category has remained a paper-thin slice of the trillion-dollar market. Now, in addition to Pimco, ETF leaders like State Street Global Advisor’s SPDRs, BlackRock’s iShares, Wisdom Tree, and others, look to increase their presence (slowly, for now) in the actively managed side of the business.

“Pimco’s lending its name into the active ETF space is a game-changer for the entire industry. It’s one of those things where if you don’t get ahead of the times, then you are left in the dust trying to catch up,” said Tom Lydon, president of Global Trends Investments and editor of ETFtrends.com.

“With these big-name brands essentially legitimizing this 0.5% corner of the $1.2 trillion ETF industry, this can only reinforce the smaller players already in the space,” said Lydon, who participated on a MarketWatch Investing Insights panel called “ETF Trading: Where the Market Action Is.”
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Joining Lydon at the April event in San Francisco were John Nyaradi, publisher of Wall Street Sector Selector and a MarketWatch contributor, and Jim Wiandt, publisher of IndexUniverse.com, Exchange-Traded Funds Report and Journal of Indexes.
Tactical strategies

Actively managed ETFs, first out in 2008, had just $5.8 billion in assets under management as of mid-April, according to ETF Industry Association data. Of the 47 actively managed ETFs on the market today, 29 have been introduced since 2010.

Why so slow?

Wiandt said a major hurdle is competitive concerns from active managers outside of the ETF space.

“The existing system for them is highly lucrative, where they have a captive audience. They have known basis points. And they have the addresses of their audience and the phone numbers of their investors and they can market to them,” Wiandt said on the panel. “And when you have an ETF, you lose that. So this intermediation, they really don’t want it. They will get there…ultimately…kicking and screaming.”

Nyaradi finds scope in actively managed ETFs for stocks and bonds but stresses that the strongest potential for either market is with “niche” strategies. Pimco’s approach, for instance, is a strategy that retail investors with modest wealth can’t readily access outside of an active ETF.

“This is where the future of actively managed ETFs lies, with niche strategies that open new opportunities either too sophisticated or difficult to execute for most investors,” Nyaradi said.

Such tactics, he added, could include index ETFs, or a commodities play such as precious metals. Or, perhaps, it’s a specific strategy such as Active Bear ETF HDGE -0.46%  , an active ETF started in January 2011. This fund, with more than $270 million under management, shorts various stocks. The ETF rises in value as the underlying holdings decline in price.
Overcoming obstacles

Active ETFs have other “relationship issues” to consider. For one, there’s the negative perception of so-called front running. Because active funds have to reveal holdings on a daily basis, they’re essentially giving a tell to competitors, something their mutual fund brethren don’t have to worry about since they report periodically. So, once in-house research is put to use in an actively traded ETF, that move is exposed to the world.

To address this issue, says Lydon, some providers have floated a few solutions, including withholding publication of positions until the trades settle, shifting to a net-asset-value or NAV-based system, reworking how authorized participants create/redeem ETF shares, or even using a proxy portfolio to imitate an ETF’s actual movements.

Pimco’s inroads in actively managed ETFs may be even more remarkable because bonds aren’t necessarily an obvious fit for an actively managed approach, by some observations.

“The conventional wisdom is that active bond ETFs may be a tougher sell because it’s even tougher to outperform the indices in the bond market,” Lydon said. “Also, transaction costs can matter in bond funds because the returns/yields are so low now.”

PIMCO Total Return ETF vs. Pimco Total Return Fund: YTD

For now, Pimco’s presence in the ETF space is generating a buzz, particularly when it comes to sibling Total Return mutual fund.

“The flagship is like Gross’s baby to be coddled while he can more freely experiment with the ETF version,” Lydon said. “The ETF version also includes a heavier emphasis on mortgage bonds and a lower allocation in Treasuries and other investment grade debt — Gross has stated that he is considering putting in more mortgage options.”

Lydon added: “The outperformance has stirred early interest and if it can keep up, or even outperform the original, we will see more people jumping in. So far, a lot of money is still sitting quietly on the side as many advisors are waiting to better gauge the fund’s performance.”

All told, the panel predicts growth for the stock, bond, commodities, and specialty active ETFs that are mostly just now finding traction. But the scope and pace of the market’s near-term future is difficult to pin down. All the research that pours into active management is expensive and investors have to warm to that premium.

“This space will grow, but the growth is largely dependent on how well managers can maintain alpha,” Lydon said. “Managers will still have to justify their higher costs.”

Rachel Koning Beals is a freelance writer based in Chicago .