Fund Companies to Expand ETF Presence in `12 By Virginia Munger Kahn

The stage is set for more exchange-traded fund launches from traditional fund companies this year. Last month, Fidelity investments moved to significantly expand its role in the ETF market by filing an application for exemptive relief with the Securities and Exchange Commission to roll out a suite of ETFs. The filing envisions the launch of index-based domestic and international stock and bond funds including 130/30 and other long/short funds.

“This filing opens the floodgates for Fidelity to enter the ETF marketplace,” says Jim Lowell, chief investment officer at Adviser Investments, which manages $2.4 billion in mostly mutual fund assets. Lowell predicts Fidelity will bring its ETFs to market within the next six to nine months.

Perhaps even more significant is the upcoming March 1 launch of the Pimco Total Return ETF. “Pimco is a game-changer,” says Robert Goldsborough, ETF analyst at Morningstar. “The fund is run by a great investor who obviously sees advantages in the ETF structure.”

If Pimco can successfully gather assets and negotiate the dangerous waters of daily portfolio disclosure––without significant evidence of front running and free riding––that will blaze a trail for active ETFs from other fund companies , says Loren Fox, senior research analyst at Strategic Insight in New York City.

Since 2009, many fund companies––including Alliance Bernstein, Dreyfus, Eaton Vance, Federated, Janus, Legg Mason, Nuveen, and T. Rowe Price––have filed exemptive relief applications with the SEC in preparation for creating ETFs.

ETFs need exemptive relief from certain provisions of the Investment Company Act of 1940 and SEC rules. To date, though, few of these ETFs from mutual fund companies have seen the light of day.  One reason is the regulatory logjam at the SEC as fund companies have inundated the commission with exemptive relief applications.  It’ll take the adoption of a rule proposed in 2008 that would provide a standard exemption for ETFs from the ’40 Act before the log jam can be broken, said one attorney, adding that should happen once the SEC can refocus its attention away from Dodd-Frank.

But concerns about active ETFs among fund company executives have also held up new launches. In addition to fears of front running, questions remain about how successful active ETFs can be at gathering assets. At $3.6 billion, actively-managed ETFs currently represent less than one-half of one percent of total ETF assets. In addition, there are fears of cannibalizing existing mutual fund portfolios and questions about finding an efficient method for leveraging existing mutual fund portfolios into ETFs.  One particularly attractive method—creating ETF share classes of existing mutual fund portfolios—has been patented by Vanguard Investments.

Answers to some of these questions are likely to come into focus this year. The introduction of new ETFs from brand name fund companies such as Pimco and Fidelity is likely to increase the credibility of active ETFs and accelerate demand, said McKinsey & Co. in an August 2011 report, The Second Act Begins for ETFs.  The asset gathering ability of active ETFs will strengthen further as more active ETFs reach their three-year track records. The first active ETFs qualified for Morningstar ratings in 2011. This year, a total of 20 active ETS will reach that milestone. That will be critical to attracting more assets from financial advisors and institutional investors.

As far as fears of cannibalization are concerned, recent evidence indicates money going into ETFs is “new” money, not money being transferred from existing mutual funds. Charles Schwab reported last year that only 15 percent of the cash transferred by retail investors into ETFs came from mutual funds. Moreover, Vanguard’s experience with ETFs should assuage concerns. While the firm’s launch of ETFs was initially seen as a defensive move, Vanguard is now gaining market share and new assets with its ETF offerings, says Lowell from Adviser Investments.

Finally, Fidelity’s recent filing may point to one path for efficiently creating ETFs from existing portfolio by using a master-feeder structure. In its filing, Fidelity stated that each master fund would operate as a traditional mutual fund and that feeder funds could be ETFs or other mutual funds. “There’s no doubt the master-feeder structure offers economies of scale,” said Goldsborough, although it is too early to tell whether the structure will be widely adopted.

While fund company filings run the gamut from actively-managed domestic and international fixed-income and equity offerings (Alliance Bernstein, Dreyfus, Eaton Vance, Janus, Legg Mason and T. Rowe Price) to passive currency and alternative strategies (Neuberger Berman and Fidelity), industry analysts think fund companies will initially focus on fixed-income offerings.

Pimco has found success with its Enhanced Short Maturity Strategy ETF. The fund is now the largest actively-managed ETF with $1.8 billion in assets. Both Legg Mason’s Western Asset Ultra-Short Duration ETF and Federated’s Active Ultra-Short Fixed Income ETF look to mine that same short maturity, quasi-money market fixed-income vein.

That said, alternative strategies hold a lot of promise for ETF launches. Notable in this area is Fidelity’s filing which focuses on indexes and alternative strategies such as 130/30 and other long/short strategies. Such offerings could tap the expertise of Fidelity’s institutional arm, Pyramis Global Advisors, which has a long track record of managing alternative strategies. The firm also has a suite of enhanced index offerings that could find their way into the ETF space, says Lowell.

Ultimately, Lowell believes Fidelity will shake up the active ETF space by creating ETFs based on its successful Select sector funds. Not only are sector ETFs heavily in demand, but Fidelity would be able to charge a premium over index sector ETFs given their solid track records. In so doing, it could move into actively managed ETFs in a big way at a profit. “They could accomplish three things in one fell swoop,” says Lowell.

Given these developments, analysts expect big brand mutual fund companies to launch more ETFs this year. “This could be a significant year for traditional fund managers expanding their presence in the ETF market,” says Fox from Strategic Insights. “The stage is set for more traditional fund firms to expand their footprint in both active and passive ETFs.”

Says Ogden Hammond, associate principal at McKinsey & Company, “If the number of conversations we’re having with fund companies is any indication, we’ll definitely see more activity in 2012.”