PowerShares' Active ETF Launch Gets SEC Green Light

by: Index Universe February 05, 2008    
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Less than three months after winning the race to offer the first prospectus for an actively managed stock exchange-traded fund [ETF], PowerShares is close to getting a green light to launch.

The Securities & Exchange Commission [SEC] has given notice that it's ready to let four ETFs hit the market and be advertised as "actively managed exchange-traded funds."

But there's a catch. The SEC is tying final approval to completion of a public review process. The last time that happened several years ago, public dissent ended any significant efforts to open up the ETF market to active management.

If no public hearing is requested, PowerShares' new lineup of active ETFs can proceed to market, the SEC said in a notice dated Feb. 1. The deadline for submitting hearing requests is 5:30 p.m. on Feb. 26.

Changes Coming?

In some respects, the proposed active PowerShares ETFs will introduce some unique innovations into the marketplace.

But many observers remain skeptical that the new crop will significantly boost returns compared to market-cap size index funds.

"What's the difference between an actively managed mutual fund and an actively managed ETF really going to be for most long-term investors?" asked Allan Roth, founder of Wealth Logic in Colorado Springs, Colo.

While not specifically addressing PowerShares' latest prospectus, he says in general the move towards more active ETFs is "narrowing the market to the point where we're now seeing ETFs more risky and more expensive than some low-cost, low-turnover actively managed mutual funds."

Active bond ETFs are already here. But that's a small piece of the overall marketplace. More than 90% of all ETF assets are estimated to be in stock-focused portfolios. That's roughly the same percentage of all open-end stock mutual-fund assets invested in actively managed portfolios rather than indexed ones.

Advances In Trading Strategies

Even if approved, questions are likely to continue how much the new PowerShares ETFs will push the actively managed envelope. Like its current crop of intellidex-based ETFs, the new offerings appear to be largely quantitatively based.

First Trust AlphaDex and SPA MarketGrader ETFs also could be considered part of these more active yet quant-based ETFs now on the market.

PowerShares first made its request for the active ETFs in November 2007. According to the SEC's notice, the sponsor will offer two ETFs subadvised by AER Advisors Inc. Those are the PowerShares Active AlphaQ Portfolio, which screens from the Nasdaq 100, and the PowerShares Active Alpha Multi-Cap Portfolio. That portfolio would come from domestic large-caps and also use AER's own ranking system.

The firm's methodology includes using computers to crunch data focusing on flow metrics. Those involve sector money flows as well as stock flows. Earnings outlook changes will also be automatically monitored. Returns on equity and changes in fundamental business data will also be sorted. On a weekly basis, AER has said that it plans to review those results. Holdings will be equally weighted.

But the biggest difference will be that the proposed PowerShares active ETFs won't be tied to any specific benchmark. That could be viewed as a key departure for the SEC, which in the past hasn't allowed any potential ETFs to launch without being matched to a specific index.

Perhaps more importantly, the funds won't necessarily let investors know what each fund holds all of the time.

Each morning, PowerShares will disclose the contents of the portfolios on their web site. Most days, the fund manager will not be able to make changes to that portfolio. But on the last business day of each week, the fund manager will be allowed to make up to three trades.

Those trades won't show up in public until the following Monday. The SEC obviously is accepting the index developers' views that since such discrepencies will only take place once a week in a limited number of trades, the fund values shouldn't deviate widely from the published holdings.

Creations and redemptions can't reflect the fund holdings exactly. To get around this, creations and redemptions will be made with a basket of securities that will be similar too-but not identical to-the actual portfolio. In addition, there will be a small cash component to true-up the value of the creation/redemption basket with the value of the portfolio holdings.

Mega-Cap ETF Even More Active

In contrast to the other two equity funds subadvised by AER, the PowerShares Active Mega-Cap Portfolio will be subadvised by Invesco, which owns both PowerShares and the AIM family of funds.

Instead of following a fixed quantitative screen, the prospectus gives the Active Mega-Cap manager wider discretion to implement a portfolio.

The fund will be able to trade at any time and on any day, in contrast to the once-per-week trading of the other two funds.

It can also theoretically trade as much as it wants. Changes in the portfolio will be reflected in the fund's published holdings on the following day, meaning the disclosed holdings may always be one day stale. In comparison, existing ETFs reveal their holdings daily.

This fund will follow the same creation/redemption mechanisms as the funds covered earlier, with representative baskets and a true-up cash component.

A fourth active ETF, the PowerShares Active Low-Duration Portfolio, will offer a similar broad mandate with bonds.

Written by Murray Coleman

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This article has 1 comment:

  •  
    Feb 06 01:34 PM
    It’s hard to determine which rebuttle against Active ETF’s is more ridiculous: that Active ETF funds could be “more risky and more expensive than some low-cost, low-turnover actively managed mutual funds" or that “many observers remain skeptical that the new crop will significantly boost returns compared to market-cap size index funds”

    Who sketched in stone ETF’s had to be low cost, low turnover or less risky? The risk of ETF’s have increased by default. The first wave of ETF’s were built on broad based indices like the S&P 500. The second wave was the sectors like financials, health care and basic materials. Since sectors are less diversified than a broad based index the risk in sector ETFs increased from 1.3 to more than 8 times the volatility of the S&P 500 index (not to mention the slippage in bid/offer spreads and tracking error). The third wave of ETF’s shot risk to the moon with the introduction of sub-sectors (such as biotech), inverse funds and leveraged funds.

    It’s not until the introduction of this latest wave of ETFs do we see the risk subside with the introduction of fixed income, commodity, and hedge fund ETF’s. Not are all are less risky, such as commodities, but they do allow for less than positive or even negative correlation that further reduces portfolio risk in an asset allocation model. Add to this the new wave of high-tech asset allocation models, such as Extreme Value Theory (EVT) and you see significant improvements in risk-adjusted returns over the cap-weighted indices.

    The Market-cap issue is the great façade. In December 2002, the small cap index was comprised of 70% value stocks and 30% growth. Exactly three years later the ratio reverse with only 20% of the index value stocks and 80% growth. How could a value manager or small cap value index possibly beat the small-cap index during these three years? This explains why the fundamentally weighted indices under-performed the cap-weighted indices last year. Market-cap weighting is a market timing index by default! This is why it’s hard to beat. The irony is the buy & hold camp is holding a market timing instrument; now that is humor.

    Furthermore, if you strip out the index funds and closet index managers you will find that active managers soundly beat the indices over time. A study out of Yale, called the ‘Active 50’ by Cremers & Petajisto introduces the Active Share ratio. The Active Share ratio follows a scientific method to demonstrate that true active managers out-perform. Read it and weep proponents of the buy & hold.

    The best part of issuing active ETF’s is it will remove the strangle hold on investors from the latest fad of early redemption penalties imposed by the mutual funds. An active ETF is the killer app against these unwarranted restrictions and penalties. What happened to the fight for fairness, transparency and liquidity?
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