However, if you include index-based ETFs that incorporate elements of active management in their benchmarks, then you could argue that active ETFs have already made a big impact on the landscape. And if you're looking for name recognition, a planned ETF version of PIMCO's Total Return Fund would bring bond guru Bill Gross into the active ETF fold, too.
An actively managed ETF is one that has an individual or team making day-to-day decisions about the portfolio and trading securities. In other words, it is not the passive investment strategy tracking an index that most ETFs use. The managers make changes to sector allocations or deviate from a benchmark index with their own investment style and research. Currently, there are fewer than 30 truly active ETFs, but the category represents a major potential growth area for exchange-traded products, which are already the hottest investment vehicles on Wall Street.
"It's a question of when, not if, active ETFs will be part of the landscape," said Tony Rochte, the senior managing director of State Street Global Advisors, at Morningstar's recent ETF conference in Chicago.
While more than 800 active ETFs have been filed with the SEC, Rochte points out that less than 1% of total ETF assets are in active products.
Sue Thompson, head of BlackRock's registered investment advisor group and 401(k) sales, says active ETFs will grow, but regulatory approval will take time. Noah Hamman, the chief executive officer of AdvisorShares, has stated that fewer companies are launching actively managed ETFs under the heightened regulatory scrutiny, and the SEC is taking longer to grant firms exemptive relief. Also, the agency has placed a moratorium on new ETFs that invest in derivatives in the wake of the financial crisis.
Active ETFs still have to overcome some obstacles, says Rick Genoni, the principal and head of Vanguard's ETF product management department. For an ETF to trade properly, its holdings have to be transparent. Active managers, however, don't want to tip their hand on trades. So firms are working on structures for active ETFs that offer the necessary disclosure without exposing the manager to front runners.
Genoni also noted that there are three subcategories of active ETFs: pure active funds, funds of funds, and active strategies rolled into rules-based indices. Since active funds usually spend more time in the regulatory approval pipeline, some firms have instead launched ETFs that wrap active strategies into a quantitative, rules-based index.
The first of the rules-based ETFs have selected high-dividend stocks, utilized technical analysis and weighted companies by other fundamental factors such as earnings or valuation. A growing class of ETFs is now offering a form of strategy-based methodology that mimics decisions made by active managers. However, instead of following the specific decisions of a manager, these types of ETFs track hand-tailored indices that screen for specific qualities in component holdings in an attempt to beat the market.
These ETFs often focus on smaller benchmarks that closely follow specific market factors like the analysis of public company filings relative to frequency of trades, purchases of stocks and increases in holdings by a firm's insiders, as well as data screening strategies that look for earnings analysis based on a company's returns.
The rules- or strategy-based ETFs offer individuals the opportunity to invest in styles and approaches that active managers tend to base their tactical portfolios on. Potential investors are able to benefit from the cheap and easy access to investment strategies that would likely require significant expense and time to mimic on their own. Of course, not every rules-based index approach is a winner, and investors need to do the normal due diligence in terms of understanding the strategy. Also, many financial advisors like to see a track record of at least three years before judging a strategy's success or failure.
Alternative weighting methodologies have been around for years, notably Rob Arnott's fundamental indexing methodology. The idea is to reflect the true underlying value of a company based on factors such as sales, cash flow, book value and dividends. Invesco PowerShares currently offers a suite of ETFs that try to reflect the RAFI Fundamental Indices, along with a suite of ETFs based on the Intellidex Indices.
The PowerShares DWA Technical Leaders Portfolio (PDP) is one of PowerShares' largest and most widely traded funds. It screens for U.S.-listed companies that demonstrate powerful relative strength characteristics from the underlying benchmark, pursuant to the Dorsey Wright proprietary methodology. This methodology analyzes individual stock performance compared to the benchmark index and the relative performance of the industry sectors and sub-sectors.
Along with PowerShares, Guggenheim Investments and WisdomTree Investments have also launched very successful rules-based funds. The Guggenheim Insider Sentiment ETF (NFO) reflects favorable corporate insider buying trends and upwardly revised earnings estimates on Wall Street. The WisdomTree Managed Futures Strategy Fund (WDTI), which has become a very actively traded fund in just 11 months since its inception, utilizes a quantitative, rules-based strategy that helps select long positions in a broad range of futures contracts that are showing positive momentum while shorting contracts that have underperformed.
While not as obvious as the fundamentally weighted indices, the equal-weighting methodology may arguably be a form of rules- or strategy-based methodology, albeit in a basic form. The indexing methodology allows for basic active management in rebalancing component holdings to reflect a specific strategy. For instance, the S&P 500 Equal-Weight Index is rebalanced quarterly to account for changes in stock components and to get back to the original weighting of 0.2% for each stock in the benchmark.
The evolution of indexing methodologies has been consistently moving away from the traditional market-capitalization method, and now a group of companies are beginning to take it a step further. Most recently, Russell Investments launched a line of strategy-based ETFs, including a low-volatility ETF strategy. The new ETF products were designed to help dampen the ups and downs from short-term market movements. While the strategies help mitigate losses in a large fall, these ETFs may also diminish gains during major stock market rallies. Nevertheless, some investors will be able to keep a toe in the markets with some downside protection and perhaps sleep better at night.
Russell Investments' new line of "Investment Discipline" ETFs attempt to follow specific strategies or "lenses" an active manager would normally follow, such as style, quality, sector and concentration, in an attempt to offer different investment philosophies with unique risk/return investment profiles. The funds screen constituent holdings through growth and valuation characteristics; earnings and balance-sheet characteristics; and exposures to various economic sectors. They are differentiated from the underlying benchmark with a number of individual components.
In an attempt to carve out market share in this nascent investment category, PowerShares, iShares and Direxion have also added their own suite of "smart" ETFs that follow strategies like low volatility, correlation, momentum or insider sentiment, covering various major indices. The new batch of "intelligent beta" or "smart beta" ETFs that try to mitigate the large market gyrations have accounted for around a third of total new ETF offerings since the start of October.
Still, investors need to be aware that these products are relatively new to the market. Potential investors should monitor the prospective ETF investments to see how they work and trade. For instance, how often a fund rebalances or reconstitutes individual holdings plays an important role in capturing returns on securities. Some indices are reconstituted monthly, while others may be quarterly, semiannually or even once per year.
With more providers expanding in this ETF space, actively managed strategies are alive and kicking, garnering a wide investment following. The new breed of rules- and strategy-based ETFs are an excellent addition to the ETF universe, providing investors with added diversification and investment options while adhering to specific investment strategies to navigate today's market environment.
Tom Lydon is editor and publisher of ETF Trends, a Web site with daily news and commentary about the fast-changing trends in the exchange-traded fund (ETF) industry. Lydon is also president of Global Trends Investments, an investment advisory firm specializing in the creation of customized portfolios for high-net-worth individuals. Disclosure: At the time of publishing, Mr. Lydon's clients owned IndexIQ Agribusiness Small Cap ETF (NYSEArca: CROP).