Not all ETFs are index trackers.
For more than two years now, exchange traded fund (ETF) sponsors have been trying to devise a workable model for active ETFs.
The immovable obstacle to moving beyond tracker ETFs to truly active ones is not the lack of potential investors. The problem lies with the ETF share creation process. The way that it works is that ETF 'participants' stump up cash or individual company stock in exchange for the ETF's shares. The incentive for doing so is that they spot arbitrage opportunities between the ETF and the index it's tracking.
The arbitrage incentive depends on the participants knowing what's in the ETF. But if a fund is actively managed, sponsors worry that posting up complete lists of constituents every trading day will lead to their holdings being copied.
The best solutions proposed so far are to make do with an incomplete or approximate list of constituents or to only publish the constituents weekly. This means active ETFs would probably trade at substantial premiums or discounts to their net asset values.
What the active future holds
It's too early to predict how active ETFs will develop, but more of them seems a virtual certainty. With that will come more confusion for investors. My own view is that active ETFs lose the foremost attraction of ETFs, which is a big choice of (stock) indices to track.
Nevertheless, there are some near-active ETFs already in the arena even for UK investors. Indeed, it looks as if the almost active ETF is set to become a lot more prevalent than exchange traded versions of conventional unit trusts/OEICs.
The near-active zone
The largest contingent of near-active ETFs are the five Powershares Dynamic Index ETFs.
Although most of these have been around since 2007, even the largest Powershares Dynamic US Fund (LSE: PSWC) only has a market cap of £17 million. These ETFs do track indices of sorts, so you can see exactly what the constituents are, but their workings, practically speaking, are unfathomable and, hence, unpredictable to outsiders.
These so-called intelligent or quantitative-active indices seem to have done better than market capitalisation ones in the first eight years of the century, but less well since the credit crunch. All of these ETFs trade very thinly indeed.
Also in the frame as near-active ETFs are a couple of funds established in 2009 that aim to imitate hedge funds.
Only the newer of the two, the db Hedge Fund Index ETF (LSE: XHFG), is listed in London. This ETF does track an index but one that follows five of Deutsche's own hedge funds, each of which follows a major hedge fund strategy.
The second of the hedge fund imitators is the US-listed IndexIQ's Hedge Multi-Strategy Tracker. It's an active fund of tracker funds, replicating IndexIQ's own Hedge Multi-Strategy Index's performance.
It manages this reasonably well but -- as a fund of funds -- the double layer of expenses take its expense ratio to 1.08%.
After hunting around for a while, I found a day old list of constituent weightings. It's strong on emerging market equities and all kinds of fixed income at the moment but has no US equities and very little invested in European equities or commodities. If and when a UK-listed equivalent ETF makes an appearance, I probably wouldn't buy it straightaway but I'd certainly want to keep track of its constituents.
In the active pipeline
Marshall Wace's Tops Global Alpha ETF was announced a week ago and is due to be launched in about one month's time.
As first glance, it looked as if it was set to be the first fully active London-listed ETF but on closer inspection it looks more akin to the db Hedge Fund Index ETF, as it tracks the firm's index of their own hedge fund strategies.
What's different is the hedge fund style expenses of the ETF; basic expenses of 1.75% and a performance fee of 20%. Although this ETF and the db Hedge Fund Index ETF may be hedge funds for the masses, that doesn't seem like an off the peg price. Marshall Wace is expecting its ETF to achieve market capitalisation of $0.5 billion quite quickly.
All in all, active or almost active ETFs are going to muddy the waters and present to investors the recurring danger of seeming familiarity.
More on ETFs:
