Industry Responds to SEC Request for Comment on Active ETFs By John Spence January 18, 2002

The mutual fund industry is putting in its two cents worth after the Securities & Exchange Commission requested comment on the concept of actively managed exchange-traded funds. The SEC has begun posting responses, and already two of the biggest names on the ETF landscape have weighed in - State Street Global Advisors (SSgA) and Barclays Global Advisors (BGI).

At year's end, San Francisco-based BGI managed 104 global ETFs holding over $21.6 billion in assets under management. Meanwhile, Boston-headquartered SSgA offered 38 funds with nearly $41.5 billion and a dominant market share.

Although comments are still flooding in, two of the forerunners in providing ETFs to institutional and retail investors have addressed the complex issues and regulatory hurdles facing actively managed ETFs.

Barclays Global, which manages a diverse offering of iShares, has a decidedly skeptical view of active ETFs. In particular, BGI anticipates that a lack of portfolio transparency will inevitably cause ETF premiums and discounts to widen in active ETFs. Existing index-linked ETFs are fully transparent, which facilitates the arbitrage mechanisms that keep the price of an ETF in line with the net asset value (NAV) of the underlying portfolio.

"We believe that ETF products that are not fully transparent will have inefficient arbitrage mechanisms and, because of this, will be significantly more likely than traditional ETFs to trade at prices that do not track NAV or otherwise closely correspond to the fair value of their underlying portfolios," writes Richard F. Morris, senior counsel for BGI.

Gus Fleites, who penned State Street's comments, acknowledges the transparency and premium/discount issues raised by BGI. However, he notes "there are potential ways to achieve an effective arbitrage mechanism with less than full transparency, and, potentially, with no portfolio transparency." According to State Street, "proper disclosure of an actively managed ETF's investment strategy and portfolio characteristics" could provide a suitable arbitrage mechanism.

At issue here is how much the manager of an actively managed ETF should disclose of the portfolio.

"Greater portfolio disclosure of an ETF definitely aids in creating greater arbitrage opportunities, narrower bid/ask spread, and lower premiums and discounts," wrote Fleites, a principal for State Street. "With that said, a non-transparent actively managed ETF will be no worse off than closed-end funds trading today. In fact, the premium/discount of a non-transparent ETF should be narrower due to the ETF's open-ended qualities. Because an open-end ETF allows daily redemptions and creation at NAV, the spread (and premium/discount) should be even narrower than that experienced by similar closed-end funds."

These are but the opening salvos as the SEC continues to ponder actively managed ETFs, but it seems clear that State Street and other firms are warm to the idea, as long as investors are made aware of the premium/discount risk in the prospectus. The comment letters also address a myriad of other issues such as just what exactly defines an actively managed ETFs and potential demand for these products from retail and institutional investors.

The SEC will continue to post industry comments at http://www.sec.gov/rules/concept/s72001.shtml.

Index fund and ETF die-hards should definitely check out Gary Gastineau's comment letter. Gastineau, managing director at Nuveen Investments, at the end of his letter also includes an upcoming article entitled, "Equity Index Funds Have Lost Their Way," which examines the hidden transaction costs of index investing and calls for more "fund-friendly" indexes.

Coming Soon: NYSE Indexes

Dow Jones and the New York Stock Exchange (NYSE) are teaming up to launch equity indexes to track the performance of NYSE-listed companies in key market sectors and regions. The new benchmarks, the first of which will be launched in the first quarter of 2002, will adopt the Dow Jones Global Industry Classification Standard.

The Big Board, which currently lists over 2,800 companies with a total market capitalization in excess of $16 billion, is hoping it can leverage its brand name in an already crowded index provider business.

"This is clearly a long term investment, and the two institutions involved - NYSE and Dow Jones - could not be more prominent in their specialties," said Gavin Quill, an analyst at Financial Research Corporation.

The New York Stock Exchange has already indicated that the new benchmarks will be the basis for exchange-traded funds - the only question is when.

"I think it is virtually certain that they will swiftly move to create ETFs based on these new indices," said Quill. "That will help bring greater prominence and liquidity to them, and of course challenge their rivals at the American Stock Exchange."