ETFs Passive No More in Challenge to $7.8 Trillion Market

Exchange-traded funds are posing a new threat to the $7.8 trillion market for active mutual funds by challenging the notion ETFs are only good for tracking benchmarks.

The $552 million First Trust Health Care AlphaDex Fund (FXH), offered by Wheaton, Illinois-based First Trust Portfolios LP, follows an index that selects and weights U.S. health-care stocks based on a proprietary mix of financial measures such as sales growth and return on assets. Since its creation in 2007, the ETF has beaten the S&P 500 Health Care Index -- 52 stocks chosen to broadly represent the industry -- by almost 6 percentage points a year, and the actively managed Fidelity Select Health Care Portfolio by 3 percentage points annually.

“This isn’t an ETF that’s trying to track a benchmark,” Todd Rosenbluth, an analyst at research firm S&P Capital IQ in New York, said in an interview. “Its aim is to beat it.”

The AlphaDex fund is one of 155 ETFs, collectively holding about $12 billion, that are blurring the line between active and passive investing and threatening to further erode the market share of traditional stock and bond mutual funds. Unlike their passive peers, which use broad indexes to match a benchmark’s return, their goal is to capture outperformance, or alpha. While their assets are still a tiny slice of the fund industry, the payoff for such ETFs is potentially enormous: The pool of money chasing market-beating returns is almost four times larger than the $2.1 trillion held by investors in passive products.

Pimco ETF

Asset managers for years have pondered how to effectively combine the security-selection element of actively managed mutual funds with the tradability, tax advantages and other efficiencies of ETFs. Most have been dissuaded by the product’s necessity to reveal its holdings daily, which allows dealers to create new shares by delivering large baskets of a fund’s underlying securities to the ETF.

Active managers, especially those focused on equities, say that transparency would make it too easy for others to front-run their movements or simply copy them without paying to be in their fund. Some firms, including BlackRock Inc., the world’s biggest ETF provider, have asked permission from the U.S. Securities and Exchange Commission to introduce active ETFs that don’t reveal holdings daily. The agency hasn’t approved any such plans.

Pacific Investment Management Co. runs the fastest-growing actively managed ETF, managed by Bill Gross. The $1.5 billion Pimco Total Return Exchange-Traded Fund (BOND) mimics the strategy of Gross’s Total Return mutual fund, the world’s largest, and doesn’t track an index. Gross buys fixed-income securities, where it’s more difficult for others to copy or trade ahead of a manager’s moves by monitoring holdings.

Hybrid Style

Funds like AlphaDex, which have an active element built into their rules-based indexes, reduce the risk of being copied because the proprietary nature of their models makes their asset selection difficult to predict. They’re also cheaper than funds that employ an active manager, making copying their stock selection impractical. The average expense ratio of First Trust’s AlphaDex series is 0.75 percent, according to data compiled by Bloomberg. That compares with the 1.41 percent charged by the average actively managed U.S. mutual fund, according to data compiled by research firm Morningstar Inc.

“It ends up being a hybrid between active and passive,” Ryan Issakainen, ETF strategist at First Trust, said in a telephone interview. “The ETF itself is still a passive instrument insofar as it follows an index, but the index is much more active than a traditional market-cap-weighted set of companies.”

‘Relative Strength’

The AlphaDex Health Care ETF is the largest of its kind in the U.S. seeking to beat a benchmark. Other funds include the $547 million PowerShares DWA Technical Leaders Portfolio (PDP) and the $382 million United States Commodity Index Fund.

The PowerShares DWA fund, which invests in U.S.-listed companies, uses an index that selects them based on “relative strength,” a proprietary screening methodology developed by Richmond, Virginia-based Dorsey, Wright & Associates Inc. The fund has advanced at an annual rate of 2 percent since its inception in March 2007, compared with the 1.2 percent gain for the Standard & Poor’s 500 Index over the same period, and the 3.8 percent increase in the Russell 3000 Growth Index.

The United States Commodity Index Fund tracks an index programmed to select from 27 eligible futures contracts based on “observable price signals.” It has returned 11 percent since its inception in August 2010, compared with a 0.5 percent decline for the S&P GSCI Total Return Index. The fund, which tracks its index using derivatives, is offered by Alameda, California-based United States Commodity Funds. The index is provided and maintained by SummerHaven Investment Management LLC in Stamford, Connecticut.

Fundamental Indexing

The idea that better indexes could be built on measures of strength such as cash flow isn’t new. Robert Arnott, the founder of Research Affiliates LLC, in 2005 debuted “fundamental indexing,” which shuns picking components of an index based on market capitalization.

Research Affiliates has licensed the use of its proprietary indexes to companies including Atlanta-based Invesco Ltd. (IVZ), which is the second-biggest provider of alpha-seeking ETFs. Invesco has about $3.5 billion within its PowerShares ETF series. First Trust is the biggest, with about $4.2 billion in ETFs that seek to beat traditional market benchmarks, according to data compiled by Morningstar.

Eroding Share

Their offerings may further erode the market share of active mutual funds, sold by traditional money managers such as Fidelity Investments, Capital Group Cos. and Franklin Resources Inc. The companies tout the ability of their managers to beat benchmarks mostly through individual security selection.

“Historically, active managers held a unique appeal to prospective investors,” said Steven Bloom, who helped develop the first ETF in the 1980s and is now an assistant professor of economics at the U.S. Military Academy at West Point, New York. “Now, ETFs are infringing on that territory by holding out the prospect of alpha.”

ETFs have benefited from the growing popularity of index- based investing, pioneered for retail clients by Vanguard Group Inc. Indexing proponents like Vanguard founder John Bogle, argue that active management will underperform markets, so investors are better off using cheaper, traditional index funds.

Trailing Benchmarks

Of 172 U.S. diversified domestic stock funds with $50 million or more in assets, a track record of at least 20 years and the S&P 500 as their primary benchmark, 10 beat the index in the two decades ended Dec. 31, according to data compiled by Bloomberg. The data doesn’t include funds that didn’t survive the full 20-year period.

ETFs and index mutual funds together attracted $173 billion in 2011 while actively managed mutual funds lost $31 billion to withdrawals, according to data compiled by the Investment Company Institute. Active funds’ proportion of mutual fund and ETF assets has declined to 79 percent from 86 percent since the end of 2006.

First Trust’s original 16 alpha-seeking ETFs, opened in 2007, attracted little interest until they established a three- year track record, a crucial milestone for many financial advisers, Issakainen said. They have since grown more than 10- fold. Another 23 First Trust funds, opened in the past 13 months, hold an additional $231 million.

Tax Advantages

“It’s coming quite often from the traditional actively managed open-end mutual fund,” Issakainen said of client deposits.

The ETF structure provides investors certain advantages over mutual funds. For those eager to trade, shares can be bought and sold throughout the day. For those who wish to buy and hold, unlike with mutual funds, they don’t share in the costs created by other investors who trade more frequently. ETFs also bring tax efficiencies that mutual funds can’t achieve.

While some providers may find limited success, alpha- seeking ETFs probably won’t do better at attracting assets than other rules-based investing strategies, Luke Montgomery, an analyst at Sanford C. Bernstein & Co. in New York, said in an interview.

Among traditional U.S. mutual funds, rules-based offerings, including quantitative strategies, hold $30 billion, according to data compiled by research firm Morningstar. Rules-based money managers remove human judgment by relying strictly on pre-set formulas, often mathematically based, to select securities.

No Oxymoron

“How good is rules-based investing at generating alpha, and do people really view it as active?” Montgomery said. “And there is still the educational hurdle of convincing investors that active ETFs aren’t an oxymoron.”

Moreover, as with active mutual funds, an ETF’s ability to beat an index doesn’t guarantee it. First Trust’s ETF that invests in consumer discretionary stocks has returned 3.4 percent this year through June 22, compared to a 12 percent return for its corresponding S&P index through the same period.

Still, as long as the SEC shows no willingness to approve less transparent active ETFs, alpha-seeking index funds may continue to gain ground, said Mark Abssy, senior index and ETF manager for International Securities Exchange, a U.S. options exchange.

“If I want to create an ETF with an active strategy that I think will outperform the market and take it to the SEC, the review process may take a very long time,” Abssy said. “But if I create a rules-based index to capture that strategy, there is already an existing framework for regulatory acceptance.”

To contact the reporter on this story: Christopher Condon in Boston at ccondon4@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net

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