ETFs' New Wrinkle: Actual Managers

When a handful of actively-managed exchange-traded funds were launched a year ago, they were touted as a product that could knock mutual funds off their perch. For investors, they offered better tax efficiency and trading flexibility than traditional funds. And, since their portfolios were tweaked regularly like a managed portfolio, they threatened the fund industry’s conventional wisdom: Investors were better off paying higher fees for the expertise of a seasoned stock picker. Surprisingly, though, the mutual-fund industry has been slow to respond, scared off by the daily transparency required by ETFs.

Until now. Grail Advisors and American Beacon have fired the first salvo, with two truly actively-managed ETFs set to launch this spring. The funds, one for large-cap value, the other international equities, will be run by American Beacon managers — real people, doing fundamental research, picking stocks and trading the portfolio, just like they would with a mutual fund. This is novel. The first so-called active ETFs, launched by PowerShares, are largely quantitative strategies with restrictions on trading. PowerShares also offers what it calls active ETFs, but those are largely quantitative strategies with restrictions on trading. 

As for those pesky disclosure concerns, Grail and American Beacon have come up with a radical solution: They just don’t seem to care. They'll report their holdings at the end of the day, every day. "If someone wants to front-run, I guess they can," says Grail CEO Bill Thomas. In other words: Bring it on.

That’s a blatant challenge to fund managers' historic secrecy. Many worry that if they reveal what they are buying, copycat investors will "front-run" them by getting into the stock before or ahead of them, either to ape the investing strategy or to drive up the price. There’s nothing illegal about that, but for a manager who wants to establish a position over time, it could be costly. And it's this fear that makes managers want to be as secretive as possible.

That concern is overblown, says Bradley Kay, a Morningstar ETF analyst. Front-running a manager is harder than it sounds — you’d have to decide whom to follow, then maintain a portfolio of identical stocks. For retail investors, trading costs and tax consequences might actually make it more expensive than just buying the mutual fund, or a potentially cheaper ETF. And, Kay notes, there’s actually a lot more disclosure and transparency already: Any mutual fund manager who also runs separate accounts is required to report changes to the portfolio as he makes them; some mutual funds already report to their institutional clients monthly.

For the majority of managers, says Kay, “it’s just ego.” He notes that there are very few managers that qualify — technically and talent-wise — to have front-running be a real concern. But the industrywide secrecy comes at investors’ expense: Right now, mutual fund shareholders only get to see what’s in their fund every three months. If a manager is building a stake in financials, say, an involved shareholder might want to know it before it’s a fait accompli. And Grail and American Beacon are betting that in this market, investors will want to know more, not less. “It’s a good-guy issue,” he says. “Transparency is a good thing.”