ETFs Passive No More in Challenge to $7.8 Trillion Market

By Christopher Condon on June 26, 2012

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) (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) (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.”

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