The SEC has cleared the way for the first set of actively-managed ETFs to trade! Well, pretty much. Here's a link to a notice that the SEC posted on its site a few days ago. (Kudos to the Wall Street Journal and IndexUniverse for catching it; I sure didn't.) 

http://www.sec.gov/rules/ic/2008/ic-28140.pdf

There has been much ink spilled over actively-managed ETFs. What will they look like? How will they work? How much will they cost? What damage could they wreak on traditional mutual funds? And on and on it has gone.

Well, now they appear to be one big-step closer to reality, albeit with a catch. The SEC "sort of" cleared four PowerShares actively-managed ETFs in that while the notice effectively exempts the funds from certain provisions of securities law that might have stood in the way of an actual listing, it also gives interested parties the opportunity to request that the Commission hold a hearing on the exemption. The deadline for requesting such a hearing is end-of-day Feb. 26, 2008. Following is a link to the prospectus for the forthcoming PowerShares actively-managed ETFs...

http://www.sec.gov/Archives/edgar/data/1418144/000110465907085013/a07-30006_1n1a.htm

What's struck us in examining the filings for the PowerShares actively-managed funds is how...well...kind of blah they seem. For instance, two of the four will be quant funds managed per a restrictive mandate that places caps on the numbers of trades the manager can make and limits those trades to a very narrow window (each Friday after market close). That might prove to be a winning strategy, and is almost certainly conducive to mitigating the risk of front-running while providing adequate disclosure to all parties concerned. However, it's exceedingly difficult to think of a similar strategy that has worked in the open-end mutual fund world.

The third of the three PowerShares active equity ETFs would target the mega-cap space. This offering is much more akin to full-blown active-management in that the manager, an institutional team at Invesco, will be free to trade as it sees fit. But here too it seems like the mandate--investing in some of the largest and most-liquid stocks on the U.S. market--is at least partly a function of the challenges that are unique to the actively-managed ETF structure. Notably, there's a tension between full disclosure of the portfolio and the risk of front-running. Also, while it's great to be able to grant the manager unfettered ability to trade, that can present challenges to the market-makers responsible for assembling the basket of securities that's traded in the course of creating/redeeming ETF shares. A mega-cap mandate makes sense given that these stocks are so actively-traded that they'd seemingly be impervious to front-running. What's more, they're enormously liquid, meaning that the market-maker should have no trouble whatsoever tracking down the securities needed to assemble creation units.

So, what's the problem? That kind of liquidity comes at a cost: market efficiency. That is, it's exceedingly difficult to exploit mispricings that high up the market-cap ladder. Can it be done? Sure. Consistently? Pretty darn tough. There are very few managers that I can think of that have been able to thrive by investing exclusively in mega-cap stocks. And, yet, that's what the team from Invesco will attempt to do using a quantitative approach. Let's just hope it carries an awfully low expense ratio (as of this writing, the prospectus did not set forth the price tag of any of the four ETFs).

The last of the four funds is a low-duration bond ETF which is slated to be managed by a team at AIM. There's nothing wrong with a low-duration bond fund, per se. But suffice it to say that in a relatively homogeneous, return-constrained space like that one, active management will only take you so far. That's not to say that active-managers can't make hay using the usual array of tools (interest-rate, yield-curve, structure, credit). But it's harder to stand-out, especially when low-cost passively-managed alternatives loom. (Also, it's worth noting that this is another mandate where nagging concerns like liquidity and front-running would seem to fade to the background.)

As others have already observed, the debut of actively-managed ETFs will be somewhat anticlimactic in the sense that, in reality, actively-managed ETFs are already alive and well. For instance, there are a bevy of ETFs that track quasi-active benchmarks. In the typical case, these benchmarks use various proprietary screens to sift a universe and select a basket of securities. This is, in effect, active security selection. The weighting and rebalancing of those securities is typically more-mechanical in nature.

But, if these ETFs are cleared--a formality, in our view--it will mark a milestone. And while this initial batch of funds hasn't exactly left us tingling with anticipation, as one of my colleagues put it, "you've got to start somewhere". True enough. True enough.