Bill Gross ETF seen as watershed moment for active ETFs

Wed Feb 15, 2012 3:40pm EST

* ETF version of PIMCO Total Return fund launches March 1

* Launch will make it highest profile active ETF

* Inability to use derivatives a question mark

* Active ETFs account for less than 1 pct of ETF assets

By Ryan Vlastelica

NEW YORK, Feb 15 (Reuters) - Exchange-traded funds have exploded in the last few years, but there's one corner of the market that hasn't seen that kind of growth: actively managed ETFs.

That could all change with Bill Gross.

Actively managed ETFs account for less than 1 percent of all assets in the $1.3 trillion ETF market, barely making a dent in the rapidly growing sector.

That's why ETF product managers and strategists are hungrily eyeing the March 1 blast-off of an active ETF run by Gross, the PIMCO high-profile bond manager, calling it a "watershed moment" for the industry.

Investors use ETFs, which trade like stocks, to gain exposure to nearly any region of the world, industry sector or asset class. ETFs are touted for low fees, transparent structure, and ability to trade throughout the day.

However, actively managed funds, which like mutual funds are maintained by a manager who selects the holdings at his or her discretion, have yet to catch on.

"If this doesn't work, it will be a big black eye for the actively managed ETF industry," said Kevin DiSano, national sales manager at Index IQ in Rye Brook, New York, which manages active ETFs. "PIMCO will call a lot more attention to the space, and if it goes badly that will cause a lag in acceptance. That's unfair because there already actively managed funds with excellent patterns of performance."

DiSano's firm manages a number of active funds, including the IQ Hedge Multi-Strategy Tracker ETF, which has $183 million in assets.

PIMCO's Total Return Exchange-Traded Fund is designed to mimic the strategy of its Total Return Fund , the world's largest bond fund at $250 billion. There's one key difference: regulators have blocked new ETFs from using derivatives, and the Total Return Fund's use of derivatives has grown in recent years.

ETFs have posted massive growth in recent years, with the industry's assets more than doubling to about $1.3 trillion since 2008, according to Deutsche Bank. But active ETFs have been left in the dust. With just $7.6 billion in active funds, they account for a paltry 0.6 percent of the asset class.

Passively managed funds account for $1.255 trillion in assets, or 97 percent of all ETF assets. The rest is comprised of semi-active and "passive plus" funds, which have $36.7 billion between them.

Active ETFs can be traded intraday, with holdings disclosed daily (many mutual funds disclose their holdings monthly or quarterly), and while their fees can be lower than mutual funds', investors have grown accustomed to ETFs with rock-bottom expense ratios. Higher taxes than passive funds are seen as roadblocks to greater acceptance.

PIMCO already operates four active ETFs, including the Enhanced Short Maturity Strategy Fund, which has $1.79 billion in total net assets and is up 0.7 percent so far this year, but the Total Return Fund is the company's flagship.

Through the end of January, the Total Return Fund had an average annual return of 8.35 percent since its start in 1987, outperforming the 7.34 percent return of the Barclays Capital U.S. Aggregate Bond Index.

The inability of the PIMCO Total Return ETF to use derivatives will prevent a perfect correlation and affect performance. The size of that difference will be watched closely and will play a role in the format's acceptance by investors.

Peter Lewis, executive director of liquid markets at Nomura Securities International in New York, said while some deviation will not have a big effect on the acceptance of active ETFs, a wide gulf would be a point of objection.

"Exactly what the correct pain threshold will be is uncertain but there will be a level of over- or under-performance that could either cause the product to wither and die or flourish and grow," he said.

From that perspective, the use by PIMCO's Total Return Fund of derivatives is notable. The fund in January held half of its assets in mortgage-backed securities. The move into mortgage-backed securities comes as the Total Return fund's cash equivalents and money-market securities fell to negative 35 percent, from negative 32 percent in December.

Having a so-called negative position in cash equivalents and money-market securities is an indication of derivative use, said Eric Jacobson, director of fixed-income research at Morningstar, who has analyzed PIMCO for more than a decade.

In addition, short-term securities are put up as collateral as a way to boost leverage and increase holdings in bonds with longer maturities such as MBS, Treasuries and corporate bonds, he said.

A PIMCO spokesperson declined to comment on what deviation there could be between the fund and the ETF.

So far this year the Total Return fund is up 2.7 percent, following two years in which gains were less than half a percent. In 2011 the fund had $5 billion in redemptions, as performance suffered from PIMCO's bet against U.S. Treasuries.

At 55 basis points the ETF has lower costs than the Total Return Fund's class D shares, which go for 75 basis points. Its institutional class carries a cost of 46 basis points. The costs are higher than other popular bond ETFs such as the iBoxx Investment Grade Corporate Bond Fund, which carries an annual expense ratio of 15 basis points.

In January, there were outflows of $20.41 million from actively managed ETFs, according to IndexUniverse data, compared to inflows of $28.81 billion into passive funds.

"This is the big test case. If it's successful, and I think it will be, it will get other fund managers off the sidelines." said Scott Burns, director of ETFs at Morningstar in Chicago. "With the actively managed funds that are already out there, none of them have had a brand-name fund or manager behind them, so there's a lot riding on this."