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Could less transparency lead to a better investing product?

Actively managed ETFs say they're being hurt by need to disclose their holdings daily

NVESTMENT FUNDS REPORTER

A much-trumpeted challenge to traditional mutual funds has yet to make a dent in the market - but a simple change in U.S. regulations has the potential to open the door to a renewed onslaught of competition.

The challenge comes from actively managed exchange-traded funds (ETFs), which are run by flesh-and-blood portfolio managers, just like most mutual funds, but charge much lower fees.

Despite this apparent cost advantage, only about 28 active ETFs are operating in the United States and 12 in Canada, according to Morningstar Inc. While passive ETFs, which track market indexes without human intervention, have attracted billions in capital and a large following among both retail and institutional investors, several active ETFs have been shuttered because they couldn't attract enough customers.

"The growth hasn't been there yet [for active ETFs] ...but there are a number of things in the works [in the United States] that could really change this quickly," said Morningstar ETF strategist John Gabriel.

A major problem has been a rule that requires U.S.-listed ETFs to reveal their holdings daily. This allows potential competitors and interested investors to front-run the ETF's trades - that is, buy stocks before the ETF can establish a full position and, in doing so, pump up the prices of those shares.

The solution? Less transparency.

BlackRock Inc., the world's largest ETF provider with its iShares brand, has joined other companies seeking regulatory approval to launch active ETFs that don't have to publish their holdings daily.

"A lot of players are waiting on the sidelines to see how the disclosure issues works itself out," Mr. Gabriel said. "It would be a game changer for active equity ETFs if they could disclose like mutual funds [which reveal holdings quarterly in the United States]."

Several U.S. mutual fund firms, including Legg Mason, John Hancock, and Janus, have filed to launch active ETFs. Big-name managers are also getting into the game. Among them is Bill Gross of Pacific Investment Management Co. LLC, which is seeking to launch an ETF version of its flagship PIMCO Total Return mutual fund in the first quarter of next year. "[Mr. Gross's entry] is definitely legitimizing the whole structure," Mr. Gabriel said.

A recent report by U.S. consulting firm McKinsey & Co. indicates that active ETFs could hit $1-trillion (U.S.) in assets within a decade if their growth follows the path of their traditional peers.

Canada already has the less transparent environment that U.S. ETF players desire. Canadian fund companies are only required to disclose their top 25 holdings once a quarter and reveal all their holdings semi-annually.

But major fund companies have yet to venture into the domestic market. Canada is lagging because most mutual funds here are still sold by advisers who are paid by commissions embedded in the fees charged by these investments, said Dan Hallett, a fund analyst at HighView Financial Group.

South of the border, there are more do-it-yourself investors and advisers who charge fees separately for their advice. "The U.S. has 10 times the population so you don't need to capture as much of that market to make ETFs economically feasible," Mr. Hallett said.

Canadian mutual fund companies will eventually embrace active ETFs as another way to distribute their offerings, predicted Howard Atkinson, chief executive officer of Horizons Exchange Traded Funds Inc., which runs active and traditional ETFs. Once a major domestic mutual fund company adds active ETFs to its line-up, "that will be a wake-up call," he predicted. "You will find a pretty quick rush to gain entrance."

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ACTIVE ETF PIONEERS

Active ETFs have experienced more than their share of setbacks during their brief history in North America.

The first was a short-term bond offering launched in March, 2008, by Bear Stearns Cos. Inc. and then closed later that year by the failed U.S. investment bank. Grail Advisors began rolling out active ETFs in May, 2009, but terminated two of its seven offerings last year. In May, a unit of Ameriprise Financial Inc., bought Grail's business, and recast its ETFs with new managers under the Columbia brand.

In Canada, Horizons Exchange Traded Funds Inc. merged its first active ETF, Horizons AlphaPro Managed S&P/TSX 60 ETF, into a passive index offering last May after taking in less than $10-million in assets.

"That's a fact of life in the actively managed space," said Horizons chief executive officer Howard Atkinson. "Some don't work out."Shirley Won

© 2007 The Globe and Mail. All rights reserved.

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