Exchange-traded funds (ETFs), in their original incarnation, mirrored various equity market indexes. ETFs that track the S&P 500, the Dow Jones Industrial Average and nearly every other equity index imaginable are widely available and wildly popular. But they are still evolving. The second generation of ETFs does not seek to replicate the performance of a particular market index; rather, it seeks to outperform its benchmarks through active portfolio management. Here we'll take a look at the benefits and challenges of actively-managed ETFs.

The Big Challenge: Transparency
This process sounds rather simple, but it is actually extremely complicated due to the way ETFs operate.

The primary issue involves transparency, as ETFs are required to reveal their holdings on a daily basis, unlike mutual funds, which only reveal their holdings on a periodic basis. Since the first generation of ETFs was based on existing indexes, the underlying holdings were widely published and known to everyone. Indexes rarely change, and when they do, the news about what is changing and when it will change is widely broadcast.

Transparency Challenge No.1: Front Running
With the development of strategies that are based on an individual firm's research, transparency is a concern to money managers on several levels. If the managers reveal their holdings, investors can use that information to construct their own portfolios without paying the money managers for their services. While this is less of a concern at the individual investor level, it involves large sums of money at the professional level. Imagine, for example, if you spent millions of dollars starting a company, hiring a research staff and building a portfolio, only to have another company use your ideas to make investment decisions without spending a dime. Similar concerns arise if you are trying to sell out of a large position or buy into a large position. Such a move can take days to implement as you buy and sell on the open market. Your competitors can use the information to their advantage, trading against you for a profit with a strategy known as "front running."

Transparency Challenge No.2: Daily Disclosure
Another concern that arose during the development of active ETFs revolved around the fact that ETFs trade throughout the day like stocks do. If an actively-managed ETF was making trades throughout the day, its holdings could change multiple times a day, or even multiple times an hour. Providing real-time trading information as the trades happen would be a logistical challenge in addition to encouraging front running. As is often the case, the development of the new product occurred prior to the development of regulatory oversight rules, so the developers were forced to make their best guesses as to the rules that would be imposed. Actively-managed ETFs were well into the development stage and had been submitted to the Securities and Exchange Commission (SEC) for regulatory review before regulators determined the requirements. Ultimately, real-time disclosure of holdings was not required.

Transparency Challenge No.3: Arbitrage
Another transparency concern involved fund pricing and arbitrage. To understand the basics of this strategy, you need to know that ETF shares can be bought and sold on the open market (the method used by most individual investors) or the shares can be returned to the firm that created the ETF in exchange for the underlying securities. For example, if an ETF holds underlying shares of two automakers, an institutional investor holding a large block of the ETF shares (known as a creation unit), can exchange the ETF shares for shares of the automakers. Due to the large number of shares required to form a creation unit, this strategy is generally engaged in only by large institutions.

Arbitrage occurs at the creation-unit level. In the traditional ETF market, if the price of the ETF does not match the price of the underlying holdings, the professional investors create or cash in creation units in order to profit from the price difference. For example, If an ETF is trading at $12 per share, but the value of the underlying stocks is $12.50, arbitrageurs would buy enough shares of the ETF on the open market to form a creation unit and then return the ETF shares to the company that created the ETF in exchange for the underlying shares of stock. The stock would then be sold, locking in the price difference as a profit.

With an actively-managed ETF, if the firm that creates the ETF does not reveal the underlying holdings, arbitrage cannot occur. The result could be an ETF that trades at a substantial premium or discount to the actual value of its underlying holdings.

Solutions for Transparency Problems in Actively-Managed ETFs
One solution that ETF providers suggested to address the transparency issue is that trades occur once per day or once per week and portfolio holdings be released after the markets close. This may not completely eliminate front running if trades take multiple days to complete, but since the fund manager does not have to reveal the trade until after it occurs rather than in real time, it discourages front running because a large portion of the trade may already be complete prior to the release of the news. As noted earlier, SEC regulators accepted these recommendations.

Additional methodologies will, no doubt, be developed as the number of actively-managed ETFs expands.

Benefits of ETFs
The expansion of ETFs in the actively managed realm offers nearly limitless choices. Consider, for example, an ETF that invests in 50 Nasdaq-listed securities in an effort to beat the Nasdaq 100 benchmark, or an ETF that invests in 50 securities in an effort to beat the S&P 500. The funds expand the number of available investments and result in lower costs for many investors, as the expense ratios for ETFs are often just a fraction of the cost of mutual fund ownership. Also, ETFs are able to keep costs low because trades occur on the open market or via redemption for the underlying securities. In both cases, the ETF manager has no need to keep large amounts of cash on hand to handle redemptions the way mutual funds managers must. ETFs can remain fully invested, putting all of their cash to work in an effort to generate investment returns, while mutual fund managers are forced to hold cash. Just be sure to keep in mind that ETF investors do pay to conduct trades, so dollar-cost averaging may not be a cost-effective strategy.

The Bottom Line
While actively-managed ETFs present some new challenges for the market and for investors, they also present new opportunities for diversified investment. As ETFs continue to evolve and new types emerge, it is up to investors to stay informed about the benefits and drawbacks of these securities and to take advantage of what they have to offer, while taking steps to mitigate any risk they may pose.