The evolution of the exchange‐traded fund: is active management on the horizon?

Abstract

PurposeTo discuss how product innovations in exchange‐traded funds (ETFs) have blurred the line between passive and active management, and to explore the legal ramifications of these developments.Design/methodology/approachDescribes how ETFs operate and how the ETF marketplace has grown; discusses the use of broad‐based indexes for most ETFs until recently; describes newer ETFs that provide targeted exposure to narrow market segments; and discusses underlying indexes that are based on performance‐based characteristics rather than market segments, along with possible difficulties in making performance‐based criteria widely available to investors.FindingsHistorically the SEC has expressed skepticism over actively managed ETFs because of uncertainty as to whether they can provide the same portfolio transparency and arbitrage opportunity that traditional ETFs can. As “Rule Sets,” or criteria for including companies in performance indexes, become more involved and less objective, the challenge will be to ensure that sufficient arbitrage opportunities exist to ensure pricing efficiency. If that challenge can be met, it may serve as a model for a truly actively managed ETF.Originality/valueExplains how the new generation of ETFs is coming closer to the line of active management and the legal issues that must be surmounted before truly actively managed ETFs are offered.