NEW YORK - Here's one that should keep you up at night. The Securities and Exchange Commission is known to approve of Exchange Traded Funds, or ETFs, because they have transparent portfolio holdings, which gels nicely with the commission's agenda to get mutual funds to disclose the contents of their stock portfolios more often. Naturally, ETFs achieve this transparency because they are based on indexes, such as the Nasdaq 100 or the S&P 500.

But how would you build an actively managed ETF, in other words, an ETF that is not based on an index, and still meet the SEC's preference for transparent portfolio holdings?

The company that comes up with the answer to that question could reap billions in new assets, some say, because it will be the first to provide investors with the cost benefits of an ETF and the advantages of active management all in one package.

"People throw out the concept of the active ETF as the Holy Grail," said Joe Keenan, VP for exchange traded products at the Bank of New York, who oversaw a Strategic Research Institute conference about new ETF strategies here last week.

The idea of an actively managed, exchange-traded fund, has been brewing for at least two years, but the concept has been getting renewed attention. In a speech to the American Law Institute and the American Bar Association last month, Paul Roye, director of the SEC's Division of Investment Management, said that the commission has already received applications involving what it considers to be actively managed ETFs. One approach is an inverse multiple of an index. Roye said the concept has "attracted considerable interest."

Rydex Funds, Potomac Funds and ProFunds are all rumored to be working on some iteration of an actively managed ETF. The ETFs might seek to double the beta, or the market returns, of an index, such as the Nasdaq 100. Although those efforts technically involve a benchmark, the SEC has deemed them to be part of the active ETF movement.

Still, the process of bringing actively managed ETFs to the marketplace has been slow. The commission sought suggestions for how the products might take shape in a concept release in November of last year. Not a single product has been approved.

Actively Seeking ETFs

That doesn't mean that the fund industry isn't thinking about introducing them. In a U.S. marketplace where more than half of all U.S. households own a mutual fund, most of them actively managed, fund companies are searching out ways to attract yet more assets. Actively managed ETFs may prove to be the answer, some say.

ETFs, meanwhile, have been a tremendous success story throughout a relentless bear market. Despite a 9% decline in ETF assets in September, according to the Investment Company Institute, assets in the vehicles have increased 56% since 1999, from $33.9 billion to $76.5 billion as of Sept. 30.

In addition, ETFs have long proved attractive for their tax efficiency and their comparatively low fees. So, companies trying to crack into the ETF business might do well to develop a new model for the funds rather than release an also-ran product that runs the risk of blending in with the 280 ETFs that currently trade worldwide.

To be sure, in developing the products, companies will have to address the issue of portfolio transparency with the SEC. Keenan said that the commission is going to focus this aspect.

ETFs have enjoyed exemptions under the Investment Company Act of 1940, largely because they are transparent. Because shares in the funds trade daily on an exchange, the shares can trade at values that vary from the net asset value (NAV) of the fund. But the products' portfolio transparency helps keep those margins at a minimum. Traders who arbitrage the funds take advantage of differences between NAVs and share prices, thus narrowing the margins for the average investor.

So, in proposing an actively managed ETF, "you would have to define what level of transparency you would be proposing," Keenan said.

Not Baring All

But an actively managed ETF would face considerable trading risks were it totally transparent. ETF managers are concerned that institutional traders would ride the coattails of truly transparent, active ETFs and drive stock prices up as new asset allocations are made.

But how would an actively managed ETF be structured? Naturally, managers would do away with the indexes, such as the S&P 500, upon which the popular Spider ETF is based, or the Nasdaq 100, upon which the QQQ ETF is structured.

Rather, active ETF managers would likely build their products around a quantitative model, a set of rules that stocks would have to meet in order to be included in the product, Keenan said. And that quantitative model, if disclosed to the public, might meet the SEC's requirements for transparency, according to Keenan.

Once somebody comes up with the so-called Holy Grail, "there's going to be added pressure to gather significant assets," he said.

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