What's wrong with actively managed ETFs?

Nov 18, 2009 @ 9:08 am

By David Hoffman

Although actively managed exchange-traded funds are just in their infancy, many financial advisers and even some ETF providers have already written them off.

That's a mistake.

This week saw the launch of two actively managed ETFs: the Pimco Enhanced Short Maturity Strategy Fund (MINT), from Pacific Investment Management Co. LLC, and the iShares Diversified Alternatives Trust (ALT), from Barclays Global Investors.

Other such ETFs are planned.

It may take some time, but actively managed ETFs are likely to catch on with investors.

Edward McRedmond, senior vice president of portfolio strategies at Invesco PowerShares Capital Management LLC, explained it best during an InvestmentNews round table on ETFs held Nov. 4, an edited transcript of which will appear in the Nov. 30 issue.

ETFs, unlike conventional mutual funds, allow investors to pay most capital gains upon final sale of the ETF. That feature means that money earmarked for taxes in a mutual fund can continue to grow within an ETF.

“If you can capture back a big part of what's lost through the mutual fund delivery vehicle, that in and of itself should be a huge value for delivering active management through the ETF structure,” Mr. McRedmond said.

Although actively managed ETFs have grown slowly since Invesco PowerShares launched the first equity-oriented versions in April, 2008, Mr. McRedmond isn't wrong about the product's potential.

Many ETF watchers, however, aren't convinced.

They say investors aren't asking for actively managed ETFs, and the transparency required for the product makes creating a truly active ETF nearly impossible.

For some, their arguments hold no water.

“In fairness, no focus group ever asked for the microwave oven,” Noel Archard, head of iShares U.S. product research and development at Barclays Global Investors, said during the round table.

But the appliances are now in almost every home. The same could be true of actively managed ETFs one day.

But what about the transparency issue?

The Securities and Exchange Commission insists that ETFs provide investors with transparency equivalent to that of stocks.

Total disclosure of holdings isn't an issue for ETFs that follow an index, but active managers are leery of telegraphing their moves for fear of tipping their hand to potential copycats or arbitrageurs.

Those fears, however, are probably overblown.

Arbitrageurs are unlikely to target an actively managed ETF unless it grows to the behemoth size of a Fidelity Magellan Fund, for example.

And while there may be a few do-it-yourselfers willing to devote the hours needed to monitor an actively managed ETF in order to duplicate it themselves, most would probably find it cheaper, easier and a lot more efficient to pay the price for the ETF.

Then there is the issue of commissions.

Because investors have to pay a brokerage commission to trade ETFs, the vehicles are not always suitable for investors — especially those who buy at regular intervals and dollar cost average.

But commissions have been declining, a trend that's likely to accelerate now that The Charles Schwab Corp. is making its own ETFs available to clients commission-free.

All of this bodes well for the development of actively managed ETFs — if the ETF creators don't shoot themselves in the foot.

Consider cost. One of the most popular features of ETFs is that they are low-cost. If ETF providers launch actively managed ETFs that are priced above their mutual fund competitors, even the other advantages of the ETF structure won't be able to win over investors.

Then there's performance. Before an actively managed ETF can attract assets, it needs to prove it can add value.

That wouldn't be an issue if ETF providers could develop an ETF as a share class of an existing, successful actively managed mutual fund. Unfortunately, The Vanguard Group Inc. holds the patent on that idea, which may limit what other fund sponsors can do.

But while it has come out with ETF shares of its existing index funds, Vanguard hasn't signaled any intention to launch ETF shares of its most popular actively managed funds. It has filed papers with the SEC, however, to offer ETF shares of existing actively managed fixed-income funds.

It's a step in the right direction.

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