The Case for Active ETFs

Experts say there could be an explosion of new active ETFs hitting the market in 2011.

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Since their debut in the '90s, exchange-traded funds have increasingly gained ground on traditional mutual funds. Total ETF assets under management in the United States topped $1 trillion in late 2010, reflecting investors' growing attraction to their low fees, transparency, tax efficiency, and stock-like characteristics. But until recently, mutual funds offered something that ETFs could not: active management. Traditional ETFs simply track an index (for example, an S&P 500 ETF invests in the holdings of the S&P 500 index), but a new breed called "active ETFs" are piloted by portfolio managers who make buy and sell decisions.

Today, there are 19 active ETFs available to retail investors (the first was introduced in 2009). Experts say there's plenty of pent-up demand for these funds, and they expect the category to grow significantly. "This will be the year of the active ETF launch," says Scott Burns, director of ETF analysis at Morningstar. One reason active ETFs have been slow to come to market is that many fund companies have had to wait a year or two for approval by the Securities and Exchange Commission. Also, because ETFs require more frequent disclosure than mutual funds, some managers have been reluctant to commit to running an active ETF. So far, active ETFs that invest in bonds have attracted the most investor dollars (PIMCO Enhanced Short Maturity Strategy ETF is the largest active ETF), mostly because investors have handily chosen fixed-income funds over stock funds since the depths of 2008's financial crisis.

Active ETFs look a lot like actively-managed mutual funds. Both are headed by a manager who chooses securities, with the goal of beating a given benchmark index. Some invest in a number of underlying funds, and others have flexible mandates, such as the ability to invest in a range of asset classes throughout the world. But there are a number of differences between active ETFs and actively managed mutual funds, such as how they trade throughout the day and how trading is taxed. Here are a few reasons to consider active ETFs:

[See Easy ETF Portfolios for Any Age.]

Lower fees. ETFs are generally cheaper than mutual funds. According to Morningstar, the average annual fee of an actively-managed U.S. stock mutual fund is 1.39 percent, while the average fee for an active U.S. stock ETF is only 0.82 percent. (Of course, traditional passively-managed ETFs remain the cheapest. The average U.S. stock ETF charges only 0.49 percent.) Morningstar research has found that the cheapest funds outperformed the highest-cost funds in every asset class over different time periods that range between three and 10 years.

Greater liquidity. ETFs trade on exchanges like stocks, so investors can buy and sell shares of an ETF throughout the day. Mutual funds, on the other hand, are only priced once at the end of each day.

More transparency. ETFs release a list of their holdings on a daily basis, while mutual funds generally report holdings on a monthly basis. If a fund is only tracking say the S&P 500 Index, for example, investors typically know what the fund is invested in all the time because the allocations of the index don't change very often. Conversely, active managers can make much more frequent changes to their portfolio. "It still seems very strange that today people are comfortable not being able to look at exactly what they're invested in at any time they want to look at it," says Noah Hamman, CEO of AdvisorShares, an investment firm that currently offers six active ETFs. "They have the right to know what's underneath that hood."

[See Fundamental ETFs Go Beyond Index Investing.]

Some managers complain that more transparency could affect their performance. "While investors may want [transparency], that may be a sticking point for many managers," Burns says. If managers are forced to report their holdings every day, it could create a problem called "front-running." That means traders could try to profit by predicting a manager's move. Most experts say these concerns are overblown.