It's Good to Be Active, But in an ETF?

Are active ETFs a better deal than their indexed cousins?

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To many investors, "actively traded ETF" probably sounds like a contradiction in terms. Most of us think of exchange-traded funds as passive vehicles distinguishable from index mutual funds only in that they trade intraday, like a stock.

Index funds, of course, merely mimic the holdings of an index, like the S&P 500, and don't attempt to beat it. Doesn't it follow, then, that active management—the use of manager discretion in picking stocks, as opposed to rules based around an index—defeats the purpose of an ETF?

[See The ETF Boom.]

Not necessarily. There's no law that says ETFs must be passively managed. The first ETFs were passive vehicles, but what Index Universe's Matt Hougan calls "quantitatively driven" ETFs—which trade based on obscure algorithms and the like—began to appear about a decade ago. The PowerShares Dynamic Market Portfolio (symbol: PWC), which referenced the Dynamic Market Intellidex Index, was one of the first of this breed.

"The line between those and pure active management is very blurry," says Hougan.

There is no universally accepted definition of "active." Index Universe goes by the Securities and Exchange Commission definition, which holds that whereas index funds must immediately reflect changes in the stock weightings of their reference index, actively managed funds can wait a trading day.

"The only real difference between most of the actively managed and [quantitative] strategies is an eight-hour delay in disclosure," says Hougan.

Morningstar suggests a somewhat different definition: whether the ETF's prospectus lists a benchmark index. If it doesn't, it's probably actively managed. Both Index Universe and Morningstar track 53 actively managed ETFs, in fixed-income and equities. With about $8 billion under management, they represent a tiny sliver of the $1.3 trillion or so in ETF assets.

Most of the action is in just three of those funds, which together account for two-thirds of the active-ETF universe. PIMCO dominates the field with its $2.5 billion Total Return ETF (symbol: BOND)—started just this spring as the tradable version of its huge Total Return fund (PTTRX)—and its $1.9 billion Enhanced Maturity Strategy ETF (MINT). Wisdom Tree's Emerging Markets Local Debt ETF (ELD) weighs in at $1.2 billion.

Whether any of these funds is for you is largely a function of your faith in active management. In any event, it's worth understanding the advantages and disadvantages of active ETFs.

[See Are Leveraged ETFs Just Double-or-Nothing Bets?]

As with passive ETFs, there is intraday trading. You don't have to hold the fund for some minimum period or risk a redemption fee, as is common with mutual funds. You can sell ETFs short and buy them on margin, as with stocks. The counter-argument: Buy-and-hold advocates say intraday trading is more of a vice than a virtue, incentivizing investors to think short-term, which is rarely a good idea.

And, of course, active strategies generally offer the potential for beating the market if a skilled, or just lucky, manager is running the show. Active management costs more, though. According to Morningstar, the 46 actively managed ETFs old enough to have the relevant data show a net expense ratio of 0.79 percent, compared with 0.59 percent for the larger pool of passive ETFs Morningstar tracks.

There's not enough of a track record to say whether higher fees buy better performance, in the aggregate. The oldest of these funds was started in 2008. As of August 17, the 37 funds that launched before January 1 posted a collective return of 4.51 percent year-to-date, compared with 4.74 percent for passive ETFs, according to Morningstar data. Although the pool of active ETFs shrinks very quickly as you go back in time, actives do beat index ETFs in one-year returns (2.25 percent to 2.00 percent) and in annualized two-year returns (4.92 percent to 4.68 percent).

One thing to know about ETF share prices—whether active or passive—is that they are driven by two factors: the net asset value (NAV) of the underlying shares, but also by demand for the ETF shares. Imbalances in supply and demand can produce sharp departures from NAV, though discrepancies tend to get traded away fairly quickly.