Active ETFs blend regular counterparts and mutual funds

Eileen Ambrose -- Personal Finance

March 28, 2010|By Eileen Ambrose Personal finance

With more than 900 exchange-traded funds, you can find one that fits every investment sector, strategy or mood you're in. Now get ready for even more variety with actively managed ETFs.

This new product combines the tax and cost advantages of a regular ETF with the expertise of a professional money manager that you get with most mutual funds.

Baltimore's Legg Mason and T. Rowe Price Associates, along with other fund companies such as Vanguard Group and John Hancock Funds, are seeking approval from the Securities and Exchange Commission to offer actively managed ETFs.

"They are an up-and-coming thing," says Brenda Wenning, a money manager at Wenning Investments in Massachusetts. "You will see mutual fund companies moving in that direction."

But the real question for investors will be whether paying a little extra for a professional to manage an ETF is worth the cost.

"That's really the million-dollar question with active management," says John Gabriel, an ETF analyst with Morningstar, which tracks funds.

Regular ETFs have been around for 17 years, and almost all of them passively track a benchmark, such as the S&P 500 index. A big advantage is that ETFs can trade like a stock throughout the day - something you can't do with a mutual fund.

Actively managed ETFs were introduced two years ago, and there are 19 of them with a total of $344 million in assets, according to Morningstar. That's a small slice of the $800 billion in all ETFs.

With an active ETF, a money manager - not some index - decides what securities to hold with the goal of outperforming the market. That's the same objective of an actively managed mutual fund, but again an ETF has benefits that the old-fashioned mutual fund doesn't.

Because an ETF trades like a stock, you can get the price of the shares at the time you buy or sell, giving you more control. When you execute a trade with a mutual fund, you get whatever the price is at the end of the day.

ETFs can trade securities in a way that avoids or reduces capital gains, so investors might not be hit with a tax bill each year. (You could owe taxes when you sell your stake in the ETF, though.)

Mutual funds trigger capital gains when they sell securities for a profit, and they are required each year to pass those gains onto investors. Because of this, you can owe capital gains tax even though your mutual fund plunged that year. Ouch!

ETFs that track indexes are inexpensive to run, so their fees tend to be low. The average annual expense ratio of an active ETF is 0.6 percent of invested assets, slightly higher than a traditional ETF but about half the cost of the typical actively managed mutual fund, according to Morningstar.

And ETFs are transparent. They must report their holdings at the end of each day, while mutual funds might not reveal this for 30 to 60 days, says William Thomas, chief executive of Grail Advisors in San Francisco, which launched seven actively managed ETFs in the past year.

"A lot of investors do appreciate the daily transparency. They want to know what they own," says Morningstar's Gabriel. Many small investors got burned during the 2008 market crash because they didn't know which stocks were in their mutual funds, he says.

It's this transparency, though, that might cause money managers to balk at running actively managed ETFs and stymie their growth.

Managers worry, for instance, that if they must reveal the stocks they bought each day, others will jump in and bid up the price, Gabriel says.

"Equity managers, in particular, are concerned about tipping off what stocks they are buying and selling," says Steve Norwitz, a Price spokesman.

Price isn't ready to announce specific ETFs it will launch, although it could start with an active bond ETF, Norwitz says. He added that Price won't introduce an ETF version of its mutual funds if daily disclosure would hurt shareholders.

Legg Mason is planning a series of stock-and-bond actively managed ETFs, but they won't be replicating the company's mutual funds, says Joel Sauber, head of Legg's U.S. products. It can take up to a year for an investment company to get SEC approval to offer active ETFs. So you might not see a rash of new active ETFs until late this year.

And even then, active ETFs will have to develop a track record of outperforming their benchmarks before the masses are persuaded to invest.

"From what I've seen thus far, there is no reason for me to go out and buy one," Wenning says.

One of the oldest active ETFs, Alpha Q Fund by PowerShares, rose 45.6 percent for the year ending Dec. 31. But its benchmark, the Nasdaq-100 Index, rose by 54.6 percent during that time.

And Grail Advisors' first active ETF, the Beacon Large Cap Value, returned 29.08 percent from its inception last May to the end of the year; while its benchmark rose 29.24 percent.

Officials with the two fund companies say the time period is too short to judge the performance of what's supposed to be a long-term investment.

Lutherville financial planner Nancy Bryant has reservations about active ETFs, saying "there is not enough history" to judge them by. She uses index funds and regular ETFs because she knows what's in them and is content with receiving a return that's similar to the market average.

"I don't have to study the manager and know what changes he is making on a daily basis," she says, which is what she would have to do with an active ETF.

One final caution: ETFs also aren't for those who invest small sums each month, a method called dollar-cost-averaging. Each time you buy ETF shares, you'll pay a commission. And those charges can eat up your investment if you make many small purchases.

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