Actively Managed ETFs: The New Mutual Funds?

By Lisa Smith AAA

The actively managed exchange-traded fund (ETF) evolution continues. The solutions to the operational challenges reviewed in Actively Managed ETFs: Risks And Benefits For Investors have largely been worked out, and now some of the biggest players in the mutual fund space have entered, or will soon enter, the market. This development promises to keep ETFs in the spotlight for many years to come.

Mainstream Appeal
Active ETFs began as a niche product in March 2007, when Bear Stearns launched The Bear Stearns Current Yield Fund. When the firm collapsed, the fund failed, giving second-to-market PowerShares free reign in the active ETF space. It was an opportunity PowerShares took advantage of, quickly becoming the biggest name in the game. Within a year, they offered five active ETFs that attracted a combined total of just over $21 million in assets under management by late summer 2009.

See also: Exchange-Traded Funds

Other product providers joined the fray, and soon the industry's big guns took notice. With Vanguard, PIMCO and State Street Global Advisors having joined the crowd, active ETFs were on their way to becoming mainstream.

They are largely picking up steam because of the tremendous success of passive ETFs, which have taken the market by storm. When a product attracts a trillion dollars, financial service providers take notice. While the United States remains the world's largest market for ETFs, they've starting to catch on overseas, too. iShares Europe announced an expectation that European assets under management in ETFs would top $200 billion in 2009. It's a far cry from the approximately $20 trillion mutual funds had in assets under management in early 2009 (30% of which was in Europe), according to the Investment Company Institute, but is still a healthy number that few firms would turn down if they had an opportunity to get a piece of the pie.

Making the Leap
The jump from passive to active management opens up the door to a broad range of active strategies that can be bought as standalone products or mixed and matched to build a portfolio. It also expands the flexibility of asset allocation decisions, enabling investors to choose passive management, active management or a combination of both, without leaving the ETF universe. (For more, take a look at An Inside Look At ETF Construction.)

Better, Faster, Cheaper
Active ETFs offer all of the advantages of mutual funds: professional management, low cost of entry based on minimum account requirements that are generally only a few hundred dollars, and low maintenance via delegating the work of stock selection, trading and performance reporting to somebody else. They also have lower expense ratios than mutual funds, better tax advantages, greater trading flexibility and better transparency of underlying holdings.

Cons
Despite their popularity, ETFs do have a downside that investors should consider. The growing interest in active ETFs raises particular concerns regarding tax efficiency and costs. One of the reasons passive ETFs are tax efficient and inexpensive is that they make relatively few trades. Going active will almost certainly reduce tax efficiency and increase costs, negating some of the reasons for buying ETFs. (For additional insight into the downside of ETFs, read 5 ETFs Flaws You Shouldn't Overlook.)

The Bottom Line
As active ETFs build market share, grow in size and get adopted by many investors and financial product providers, they will become a serious rival to mutual funds for market share. The exciting possibilities offered through active ETFs are still in their infancy, but the future looks bright. Additional efforts are underway to further refine and build upon the infrastructure models now in place, and innovative firms are already seeking ways to change the way holdings are disclosed to create nontransparent ETFs. That single development alone would likely add additional names to the list of firms interested in doing business in this space. The ETF space has plenty of room for growth and innovation. Watch closely enough, and you just may find yourself investing in the industry's latest creation.

If you are curious to learn more about the differences between mutual funds and ETFs, and how to take full advantage of ETFs in your portfolio, read Mutual Fund Or ETF: Which Is Right For You? If you are interested in adding ETFs to your portfolio, How To Pick The Best ETF will help you choose from among the hundreds of exchange-traded funds on the market.

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