ETF Expert: Active Management

With some 800 unique exchange traded funds listed in the U.S. alone at the end of 2009, there are precious few asset-class niches that have not yet been filled. Looking to invest in municipal bonds maturing in 2014? There's a fund for that. How about nuclear power stocks? There's another fund for that, too. Corporate spinoffs or companies that are buying back shares? Check and check.

As each new fund launch leaves the field a little more crowded, it becomes harder and harder for any one particular fund to differentiate itself from the pack. And since almost all ETFs are set up to track an index, a competitor can appear at any time offering essentially the same fund. If new funds are to be able to attract investors, they will likely need to exhibit something unique, and offer investors the chance not only to match the performance of a particular index, but to exceed it.

For an increasing number of investment managers who either already market ETFs or are looking to start, the pixie dust needed to get new funds off the ground is active management. Mutual funds and hedge funds have long used the drawing power of star portfolio managers to attract investors, and the decade-old ETF industry is now ready to join the crowd.

There are about a dozen actively managed ETFs currently trading in the U.S., though many more expected in the near future. Most of the funds are small, with $25 million in assets or less, though the PIMCO Enhanced Short Maturity Strategy Fund (MINT, $100, NR) has managed to gather more than $100 million, making it by far the largest. PowerShares, iShares, Bethesda, MD-based AdvisorShares and San Francisco-based Grail Advisors also market actively-managed funds, while mutual fund companies including T. Rowe Price, John Hancock Funds and Putnam Investments are all interested in launching their own ETFs.

"Although still a relatively small part of the market, we see growing interest in actively managed ETFs," says Tom Graves, analyst with Standard & Poor's Equity Research and a co-developer of S&P's ETF report. "We expect a growing presence of large, traditional mutual fund or money management businesses in the actively managed ETF areas," he says, because actively managed ETFs offer "an opportunity to further leverage investments that they have already made in such infrastructure as product distribution and research."

PowerShares was among the first to bring actively managed ETFs to market, launching five funds between April and November 2008. Its largest fund is the Active US Real Estate Fund (PSR, $34, Marketweight), which has about $10 million in assets invested in real estate investments trusts selected from the FTSE NAREIT Equity REITs Index. It also markets three actively managed equity ETFs and one fixed-income fund. Grail Advisors launched its first actively-managed ETF in May, 2009, the Grail American Beacon Large Cap Value ETF (GVT, $30, Overweight), and has about $3 million in assets. Since then, it has started six other actively-managed ETFs.

In September 2009, AdvisorShares launched the DENT Tactical ETF (DENT, $19, NR), an actively managed fund that uses "proprietary economic and demographic analysis" to identify consumer spending patterns and attractive asset classes. As of early February it had about $25 million in assets invested in a concentrated portfolio of seven other ETFs, with iShares MSCI Chile Investable (ECH, $53, NR) its largest holding.

BlackRock's iShares started the Diversified Alternatives Trust ETF (ALT, $49, NR) in October 2009, which now has $30 million in assets. The fund owns long and short positions in futures contracts on money market securities and forward currency contracts.

Even with the attractions of active-management, there is still a great deal of hesitation on the part of fund sponsors to launch new actively managed ETFs. One of the major advantages ETFs claim over mutual funds--their lower costs--will necessarily be undercut by introducing active-management, simply because the manager must be paid. While the actively managed ETFs that are currently available have expense ratios that are broadly competitive with other ETFs, their fees are much higher than the least expensive ETFs, and it is an open question how profitable those funds are for their sponsors and therefore how long they will last.

Another issue for fund sponsors--especially those looking to create a new ETF share class for an existing mutual fund or convert the fund entirely to exchange-traded shares--is that of the daily disclosure of holdings. Mutual fund managers disclose holdings quarterly, and even then have 60 days following the end of the quarter to file the information with the Securities and Exchange Commission. Whether they could function as well when their portfolio moves are scrutinized daily remains to be seen, as does whether other investors might find ways to front-run their trades. Having multiple managers for each fund would obscure the moves of an individual manager, but would probably also drive up costs.

Lastly, there is the issue of track records. Star portfolio managers attract investors with track records of success, the longer the better. Managers working for newly launched ETFs would need years to establish a track record strong enough to attract new investors. Whether they can find enough investment to stay in business that long is yet another unanswered question that actively-managed ETFs will have to answer.

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S&P Senior Financial Writer Vaughan Scully can be reached at . Send him your ideas for ETF story topics.

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