After a number of false starts, actively managed Exchange Traded Funds (ETFs) finally made it into the marketplace nearly three years ago. But so far the response has been less than enthusiastic. Since they first appeared in early 2008, only 33 actively managed ETFs are in existence with just $3 billion in assets, representing a tiny fraction of the overall Exchange Traded Fund market. There are signs however that all that could change and 2011 could be the year actively managed ETFs take off.
First, the overall Exchange Traded Fund market has surpassed the $1 trillion in assets mark. And second, this is the year the first actively managed ETFs will qualify for Morningstar’s Fund ratings, which many investors rely on to determine where to invest their money. And the first active ETFs will be reaching their three year mark next month.
As you probably know, ETFs exploded onto the market in the 1990s as a low-cost, more transparent and tax friendly alternative to mutual funds. Plus, you trade them like stocks. It didn’t take long for investors to start pouring money into them, even if they really didn’t quite understand how they work.
Basically, a traditional exchange-traded fund was what’s known as a passive investment in that it simply tracks an index whether that index is tied to stocks like the S&P 500, or bonds or even commodities. Where the value of the index went, so did the ETF. Then, after a number failed attempts in the early 2000s, an actively managed ETF was introduced in February 2008 that was controlled by a portfolio manager who made buy and sell decisions.
According to a report in U.S News and World Report many new active ETFs are expected to join the market in 2011 and that should attract more investors. Scott Burns, director of ETF analysis at Morningstar says this will be the year of the active ETF launch.
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 (SEC). Another reason is because ETFs require more frequent disclosure than mutual funds and 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 Intermediate Muni Bond Strategy ETF is the largest active ETF). But that may be because investors chose to put their money into fixed-income funds instead of stock funds that took a beating in 2008 and 2009.
The U.S. News article points out that while active ETFs are similar to actively-managed mutual funds, there also a number of differences as well such as how they trade throughout the day and how that trading is taxed.
For example, 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. Both are more expensive than the average passively-managed stock ETF, which charges only 0.49 percent.
You may want to take note. 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.
U.S. News says another difference between actively traded ETFs and their mutual fund counterparts involves liquidity. ETFs trade on exchanges like stocks, so investors can buy and sell shares of an ETF throughout the day and that includes actively traded ETFs as well. Mutual funds, on the other hand, are only priced once at the end of each day.
If transparency is an issue, actively managed ETFs release a list of their holdings on a daily basis, while mutual funds generally report holdings on a monthly basis. Some fund managers complain that more transparency such as revealing their trading strategies could affect their performance and contribute to something called "front-running." That means traders could try to profit by predicting a manager's move.
As enticing as they may sound, heed this advice. Before you invest in an actively managed ETF, keep in mind they’ve only been around for a couple of years. So at least wait until Morningstar has a chance to review their performance and issue a rating. That way you’ll be able to see whether the fund manager knows what he or she is doing.
