By Robert Powell, MarketWatch
Last Update: 12:01 AM ET Aug 15, 2012
BOSTON (MarketWatch)A growing number of investment firms, hoping to jump on the exchange-traded-fund band wagon, are launching actively managed ETFs.
In recent weeks, for instance, several large managers best known for their active management, including PIMCO, BlackRock, Fidelity Investments, and John Hancock, either plan to or have already launched funds that seek to give investors the best of both worldsmostly low costs, intraday trading and a chance to beat the indexes.
But do such funds belong in your portfolio? In a word, yes. But experts caution that you shouldnt add actively managed ETFs to your mix without knowing full well the pros and cons of such funds.
First and foremost, investors need to understand that ETFs are a legal and regulatory structure that makes an investment strategy broadly accessible to investors, said Stephen Horan, who is the head of university relations and private wealth at the CFA Institute. ETFs are not an investment strategy in and of themselves. Nor are they a separate asset class.
Thus, said Horan, the pros and cons of actively managed ETFs mostly boil down to the pros and cons of active investing vs. passive investing and the pros and cons of ETFs vs. traditional mutual funds.
Active vs. passive
To be sure, the advantages of passive investing are well known, according to Horan. They include low management fees, low transaction costs, tax efficiency, predictable performance relative to a benchmark, and perhaps, superior performance relative to the average active manager, said Horan.
Active management, by contrast, provides an opportunity for some investors to outperform a benchmark even if the data suggest that the odds are against them, said Horan
Management fees and transactions costs for active investing, meanwhile, are about the same for ETFs and mutual funds, said Horan.
Others, however, say there can be a cost difference. Many of these ETFs have reasonable expense ratios, but some are more expensive than their open-ended mutual fund counterparts, said David Zuckerman, a principal and chief investment officer with Zuckerman Capital Management.
Consider, for example, the total return strategy funds managed by Bill Gross at PIMCO. The Total Return ETF charges 0.55% in expenses, while the institutional share class of PIMCO Total Return charges only 0.46%, Zuckerman said.
Mutual fund vs. ETF
According to Horan, traditional mutual funds and ETFs are similar structures. The most notable differences are the ability of ETF investors to trade intraday at market prices rather than only at the end of the day at net asset value or NAV and the tax-efficiency associated with the ETF share creation and redemption process, Horan said.
For long-term investing, however, the ability to trade intraday is not that valuable, said Horan. Some folks, for example Jack Bogle, argue that simply the temptation to trade during the day is negative attribute of ETFs, Horan said. Others argue that the added flexibility cannot make investors worse off. It boils down to how important one believes the behavior biases are.
For his part, Zuckerman agrees that being able to trade an ETF intraday may not be in an investors best interest. Ironically one of the biggest pros of actively managed ETFsthe fact that they trade on exchanges throughout the daycan also be one of the biggest cons of actively managed ETFs, said Zuckerman.
According to Zuckerman, research has shown that ETF investors tend to trade much more frequently than investors in similar open-ended mutual funds, and studies have shown that high portfolio turnover hurts returns. So while some investors may like the ability to trade actively managed ETFs throughout the day, research suggests that most investors will fare better in a traditional open-ended mutual fund if it uses the same strategy as an actively managed ETF, said Zuckerman. The traditional open-ended mutual fund structure is more conducive to taking a long-term view of an investment strategy when compared with actively managed ETFs that trade on exchanges throughout the day.
The second important distinction between ETFs and mutual funds, tax efficiency for example, relates to the active vs. passive decision, said Horan. Because passive investing is already a tax-efficient investment strategy, the additional tax benefit of the ETF structure is somewhat modest, Horan said. In theory, the ETF share creation and redemption process should have more benefits for active investing, which is characterized by higher turnover and higher capital gains recognition. Interestingly, however, few of the new actively managed funds seem to focus on tax efficient portfolio management.
Active ETFs vs. passive ETFs
According to Zuckerman, one of the biggest downsides to actively managed ETFs is that, just like passively managed ETFs, they can deviate from intraday indicate value. Exchanges publish estimates of intraday indicative value so that investors can determine if an ETFs price is consistent with the current value of underlying holdings, said Zuckerman. Actively managed ETFs can trade at a premium to intraday indicative value, which is a risk that investors in actively managed ETFs need to manage. With an open-ended mutual fund, there is no deviation from NAV, which is published after each trading day.
Indeed, some say actively managed ETFs might not be as transparent at passive ETFs. But Jim Wiandt, the founder and CEO of IndexUniverse views that as a non-issue. I think that has been the big issue, said Wiandt. Everyone holds up the transparency issue and SEC to blame, but I think thats a red herring. I absolutely think where theres a will theres a way, here and the Securities and Exchange Commission will ultimately be amenable to anything that improves the investor experience. And actively managed ETFs are likely to do so.
Said Wiandt: If Im an investor, Ill always take more options. And the tax efficiency, lower overhead and hopefully increased transparency are all benefits that would pertain to an actively managed ETF the same way they do to index ETFs.
Robert Powell is editor of Retirement Weekly, published by MarketWatch. . Follow his tweets here.
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