ETF Talk: Actively Managed ETFs

Active management used to be the exclusive province of the mutual fund industry, but thanks to some new exchange-traded funds (ETFs), those days of exclusivity are over.

Actively managed mutual funds frequently do not outperform market averages, so it remains to be seen how actively managed ETFs will fare under a loosening of their traditional focus on matching the returns of specific indexes.

To my knowledge, Invesco PowerShares is the first ETF provider to take the plunge into actively managed ETFs. The company unveiled its plans formally in a Webcast aired Wednesday, April 30. The Invesco PowerShares move into actively managed ETFs shows that the ETF industry is taking a big step forward in trying to compete with mutual funds on what traditionally has been mutual fund turf.

Of course, actively managed ETFs will need to prove themselves as superior to their counterparts that try to mirror the performance of selected indexes. Those of you who have subscribed to any of my advisory services for any length of time know that I regularly scour the mutual fund universe for underperformance. The worst offenders find themselves with the dubious distinction of being named to my "Lemon List" of sour funds.

Well, I can envision the day when I may need to do likewise with actively managed ETFs. I personally wish the people at Invesco PowerShares well, and I will be among those industry observers who track the performance of their actively managed ETFs closely.

The Wheaton, Ill.-based investment firm launched the following funds on April 30:

• PowerShares Active Low Duration Fund (PLK)
• PowerShares Active Mega Cap Fund (PMA)
• PowerShares Active AlphaQ Fund (PQY)
• PowerShares Active Alpha Multi-Cap Fund (PQZ)

Actively managed ETFs are investment vehicles that involve the trading of assets within a portfolio, in contrast to traditional ETFs that use a strategy of buying and holding a market basket of equities that attempt to track a specific sector or region. With the advent of actively managed ETFs, investment teams will rely on research, expertise and proprietary processes to choose their portfolio holdings. The intent of active management is to provide higher returns than benchmark indexes, consistent returns, effective risk management, and reduced volatility.

ETFs also should be able to maintain a tax-efficient structure to substantially mitigate capital gains distributions by using an in-kind redemption process until they sell their shares, said Ed McRedmond, senior vice president of portfolio strategies at Invesco PowerShares. Although actively managed ETFs logically will trade stocks more often than index-based ETFs, careful management of the in-kind transfer process may give the managed ETFs a similar degree of tax efficiency, he explained. However, there is no guarantee that the PowerShares actively managed ETFs will not distribute capital gains to their shareholders.

One feature that investors should like is that the investment company plans to report its holdings in each ETF daily. In contrast, the holdings of mutual funds usually are disclosed at the end of each quarter.

The introduction of these new, actively managed ETFs is an indication of the growing popularity of ETFs. The United States clearly is a major source of investable assets for ETFs. It took mutual funds 44 years to reach $450 billion in assets under management in 1984, while ETFs amassed $470 billion in assets after just 14 years. ETFs worldwide currently are estimated to have $570 billion in assets under management, and Morgan Stanley projects that the assets will top $2 trillion by 2011.

Actively managed ETFs should be able to retain traditional advantages over mutual funds through lower expenses, the transparency of reporting each fund’s holdings every day, and trading at or near net asset value (NAV). In addition, the presence of a fund manager may allow actively traded ETFs to be marketed as comparable to mutual funds in responding to changing market conditions. In this way, actively traded ETFs eventually could become part of 401(k) plans.

Finally, ETFs appear to be gaining momentum in their competition with mutual funds. A Charles Schwab survey cited during the April 30 Webcast found that 36% of 1,006 independent investment advisors said that they planned to put more of their clients’ money into ETFs during the next six months. Mutual funds that use hedging strategies followed far behind with 14% of respondents. Investors should consider ETFs a proven investment vehicle that has a role to serve in virtually everybody’s portfolio.