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Despite the fact that a good number of retail investors still don't fully grasp the role that exchange-traded funds can play in their portfolios, ETFs are one of the fastest growing investment products around. In fact, assets in ETFs recently reached the $1 trillion mark. But we all know the folks on Wall Street can't leave well enough alone -- they continually have to come up with new products and new twists on existing products to compete for new money. And so far, signs are pointing toward ETFs heading into more active waters.
Although the year's just getting started, 2011 is shaping up to be a big year for active ETFs. T. Rowe Price looks set to launch its first actively managed ETF, a fixed income offering, early this year. Elsewhere, firms such as Vanguard and Eaton Vance are also reportedly considering or moving toward launching their own active ETFs. Experts predict that a flood of active ETFs is likely to hit the market this year, as more firms move forward with their plans.
For all the hoopla surrounding active ETFs, the products have actually struggled to gain footing in the market. Some funds have had their filings to launch active ETFs sitting with the SEC for two years, limiting the number of new funds on the market. Once launched, most active ETFs have failed to attract meaningful assets into their folds, with most funds holding only a few million in net assets. One notable exception here seems to be the Pimco Enhanced Short Maturity Strategy ETF (NYSE: MINT ) , which has amassed roughly $800 million in assets, according to Morningstar. But despite the slow start for active ETFs, investors are likely to hear a lot about them in the coming year.
Proceed with caution
So will active ETFs be the mutual fund-killer that many predict? Well, it's possible that once active ETFs hit a critical mass in the market, they may in fact steal business from more expensive actively managed mutual funds. However, given that mutual funds have a solid toe in the retirement plan world, where the majority of investors' assets lie, I wouldn't count on them being dethroned any time soon. But active ETFs could shake up the investing world and put active managers on notice, forcing fees downward, which is a good thing for all investors.
However, I urge investors to be cautious when it comes to active ETFs. I'm a bit skeptical about their long-term staying power, and more importantly, how investors will end up using them. Like many investment ideas, the concept may be sound, but in practice a world of problems may arise.
One of the key attractions of exchange-traded funds is their lower price in comparison to actively managed funds. However, as more and more active ETFs come on to the market, I'm betting that many of them will have fees equal to or greater than many active funds' expenses. Likewise, many new active ETFs will be of the offbeat or narrowly focused variety, rather than a broad-market, diversified option that would be appropriate for most investors. That could lead to a lot of folks buying unnecessary and inappropriate funds just for the novelty factor -- a sure recipe for disaster.
A motley crew
To confirm these suspicions, let's take a quick look at some active ETFs already on the market. While some fund expenses are reasonable, such as 0.29% for PowerShares Active Low Duration (NYSE: PLK ) , others are rather outlandish. For example, AdvisorShares Dent Tactical ETF (NYSE: DENT ) clocks in at 1.50%, while the Mars Hill Global Relative Value ETF (NYSE: GRV ) charges 1.49%. That's more than many actively managed mutual funds! When fees get to this point, active ETFs lose any cost advantage they may have over their mutual fund competitors.
Likewise, a good number of active ETFs currently available focus on more obscure or alternative areas of the market that most investors don't really know how to invest in. The 10 funds offered by WisdomTree are all currency funds, including the WisdomTree Dreyfus Indian Rupee Fund (NYSE: ICN ) and the WisdomTree Dreyfus South African Rand Fund (NYSE: SZR ) . The iShares Diversified Alternatives Trust (NYSE: ALT ) utilizes futures contracts, including commodities and currencies, to maximize absolute returns. While some of the other funds listed do focus on broader sections of the stock or bond market, they are all new offerings and have a limited track record for investors to judge.
The bottom line is that while some investors may find a use for active ETFs, right now most folks shouldn't spend too much time worrying about them. These funds are still relatively new, and I'm a bit hesitant about jumping onto the new product bandwagon. We're likely going to see a lot of these funds hitting the market this year, so if you're thinking about buying an active ETF, make sure you know what you're getting into. Stick to low-cost funds that invest in wide swaths of the market, and make sure you're not day trading your funds. For everyone else, I'd recommend taking a wait-and-see approach to this rapidly developing segment of the ETF market.