ETFs You Just Don't Need

Exchange-traded funds have become a trillion-dollar industry for the managers that run them. Yet with investors seemingly hanging on every innovation from ETF providers, one trend that many have predicted for some time isn't one that you need to follow anytime soon.

Active ETFs are coming
For years, investors have been waiting for actively managed ETFs to hit the scene. Until now, most ETFs have been passively managed, meaning that their sole investment strategy is to follow whatever index they're intended to track. Passive strategies have the advantage of being simpler to understand and cheaper to implement. But they also hamstring funds into mindlessly following their indexes, even if those indexes prove disastrous or simply don't work as viable strategies.

In contrast, active ETFs would look much more like their traditional mutual fund counterparts. Rather than blindly tracking an index, active ETF managers would be able to exercise their judgment by making stock picks of their own, with the goal of actually outperforming their benchmark rather than just matching it.

What's out there
Despite interest from investors, though, active ETFs have been slow in becoming available. Only 19 active ETFs currently offer shares, as regulatory delays have kept fund managers like T. Rowe Price (Nasdaq: TROW  ) and State Street (NYSE: STT  ) on the sidelines for now. Moreover, at just $3 billion under management, the active ETF segment is dwarfed by passive ETFs, which passed the $1 trillion mark in assets under management last year.

Moreover, the most successful active ETFs thus far haven't come from sectors that you'd probably expect. Of that $3 billion, fully two-thirds has been invested in just three ETFs: Pimco Enhanced Short Maturity (NYSE: MINT  ) , WisdomTree Dreyfus Chinese Yuan (NYSE: CYB  ) , and WisdomTree Emerging Markets Local Debt (NYSE: ELD  ) . In other words, the biggest active ETFs right now are bond and currency funds rather than stock funds.

Of course, given the tendency for the ETF market to go wherever the hot money is, focusing on the red-hot bond market rather than stocks makes a certain degree of sense, especially over the past year. But the structure and limitations of active ETFs suggests another reason why stock-focused funds haven't made a big splash yet -- and may not become popular for years to come.

The disadvantages of active ETFs
The ETF structure has a number of advantages for investors. You can trade shares of ETFs throughout the trading day, rather than just once per day as with traditional mutual funds. ETFs often have tax advantages that mutual funds can't match. And at least for passive ETFs, average costs tend to be far lower than overall levels for mutual funds.

But one disadvantage -- at least from fund managers' perspective -- is that ETFs require daily disclosure of holdings. That puts active ETFs under the microscope every 24 hours, compared with mutual funds having to disclose holdings only every few months.

With certain asset classes -- such as bonds and foreign currencies -- markets aren't necessarily liquid enough for competitors to take advantage of daily disclosure to free-ride off active ETF managers. But an active ETF that bought regular stocks would potentially have that problem, as shadow investors could make the same trades as the ETF with only a single day's lag time without paying the ETF's fee.

In addition, some have questioned whether active ETFs will have the same favorable characteristics as their index-tracking counterparts. Dent Tactical (NYSE: DENT  ) , for instance, weighs in with a pricey 1.50% expense ratio, topping the average expenses for active mutual funds. In addition, higher turnover could potentially lead to taxable distributions -- although thus far, active stock ETF provider Invesco's (NYSE: IVZ  ) PowerShares have avoided making any capital gain distributions on all but one of its active ETFs.

Wait and see
Perhaps the best argument against active ETFs, at least for the moment, is that they haven't been around long enough to have built a strong track record. As with active mutual funds, many investors prefer to wait until a fund manager has a proven reputation for successful investing before committing their own money.

For now, active ETFs are an interesting idea. But until they get all the kinks out and become much better-established, smart investors will steer clear and wait to see how things turn out.

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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger has more than enough investments to choose from without new ones that don't add anything. He doesn't own shares of the companies mentioned in this article. The Fool owns shares of T. Rowe Price Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy knows what you need.


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  • Report this Comment On February 01, 2011, at 8:25 PM, 8307c4 wrote:

    Yeah right whatever and Warren Buffett can join the KMA club too.

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