Here Come the Actively Managed ETFs

Last Updated Apr 22, 2011 2:52 PM EDT

Ever since the first exchange-traded fund (ETF) appeared on the scene in 1993, ETFs have been synonymous with indexing. The vast majority of ETFs in existence today are passively managed, tracking various market benchmarks.

And as ETFs have grown in popularity, actively managed ETFs have long been seen as the next big thing in the industry. A Dow Jones article from 2000 described how fund managers were "working furiously" to bring actively managed ETFs to market.

That furious work, thus far, has yield little in the way of results. While there are a handful of actively managed ETFs on the market today, their combined assets total just $130 billion -- a mere fraction of the $1.1 trillion invested in indexed ETFs. Further, the largest actively managed ETFs are focused on fixed income and currencies; actively managed equity ETFs are an unpopular segment of an unpopular investment style.

But two recent developments indicate that the market for actively managed ETFs may finally be ready to start meeting the financial media's expectations.

First, mutual fund manager Ameriprise recently announced that it was acquiring Grail Advisors. Grail is seen as something as a pioneer in the ETF space, with five actively managed ETFs (three equity and two fixed income). But investors have been slow to embrace the firm's funds, which have a combined asset base of just $20 million, leaving Grail little choice but to put themselves on the block.

Regulatory approval of actively managed ETFs has long been seen as one of the biggest hurdles in bringing these funds to market, and with the Grail acquisition, Ameriprise has eliminated that as a stumbling block. With the ability to now offer ETF versions of their actively managed mutual funds, and an army of financial advisors standing ready to push their products, Ameriprise is positioned to make a big push into the world of actively managed ETFs.

But what might really attract investor attention to actively managed ETFs was the news this week that PIMCO is bringing out an ETF version of its hugely popular Total Return fund.

Total Return -- which is the largest mutual fund in the world -- is run by Bill Gross, who has demonstrated that he is that rarest of creatures: an active manager with a stellar long-term record.

By virtue of that track record, Gross is one of the most well known and widely followed participants in the mutual fund industry, and the fact that he's now managing an actively managed ETF will surely bring a great deal of attention to the field.

So what does this mean? First and foremost, the latter announcement is likely good news for investors who have been interested in investing with Bill Gross, but have been put off by the cost of Total Return. The expense ratio for Gross's ETF (which will not be a mirror image of the mutual fund of the same name) have not been announced yet, but it will doubtless be cheaper than the 0.9 percent levied on the A-class shares of Total Return. Even better, the ETF won't be accompanied by the 3.75 percent sales load that investors in the fund are charged.

That aside, it's hard to get too excited about the notion of actively managed ETFs becoming more popular. It's important to see these announcements for what they are -- an attempt by active managers to climb aboard the engine that's been driving the mutual fund industry's growth over the past five years. These managers are concerned, first and foremost, with their own bottom line. Further, no matter what form the fund takes, an actively managed fund is an actively managed fund. And Bill Gross aside, active managers have a notoriously bad track record.

True, it's reasonable to expect that the lower expenses that might be charged on these ETFs will result in higher returns relative to their mutual fund counterparts. But even those expense ratios will inevitably be higher than what investors might pay for a low-cost index fund, which will in turn produce index-lagging performance over the long-term.

As I wrote a few months ago, for instance, Ameriprise's mutual funds are -- overall -- very underwhelming investments. And the form those funds take -- traditional mutual funds, ETFs, separately managed accounts, variable annuities, etc. -- has zero impact on the ability of the manager to add value over the long term, which is the primary thing investors should be concerned about.

True, investors in actively managed ETFs will be able to buy or sell their investment throughout the day. Unfortunately, the track record of investors using that methodology in traditional ETFs indicates that it's much more likely they'll end up hurting their returns than adding value.

With its myriad of questionable investments following specious benchmarks, the ETF industry provides plenty of reasons to give investors pause. And to the extent that actively managed ETFs grow in popularity, they'll simply add to the pool of investments that most ETF investors would do well to avoid.

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  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.

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