ETFs Get Active

Mutual funds may not have the low management fees, easy-to-use structure and perceived transparency of exchange-traded funds, but they are typically closely monitored by money managers who reallocate their portfolios to give investors the very best returns.

Now ETFs want in on this game, too. ETFs are designed to merely track indices, but new products are appearing that give investors the benefits of active management. Moreover, some industry watchers say that true actively managed ETFs aren't far off in the distance.

"If you look at the more recent crop of ETFs, you'll see funds that are based on indices that are intended to be 'better indices,'" says Tony Baker, managing director of the exchange-traded marketplace at the American Stock Exchange. "They are based on someone's research that indicates that this basket of stocks [has been carefully chosen] to be better than a standard index."

These new forms come as the traditional marketplace for ETFs becomes more and more crowded with products focusing on very narrow segments.

"There are not many more ways to slice and dice [indices]. We're in the ninth inning there. But in terms of the next generation of ETFs, we're in the first inning," says Dan Waldron, vice president of ETF product development for First Trust Portfolios.

His company's First Trust Strategic Value Index Fund(FDV Quote) tracks 40 stocks selected from the S&P 500 based on price-to-earnings ratios to create a basket of value stocks. The portfolio is then reconstituted monthly using these criteria, making it very close to an actively managed portfolio.

"Alpha is the buzzword you're going to hear, and in the next generation of ETFs, it's all about generating alpha, or above-market returns," Waldron says. "As needs have evolved, clients are demanding performance above, say, the S&P 500... You are seeing in these ETFs things that fund managers already do, which is screen stocks and look for certain investment attributes."