Non-Index Exchange-Traded Funds On the Horizon

The entry of heavyweight Vanguard into the exchange-traded fund business should pave the way for other fund companies to launch their own versions of these new-fangled index products. But what about actively managed funds? Will they ever come in the exchange-traded variety?

The consensus at an industry conference in New York this week sponsored by the Institute for International Research is that they will. In fact, you can expect to see the first filings for these actively managed funds showing up at the Securities and Exchange Commission by the end of the third quarter, says Larry Larkin, senior vice president at the American Stock Exchange.

Larkin says six fund firms are toying with the idea of an actively managed exchange-traded fund, though he wouldn't name names.

Exchange-traded funds have several advantages over traditional mutual funds. They are continually priced and can be traded throughout the day, just like a stock. And holders are less likely to be hit with taxable capital-gains distributions than investors in traditional index funds.

The first actively managed funds that trade on exchanges may look closer to enhanced-index funds than to diversified portfolios like (FMAGX)Fidelity Magellan. Enhanced-index funds try to closely track an index while somehow improving upon that benchmark's returns by using stock picking or leverage.

Of course, filing with the SEC doesn't mean the products will start trading anytime soon.

From concept to launch, it took two years for the Nasdaq 100-tracking stock (QQQ) to see the light of day. Vanguard has been working the SEC for a year on its own exchange-traded funds, and it just filed for approval of those last week.

And a stumbling block to creating an actively managed version is the transparency of the underlying portfolio.

Existing exchange-traded funds track known stock indices, so institutional investors and traders know at any given time which stocks make up each of the indices. This information is obviously key in creating new shares of the exchange-traded portfolios and allowing market makers to hedge or offset the risk they bear in trading these instruments.

However, that necessity could become an impediment when talking about actively managed funds. No fund company or fund manager would want to reveal everything that's in a fund on a regular basis. In fact, the manager and the shareholders could be at a disadvantage if the public knows what's in a fund at all times.

Some professionals in the exchange-traded fund business say there's a way to deal with this issue, though the details are murky at this point.

However, with an enhanced-index fund, a portion of the fund is always a known entity.

And to all of you who plan to email me to say that actively managed exchange-trade funds already exist: they're called closed-end funds: Yes, I know, but because of their structure, close-end funds usually trade at a discount or premium to their net asset values. Exchange-traded funds are structured so that these premiums and discounts are almost non-existent.

More, More, More

Meanwhile, investors can sit back and watch a virtual explosion of new index products in the budding exchange-traded sector, and with it, some healthy price competition that should drive down the cost of owning index funds.

In addition to Vanguard's five funds, which I detailed in a story on Friday, you'll soon see:

More than two dozen funds from Barclays Global Investors, the first four of which will launch on Friday. These so-called iShares will track the S&P 500 (IVV:Amex), Russell 1000 (IWB:Amex), Dow Jones U.S. Technology (IYW:Amex) and Dow Jones U.S. Internet (IYV:Amex) indices. A second batch, tracking 10 additional indices, should come out one week later.

At least eight new funds are coming from State Street Global Advisors, which oversees one of the oldest products in the sector, Spiders (SPY).

State Street's new funds should arrive around the middle of June. They'll track four Dow Jones indices covering large-cap growth, large-cap value, small-cap growth and small-cap value stocks; the Dow Jones Global Titans world-stock index; the Morgan Stanley Internet index, known as the MOX; the Morgan Stanley High Tech 35 index, and a REIT index, says a State Street spokeswoman.

More index products from the people who brought you the QQQ. John Jacobs, a senior vice president at the Nasdaq, says the exchange is exploring a product that will be broader that the popular QQQ, which commands about $11 billion in assets. That index consists of the 100 largest non-financial companies on the Nasdaq. A new exchange-traded product might include smaller companies and/or financials.

Nuveen Investments, known for its unit investment trusts (UITs), is also expected to get into the game. UITs are similar to exchange-traded funds except that they don't trade on exchanges and have finite lifespans.

Watch to see if State Street lowers the expense ratio on the Spiders even further. It fell to 0.12% earlier this year. But now Barclays has come in with a competing S&P 500 index fund at 0.09%. And who knows where Vanguard will come in? Its old-style (VFINX)500 Index fund is starting to look a little pricey at 0.18% annually in expenses.

Web Alert

Barclays just opened the Web site for its new exchange-traded funds at www.ishares.com. The site includes descriptions of all the upcoming products and how to use them in your portfolios

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