A Push Is On for Actively Managed ETFs

There's reason to believe ETFs are better suited to beating their benchmarks than mutual funds. Open-end mutual funds issue and redeem shares once at net asset value. That means there is always money coming in and going out that isn't invested. This cash acts as a drag on performance.

What's more, when more money is walking out the door than new money coming in, mutual funds may have to sell shares they want to raise cash.

Scott Gibson, a professor of finance at the William and Mary Mason School of Business in Williamsburg, Va., says these "forced sales" may cause actively managed funds to underperform their benchmarks.

In a recent study he co-wrote, Gibson says that if active-fund managers are able to make trades purely on investment merit, they would beat their indices by 2 to 3 percentage points a year.

"Informed buys of stocks outperform the indexes by 2.8 percentage points, and informed sales underperform by 0.7 percentage points." Gibson says. "And when managers are forced to sell stocks they would rather hold, those stocks go on to beat the market by 1.6 percentage points."

ETFs don't have to keep any cash on hand, because investors buy and sell them from each other. So they can remain fully invested. Gibson says that should give them a better shot at outperforming.

But giving ETFs more freedom to pick stocks could undermine some of their appeal, because they're unlikely to be as transparent about their holdings as those that passively track indices.

Also, active trading tends to drive up costs, eating into returns.

Ron DeLegge, editor and publisher of ETFGuide, a San Diego-based Web site focusing on ETFs, says actively managed ETFs could trade out of line with their net asset values, much like closed-end funds.

"We don't need actively managed ETFs because they already exist," he says. "They're called closed-end funds. I have yet to hear anyone explain to me in less than 30 seconds the difference between the two. And since closed-end funds deviate from their NAV, trading at a premium or discount, the same thing could happen to active ETFs."

DeLegge questions whether the firms planning these products have investors best interest at heart. "Who needs actively managed ETFs more -- managers trying to distribute their actively-managed solutions or foolish investors who don't even know what an ETF is?" he says.