ETFs Evolve -- For Better or Worse?

The proposal would formalize what has, in fact, been the SEC's practice for the past couple of years as the agency struggled to keep up with the flood of ETF applications, Siegel says. The first WisdomTree fund, he recalls, was in the registration process for more than a year before being approved in June 2006. "There was a lot of criticism that they were going way too slow."

The SEC is also seeking comments on whether it should approve actively managed ETFs. Like managed mutual funds, these would use teams of analysts to seek hot investments, rather than simply buying and holding the stocks in a passively managed index. The SEC, however, set a tough hurdle: Managed ETFs will have to immediately disclose changes in their holdings, perhaps daily. Managed mutual funds disclose holdings only every six months, and then state what they own on the reporting deadline without providing details on what they had bought and sold during the previous six months.

Immediate reporting is needed for managed ETFs so that institutional investors could continue to buy and sell creation units, says Wharton finance professor Marshall E. Blume. Otherwise, ETF share prices would not accurately reflect the value of the stocks they represent.

Blume notes there still are many unanswered questions about how managed ETFs would operate and prevent manipulation. "I can see all sorts of shenanigans," he says. Anyone who knew that an ETF's holdings were different from those of the creation basket, even if for only a short period, could profitably trade on the knowledge at the expense of the ETF's shareholders. Since the holdings would have to be disclosed to institutional shareholders very frequently, many people might be in a position to game the system, he says. "So anyone with knowledge of what's in the fund has to be barred from trading" in ways detrimental to the ETF.

Siegel notes that frequent disclosures can undermine one of the theoretical benefits of actively managed investments by revealing the manager's strategy and insight into bargains. If everyone knows a superstar ETF manager is buying XYZ stock, others will do the same and the heightened demand will drive the stock's price up until it's no longer a bargain. "The advantage of getting in early because you think this is a good buy may be to some extent nullified," Siegel says.

Vanguard's Bogle has a harsher criticism of managed ETFs. The whole idea of owning a managed mutual fund, which Vanguard offers alongside its index products, is to benefit from the manager's skill over the long term, he says. Why, then, would an investor need the ability, offered by ETFs, to trade in and out of the same fund during a single trading day? "I don't see any added value now that you can trade ... all day long in real time."

Some of the cost benefits found in indexed ETFs will be lost with managed ETFs, since all those stock pickers will have to be paid, Allen says. But managed ETFs may still offer slight cost advantages because they won't have all the bookkeeping, communication and administrative costs borne by mutual funds. Managed ETFs also should provide some tax savings compared to managed mutual funds, but probably will not be as tax efficient as index ETFs, he says.