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Editor's note: This is the third of five stories looking at the past year and at the year ahead in mutual funds and exchange-traded funds. The first looked at real estate funds that crashed and burned in 2007; the second looked at a closed-end venture capital fund that turned its performance around.

There are those who view active management as the holy grail for exchange-traded funds. To others, it's pure blasphemy.

ETFs are portfolios of securities that trade throughout the day on an exchange, like stocks. They are known for their low costs, tax efficiency and transparency.

To date, all of the products available in the U.S. passively track indices, much like indexed mutual funds.

Allowing ETFs more freedom to buy and sell what they want when they want would put the $550 billion industry in a better position to compete for assets with mutual funds, which can be either actively or passively managed.

But ETF providers have struggled to come up with a formula that would pass muster with the

Securities and Exchange Commission


A key sticking point, according to industry participants, is how much information actively managed ETFs would be willing to reveal to investors about their holdings.

ETFs publish their holdings daily. This helps market makers create and redeem shares, a process that helps to keep the fund's price in line with the value of its holdings.

Transparency is also a key selling point for ETFs, since mutual funds are required to disclose what they hold only twice a year. Investors value the increased disclosure, since it helps them avoid building large positions in individual stocks or market sectors, due to overlapping holdings of various funds they own.

But actively managed funds are loath to divulge their holdings for fear that others will copy them, or even worse, front-run them. Front-running is buying the same shares first, and it usually drives up the price for the second buyer.

Despite the obstacles, a number of ETF providers are on a quest to make stock-picking expertise available through these investment vehicles.

Coincidentally, the most recent prospectus filing comes from Grail Partners, a merchant banking firm specializing in investment management. Its proposed Grail U.S. Value Fund would seek to outperform the Russell 1000 Value Index by 2 to 4 percentage points a year.

The Grail filing follows on the heels of four proposed offerings by PowerShares, a unit of


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, in late November.

Three of the proposed funds would invest in stocks:The PowerShares Active AlphaQ Fund would use a quantitative screen to choose the best 50 stocks on the


; the PowerShares Active Alpha Multi-Cap Fund would use a similar methodology to pick 50 large-cap stocks, and the PowerShares Active Mega-Cap Portfolio would hold 50 "mega-cap" U.S. stocks.

The fourth potential offering is a bond fund. The PowerShares Active Low-Duration Portfolio would seek to outperform the Lehman Brothers 1-3 Year US Treasury Index.

The proposed funds aren't really new, however. AER Advisors, a small investment management firm in Rye Beach, N.H., filed an application to launch these ETFs several years ago but never received the go-ahead from the SEC.

PowerShares, the ETF powerhouse from Wheaton, Ill., recently partnered with AER to rebrand the funds. AER will be the fund's adviser, and PowerShares will distribute the shares.

There are a few other contenders. In March,

Bear Stearns

( BSC) filed its first prospectus for an actively managed ETF called the Current Yield Fund. This fund would act like a money market fund but seek higher returns by taking on some riskier investments.

And Gary Gastineau, who ran the American Stock Exchange's ETF department in the late 1990s, is a big proponent for actively managed ETFs. His firm, Managed ETFs, of Summit, N.J., has filed plans for a few funds but has yet to get the green light.

Industry insiders say the SEC has informally indicated that the first actively managed ETF also will be the most transparent.

That could work to PowerShares' advantage. According to SEC filings, its four proposed funds would provide more frequent disclosure of its holdings than the one from Grail Partners.

Meanwhile, the American Stock Exchange has taken steps to be the first exchange to list actively managed ETFs. It has received three patents for processes to trade actively managed ETFs without disclosing the portfolios. It has five more patents pending.

The Amex says it is deeply involved with some firms trying to bring the active ETFs to market, but it declined to mention names.

Whichever firm launches the first actively managed ETF will earn some serious bragging rights, not to mention first pass at mainline mutual fund investors.

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


, 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.