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.