Active management is a hot topic in the exchange-traded funds industry.But most of the enthusiasm at a conference sponsored by Index Publications and Financial Advisor Magazine last week was on the part of potential issuers. A survey of financial planners who attended the event in Palm Beach Gardens, Fla., indicates actively managed ETFs may be a product in search of a market. 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. All of the products currently available in the U.S. passively track indices, much like indexed mutual funds. But providers are banking on active management as a way to attract new investors and compete more effectively with mutual funds. "I think actively managed ETFs are inevitable," says Stephen Sachs, director of trading at ETF provider Rydex Investments. "It should be good for investors in that it should have lower fees than an active mutual fund." But he adds, "I don't know if it will work. That remains to be seen." Mark Woody, senior financial adviser at Ameriprise Financial in Norman, Okla., thinks there could be a place for actively managed ETFs in his clients' portfolios. "The traditional indices will remain the core, and active ETFs could be satellites," he says. He says the products will have to prove themselves. "The proof will be in the pudding. I'm concerned about holding down client costs, and worry about tax efficiency. I wonder if we are really just building an actively managed mutual fund with another name. If so, I have concerns about mutual funds coming back in a different form." Other financial planners are even more skeptical. "Actively managed ETFs are a ridiculous idea," says Glenford Newman, investment adviser at New Jam Financial Strategists in Peekskill, N.Y. "As investment advisers, we're here to cut client fees. Why else would our clients pay us?" He adds, "The reason we switched from index funds to ETFs was so we could get out any time we wanted. We wanted the flexibility. We weren't looking for someone to manage it for us." Gwen Barringer, a certified financial planner with Capital Investment Group in Raleigh, N.C., is receptive to the idea of an actively managed product with lower fees than a comparable mutual fund. "I'm interested in holding down client costs," she says. But the planner is also concerned that actively managed ETFs might not be as tax efficient as ETFs that track indices. Every time a fund sells shares of stock, a taxable event occurs. Because passively managed ETFs have very little turnover, there are few if any capital gains inside the fund. But an actively managed ETF would be able to buy and sell stocks frequently, triggering capital gains (or losses) before fund investors unload their shares. And Andrew Cosgrove, director of Bluestone Financial in Bethesda, Md., probably speaks for a lot of people in his profession when he says, "I haven't given it a lot of thought." A number of investment advisers at the conference had little understanding of how passively managed ETFs work, even though they have been around for 14 years. Financial planners are an important audience. Unlike mutual funds, which are widely available in employee-sponsored retirement plans and can sometimes be purchased directly from the management company, ETFs must be purchased through a broker. "I don't think that a ready-built audience is there," says Jim Wiandt, publisher of Exchange-Traded Funds Report, which organized last week's conference. "I think they will have to be sold and distributed." For this reason, he thinks mutual fund companies, which already have distribution channels, are the most likely candidates to launch actively managed ETFs. Ready or not, actively managed ETFs are on the way. "I will almost guarantee that you will have actively managed ETFs this year," says Benjamin Fulton, executive vice president of PowerShares, a unit of Invesco ( IVC) that has a product in registration. Fulton says the benefit of active ETFs is that "they will offer more opportunistic strategies. For people running the fund, the big difference between active and passive ETFs is that passive ETFs react after the market and active ETFs can go in and make changes."
"This could be a phenomenal tool," says Greg Friedman, head of iShares Product Management Americas, a unit of Barclays ( BCS). "It will be exciting to see the first one, exciting to see where it goes and how it branches out in the ETF world." A key sticking point is how often actively managed ETFs will disclose their holdings. ETFs that track indices provide daily disclosure. Providers say the Securities and Exchange Commission would like to see similar disclosure for actively managed ETFs. But they are reluctant to be so transparent, because this would make them vulnerable to front-running by investors. Not surprisingly, index providers are skeptical, because actively managed ETFs would compete with the products they license to track their benchmarks. "Why does the ETF industry want to go down the path of mutual funds?" says Jerry Moskowitz, president of indexing company FTSE Americas, a unit of Pearson's ( PSO) Financial Times. Moskowitz says active management will generate higher fees and lower returns, two things that are only going to be more problematic when the outlook for the financial markets is so uncertain. He says the big push for actively managed ETFs "shows the industry is desperate about running out of product ideas." David Blitzer, chairman of the index committee at Standard & Poor's, has a similar view. "I think about active ETFs the same way I think about active mutual funds: Index funds perform better." Blitzer says he has no sympathy for potential issuers concerned about front-running. "We announce the changes to the S&P 500 three to five days ahead ... and active mutual fund managers still can't beat us."