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The SEC moves one step closer to approving actively managed ETFs

Last week the SEC issued a notice that gave near final approval to Invesco Ltd.’s PowerShares Capital Management unit to issue actively managed ETFs. You can read the SEC release (pdf file), but here are the details and how it changes the investing landscape.

Actively Managed ETFs

Just to review, an ETF today tracks an index, much like an index mutual fund does. But unlike an open-end mutual fund, an ETF trades on an exchange like individual stocks. Unlike a mutual fund, an ETF can be bought on margin and traded throughout the day. It is generally more expensive to buy an ETF due to commissions and the bid/ask spread, but there are no redemption penalties that come with some mutual funds, expense ratios generally are lower, and ETFs tend to be more tax efficient. You can read read Rick Ferri’s article about ETFs vs. mutual funds for more information.

If the SEC gives its final approval, you will soon see actively traded ETFs. Like an actively managed mutual fund, an actively managed ETF will pick and chose which stocks or bonds to invest in based on the funds analysis of individual investments.

What’s the big deal with an actively managed ETF?

While it may seem like a simple thing to construct an actively managed ETF, there are several hurdles these investment vehicles needed to clear. First, ETFs must disclose their holdings each day. The problem for actively managed ETFs is that they won’t want to give away their trading strategies. In fact, fund managers go to great lengths to conceal this information. For actively managed mutual funds this isn’t a problem because they aren’t required to disclose their positions on a daily basis (remember, mutual funds don’t trade on a national exchange like an ETF does).

Second, if the exact positions of an actively managed ETF are not known, the price of an ETF on a high volume trading day may develop a large premium or discount to the net asset value (NAV) of the fund. With index based ETFs, “authorized participants” can address any price discrepancy by releasing or redeeming shares into the market. If the positions of an actively managed ETF are unknown, however, this strategy to remove large premiums or discounts from the market won’t work.

These problems aren’t insurmountable, but it explains why the SEC has been slow to approve actively managed ETFs.

Who will benefit from actively managed ETFs–investors or fund companies?

This is the real question. Will actively managed ETFs benefit investors or line the pockets of fund companies? History tells us that most actively managed mutual funds underperform their benchmark, particularly over the long term. Add to that the low cost of index funds, and actively managed funds look like a raw deal. Offering an actively managed fund in the form of an ETF won’t change this. Still, there are situations when an actively managed fund is preferable to an index fund. However, if you do invest in actively managed funds (and I have a few), the ETF alternative may prove advantageous for the same reasons that ETFs can be the better choice over index funds: taxes, lower costs, flexible trading options.

Finally, Rick Ferri devotes a short chapter to actively traded ETFs in The ETF Book: All You Need to Know About Exchange-Traded Funds.

Author Bio

Total Articles: 1080
Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Article comments

FourPillars says:

I don’t understand why these companies don’t just create new low cost mutual funds. Actively managed ETFs just don’t make sense to me for the reasons you mentioned.

Clearly they are trying to capitalize on the “etf” craze sweeping the country.

DR says:

FourPillars, I agree that much of the push for actively managed ETFs is to meet investor demand that doesn’t make much sense or cents. It’s selling the hope of market beating returns over the reality. That said, I can imagine a few actively managed ETFs that would be worth considering. A TIPS fund or foreign bond fund come to mind.