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The future of actively managed ETFs.

IN THE MONTHS leading up to the launch of the first actively managed ETFs, industry commentators were generally divided into two camps. On one side were those who believed actively managed ETFs would be a game-changer, while on the other were those who suggested these funds would ultimately fail to attract significant assets. In hindsight, both forecasts have proven to be too extreme, as the successes and failures of actively managed ETFs have been more nuanced.

One complication in determining just how successful actively managed ETFs have been is the fact that there is a gray area between active and passive approaches. For example, an ETF is generally considered passive when it tracks an index; however, many indexes follow rules that seek to deliver better risk-adjusted returns (or alpha) than traditional benchmark indexes. Should these ETFs be classified as active since they seek alpha, or should they be classified as passive since they follow an index? In either case, many of these funds have gained a significant following, especially among investors and financial advisors who still believe in active management but are drawn to the benefits of ETFs versus traditional mutual funds.

By the same token, there are those exchange-traded products (ETPs) that are technically actively managed since they don't track indexes, but whose objectives are to simply deliver market returns. Many of the largest currency ETPs fit into this category as they seek to deliver returns that are reflective of the change between two currencies. While many investors are likely unaware that these ETPs are considered active, to the extent that returns are in line with their objectives and investors have an efficient vehicle with which to speculate on various foreign currencies and hedge currency risk, this distinction is essentially irrelevant. Generally speaking, the success in asset gathering, as well as the utility of this group of ETPs, has developed irrespective of its active or passive classification.

Finally, there are those ETFs that are classified as actively managed, but also seek to deliver better risk-adjusted returns than the market, similar to traditional actively managed mutual funds. This is the group of ETFs that most financial advisors think of when considering actively managed ETFs' general success. While some ETFs in this category have been quite successful, many others have failed to attract interest, leading some to close down. This may be due to the fact that investors recognize not all portfolio managers are equally skilled in delivering alpha. For example, according to S&P Indices Versus Active (SPIVA), less than a third of large-cap core managers outperformed the S&P 500 during the five years ending in 2011. Therefore, in order to attract new investors, an ETF sponsor must either wait patiently for a new fund to develop a track record that demonstrates the manager's skill, or it must employ a well-known manager who already has a proven track record.

This presents a challenge for fund companies, since many of the best active managers are hesitant to publish their holdings on a daily basis, fearing other investors might mimic portfolio changes, thereby influencing the price at which the fund might buy or sell its holdings. Additionally, mutual fund companies considering whether or not to offer actively managed ETFs alongside traditional actively managed mutual funds must weigh the risk that an ETF might cannibalize investor dollars that would otherwise have been allocated to the traditional mutual fund.

And yet, despite these concerns, there have been a few success stories in which well-respected managers have made the transition to ETFs without much difficulty. As new asset flows continue to favor ETFs over traditional mutual funds, I believe the incentive for good active managers to enter the ETF industry will be too large to resist. If this shift does take place, actively managed ETFs will undoubtedly cannibalize asset flows from traditional funds, but these ETFs may also win back investors who have eschewed traditional mutual funds, not because they no longer believe in active management, but because of the potential advantages offered by ETFs in terms of cost, transparency, taxefficiency and tradability.

EXTENDING THE CONVERSATION

For further coverage of exchange-traded funds, mutual funds, and other investing options, visit AdvisorOne.com and choose the ETF or mutual fund channels.

Ryan Issakainen is an exchange-traded fund strategist for First Trust Advisors.

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Title Annotation:THE ETF ADVISOR
Author:Issakainen, Ryan
Publication:Investment Advisor
Date:Oct 1, 2012
Words:718
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