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With ETF assets now exceeding $1 trillion in the United States alone, the traditional mutual fund industry continues to be increasingly marginalized. However, one stronghold that the mutual fund industry was able to maintain was in active management. For the longest time, investors who wanted to access active management only had mutual funds or hedge funds to look to. That changed with the arrival of actively-managed ETFs almost three years ago. However, they still remain very much a novelty for many investors and even fund companies. The debate on their merits and weaknesses continues unabated.

A little while ago, U.S. News came out with an article pushing the case for actively-managed ETFs. The article focused on four key points that differentiate Active ETFs from their mutual fund counterparts:

1. Lower Fees: One of the complaints for investors in active mutual funds has been the high fees that they have to pay, with mutual fund MERs sometimes being north of 2%. With Active ETFs, investors are generally able to benefit from lower costs, as ETFs do not charge investors with trailer fees, marketing/distribution fees, etc. Some Active ETF issuers such as AdvisorShares have come out with strategies that have fees as high as 1.85%. However, if you look at the kind of strategies their products are providing, most of AdvisorShares’ Active ETFs are multi-asset class, tactical funds that run strategies usually available only in hedge funds that go by 2/20 fee structure. Hence, it’s important to compare similar underlying strategies when making cost comparisons across investment vehicles. As U.S. News reports, the average annual fee for an active stock mutual fund is 1.39%, while it is 0.82% for an active stock ETF. From our own data, active bond ETFs have an average fee of 0.49%.

2. Greater Liquidity: Mutual fund investors can only buy or sell their shares once every day, at the end of the trading when the fund NAV is struck. As a result, this hampers their intraday liquidity, and investors don’t know what price they are going to get for their shares until the ending NAV is determined. With Active ETFs, because they provide intraday indicative values which approximate the fund’s NAV, investors are able to trade intraday just as they can with any other ETF. They are also provided with the flexibility of using stop losses, going short, buying on margin and all the other things they could do with a normal stock order. This benefit is obviously not as useful for very long-term investors who are not as concerned about the intraday movements in price.

3. More Transparency: Mutual funds are only required to disclose their holdings to the public once every quarter, and with a 60-day lag. This means that when investors see the holdings disclosure, they’re looking at data that is 60 days old. With actively-managed ETFs, fund companies are required by the SEC to disclose their complete holdings on the fund website daily, with a one-day lag. So every morning, Active ETF investors would be able to see the holdings of the fund as of yesterday’s close. This is, however, one of the most debated issues in the Active ETF space.

4. Greater Tax Efficiency: ETFs, whether active or passive, are in general more tax-efficient structures than mutual funds. The main difference is that investors in Active ETFs don’t pay taxes until they sell their own shares. In other words, they only have to bear the cost of their own actions. In mutual funds, however, investors may incur taxes when the portfolio manager has to sell securities to fund other investors’ redemptions.

Around the same time, Dan Caplinger at The Motley Fool put forward his own arguments on why investors don’t need to bother with Active ETFs, as he chose to focus on their disadvantages.

1. Fund Disclosure: With complete fund disclosure required every single day, the portfolio manager’s positions will be under much greater scrutiny than would be the case if he/she was managing an active mutual fund. This can lead to the potential of copycats following the fund’s daily changes and replicating the portfolio without having to pay the fund fees -- a disadvantage from the fund manager’s perspective. Another key issue related to fund disclosure is the potential for front-running. If the manager behind the Active ETF deals in somewhat illiquid securities, he may not be able to complete his intended trades within one trading day. This means that halfway through his trade execution, he would be letting everyone know what positions he is building up or trimming down. Potential front-runners could use this info to bid up or sell those securities ahead of the manager completing his trades, which could harm the pricing that managers receive, especially if the security is illiquid.

2. Higher Taxes Relative To Index ETFs: The second mentioned disadvantage is the potential for higher taxable distributions relative to passive ETFs that just track their index, and hence have much lower turnover. In our opinion, it should be natural and expected that active funds will have higher turnover and hence potentially lower tax efficiency than index ETFs. The important comparison is between Active ETFs and active mutual funds, which are both providing access to similar underlying strategies. And on that front, Active ETFs are still more tax efficient than active mutual funds.

One thing both articles did agree upon was that Active ETFs are coming, whether investors like them or not. This certainly is true, since many of the major fund companies have lined up to launch actively-managed ETFs; the main thing slowing the pace of new launches is the SEC’s regulatory process. Also, both authors advise caution due to the short track record of these active managers. The first actively-managed ETFs will achieve their three-year track record in April 2011.

Disclosure: No positions in above-mentioned names.

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Source: Pros and Cons of Actively-Managed ETFs