What's So Great About Actively Managed ETFs?

In our recent post on actively managed ETFs being closer to a reality than ever before, reader Marketworth wanted to know the difference between an actively managed ETF and a traditional one.

We're here to help.

Traditional ETFs track underlying indexes, which for the most part, don't change a whole lot. In some, there is quarterly rebalancing, while in others, the components are changed once every few years (as in the Dow Jones industrial average). It's known as passive management: investors are not trying to beat the market, they're just playing alongside it.

It's a reason ETFs are relatively cheap when compared with mutual funds; there's no need for a manager to move things around. With an index, you more or less can set it and forget it and you always know what you own.

Actively managed ETFs operate more like mutual funds. Behind them, instead of an index, will be a manager who will be doing the research, then picking and choosing securities based on the findings. That manager isn't working for free, either, and the fees are passed on to the investor.

But, wait. What does that do for the cost of these funds and the transparency?

The answer is that it remains to be seen. The transparency issue in particular has been a big concern of the SEC. If there's a fund manager doing the homework and actively managed ETFs are totally transparent, there's nothing to stop investors from playing along. The prices of those securities could be affected, and they would get the benefits of the manager's research without the cost.

One solution that's been offered is to release daily holding information, as opposed to mutual funds, which report their holdings typically either monthly or quarterly.

Another key difference between active ETFs and mutual funds is the way they trade. Mutual funds trade once a day, at the end of the day. All ETFs can trade at any time, just like stocks.

Comments

[Indexor]

Here's another opinion. The reason the SEC is so concerned about allowing active ETFs, is partly the admission that open-end mutual funds have been flawed for decades, and the SEC has simply turned a blind eye, and is unwilling to admit their error and fix the problem.

Investors have flocked to ETFs for three reasons:

1. Ability to buy/sell intraday at current market prices, not stale once-per-day prices. As a growing number of investors wake up to the fact that Buy-and-Hold is reckless and can be extremely dangerous to ones wealth in down markets such as 2000-2003 (although it keeps the ongoing income stream of fees pouring into the fund company on a daily basis), the importance of liquidity will gain in credibility. ETFs cannot arbitrarily close to new fund flows, add 2% redemption fees or unilaterally change or tilt a fund's investment style. Open-end funds should't either.

2. Expense ratios are much lower and more realistic. The SEC should have capped expense ratios a long time ago on open-end mutual funds, at increasingly lower percentage levels as fund assets grew, especially for funds in 401(k) accounts where individual investors have been completely taken advantage of for far too long.

3. The compelling logic and historical experience proves that indexing is a much more intelligent choice for providing consistent returns for the vast majority of investors.

A simple solution (to the horror of the mutual fund companies) would simply apply the same liquidity and transparency rules of ETFs to open-end mutual funds, while capping their expense ratios.