Actively managed ETFs likely to surge

The market for actively managed exchange-traded funds has been slow to take off, but the funds' assets may swell once they have a few years of performance to tout, observers said. The $1.23 billion in assets that Morningstar Inc. estimates are held by the 22 active ETFs in the United States looks paltry compared with the $955 billion held by 1,049 index-based ETFs. But active ETFs weren't even legal before 2006, and the first actively managed ETFs didn't make it to market — after thorough review by the Securities and Exchange Commission — until 2008. “We always expected actively managed ETFs would grow slower than index-based ETFs,” said Edward McRedmond, senior vice president of portfolio strategies at Invesco PowerShares Capital Management LLC. “They didn't have a track record and there were no historical returns for such a product.” Morningstar ETF analyst Scott Burns pointed out the risks that advisers take when buying something without a performance history. “If you buy something with less than a three-year track record and it blows up, you're probably fired,” he said. But Mr. Burns predicted that active ETFs will become increasingly popular because they are low-cost, tax-efficient, transparent and liquid. Some investors who previously chose hedge funds for exposure to alternative investments are now looking at actively managed ETFs for that component of their portfolios, he said. Importantly, active ETFs that have a “decent amount invested in them” are performing well, he said. Two of the larger active funds include the iShares Diversified Alternatives Trust (ALT), which has $107 million in assets, and the Pimco Enhanced Short Maturity Strategy ETF (MINT), which has about $448 million in assets. But other funds are having trouble getting out of the starting gate. Some smaller actively managed ETFs that failed to grow already have thrown in the towel. For example, Grail Advisors LLC closed two of its actively managed ETFs recently because they weren't attracting enough assets.

ROUGH START

Dozens of actively managed ETF registrations now await examination by the SEC, Mr. Burns said. Some commission officials have raised concerns about the use of derivatives within actively managed ETFs. Once they can show three-year returns and have Morningstar analysts following them, actively managed ETFs may become even more popular with investors and financial advisers, Mr. McRedmond said. “We believe there may be a wave of adoption” in the next one or two years as the benefits of actively traded ETFs over mutual funds is shown, he said. With ETFs, investors can see what the fund owns every day, which Mr. McRedmond said is in-creasingly important. “Transparency has been a big thing that has made investors interested in ETFs, especially in such volatile markets,” he said. Invesco was the first firm to market an equity-oriented actively managed ETF, launching four funds in April 2008. The firm established a fifth fund seven months later and the group has attracted $62.8 million in assets. The company is considering introducing more actively managed ETFs.

"MISSING PIECES'

Another firm, AdvisorShares Inc., offers four actively managed ETFs with a total of $98 million in assets. It expects to have two more on the market by the end of the year, and has seven additional funds either in registration or preparing for registration, according to its chief executive, Noah Hamman. AdvisorShares has staked its business on the success of actively managed ETFs, recruiting successful portfolio managers to use its ETF platform. “Investors wanted a new and better way to manage their money, and the index ETF space was saturated,” Mr. Hamman said. “Real portfolio managers and strategies that can react to the changing market were the missing pieces for ETFs.” It is natural that an active strategy will take longer to catch on, Mr. Hamman said. “With an index-based ETF, in-vestors know what it is they want,” he said. “With active management, people shop for that.” Scott Kays, president of Kays Financial Advisory Corp., said that none of the actively managed ETFs available has performed well enough to include in his clients' portfolios. However, he thinks that active ETFs are the “wave of the future” because of their cost and tax benefits. The firm, which manages about $145 million in assets, already uses index-based ETFs, which have been around since 1993. Mr. Kays thinks that the selection of particular sectors of equities is what adds value to an active ETF or mutual fund, rather than individual stock choices made by the manager. Therefore, he prefers to invest in index-based ETFs that represent the sectors that he chooses, he said. Mr. Kays doesn't rule out active ETFs for the future. “If we saw an actively managed ETF with performance that would justify the investment, we would select it for clients,” he said.