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Actively Managed ETFs on the Rise

State Street: Actively managed funds like those offered by Russell, Powershares, AdvisorShares, and Vanguard have a role in every portfolio.

Exchange-traded funds have been nearly synonymous with passive investing ever since the industry was launched in the 1990s.

Unlike mutual funds — which are often actively managed and traded once a day after the market close — ETFs are traded throughout the day, like stocks. They tend to be passively managed, mirroring an index or sector. That helps ETFs maintain one of their supposed advantages over mutual funds: They are cheaper, with fees well below 1 percent. Mutual fund fees are often twice as high.

A growing number of ETF sponsors are adding actively managed funds to their offerings, though. While a certain number of actively managed ETFs have been around for years, their ranks are on the rise. Russell, whose indexes are the basis for many ETFs, said last year it would launch six actively managed ETFs. It acquired the actively managed U.S. One Fund to launch its expansion. Powershares, AdvisorShares, and Vanguard have actively managed ETFs too.

“I am becoming a convert on this one. I was bearish on actively managed ETFs for quite awhile, but I have come about a little bit because people are getting their hands around what it is and how it works,” says Jim Ross, senior managing director at State Street Global Advisors and head of the asset manager’s ETFs. State Street has four actively managed ETFs in registration, including one that will hold real assets such as gold and real estate investment trusts, according to Ross. “In our view, actively managed funds have a role in a portfolio,” he says.

ETF sponsors have staked much of their business on the fact that an estimated 80 percent of active mangers don’t beat the market.

“Most mutual funds are run by managers trying to pick winning stocks. We know from empirical research that after fees charged, most give no value to investors. Timing the market is very difficult,” says Wharton professor Jeremy Siegel, a spokesman for ETF sponsor Wisdom Tree. Nonetheless, even Wisdom Tree has one actively managed ETF in its lineup, the Managed Futures Strategy Fund.

The biggest impediment to actively managed ETFs is whether the fund manager can get comfortable with the transparency requirements associated with ETFs, according to Ross. Because ETFs trade like stocks, managers must report their holdings to the Securities and Exchange Commission. While managers might have some leeway — reporting their holdings once a day, instead of constantly updating them — that level of transparency creates a challenge, especially for equity managers.

The risk, Ross says, is that other investors will get ahead of the ETF manager’s order, pushing up the price of the target shares before the order can be fully executed. That risk varies from one asset class to another. It is particularly pronounced in the market for smaller cap stocks, where one trade by a large fund can easily push the price of a stock up or down. It is less of a concern in the currency markets, which are larger.

While plenty of managers will never feel comfortable revealing what they hold, “some will say such concerns aren’t as relevant as they once were, because there is so much market information available anyway,” Ross says.

Given the rising demand for ETFs: “I don’t blame ETF sponsors for trying to expand their franchise,” says Lewis Altfest, CEO and chief investment officer at Altfest Personal Wealth Management.

Ross says it is too early to know how big the actively managed ETF business will be, but that it is on the rise. “I don’t know if it is going to be a $30 billion business in three years or a $100 billion business in five years, but it is growing,” he says.

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