"If it's that mechanical, I don't think it's active in terms of decisions being made," Tjornehoj continues. "That's why I'm skeptical about the moniker of active ETFs. I want to see personality behind a fund."

Disclosure Issues

Tjornehoj believes that one reason for the slow growth of active  ETFs is that there hasn't been a big investor push for the products. "The whole premise of ETFs is to get very cheap access to diversified portfolios," he says. "When you start tinkering with that premise by offering index funds with narrower focus and more frequent reconstitutions, then pretty soon the cost advantage is gone."

Robert Goldsborough, the Morningstar analyst, says actively-managed ETFs are expensive relative to traditional index-tracking ETFs, but are inexpensive relative to actively-managed, open-end mutual funds.

Many industry observers believe that more and more traditional mutual fund companies will eventually roll out ETFs to prevent clients from jumping ship to ETF providers. In turn, that could boost the number of active ETFs. "My sense is we'll get more big-name mutual fund and asset managers entering the space to leverage their research staffs and distribution networks for delivering actively-managed ETFs," says Tom Graves from S&P.

But fund companies need to overcome certain obstacles, such as greater transparency regarding their holdings. Mutual funds generally release their portfolio holdings on a quarterly basis, but putting a particular fund's strategy through an actively-managed ETF structure that trades throughout the day would require more transparency. That would expose a fund's trading positions to the open market, raising fears about the potential front running by investors.

"I think there's a reluctance by mutual fund companies to put their best products forward as an ETF because of the attendant disclosure issues," Tjornehoj says.

Patent Pending

Tjornehoj also believes mutual fund companies might have legal problems when it comes to translating their traditional open-end portfolios into accompanying ETFs. That's because Vanguard patented the method of taking a mutual fund and creating an alternate ETF share class that trades on an exchange.

"In my mind, that's the most efficient way to create a new structure, but it's patent protected," Tjornehoj says. "Lacking that, mutual fund companies have to do something different, and to me that's a significant hurdle."

Vanguard spokesman John Woerth doesn't agree that the company's patent is holding up the flow of new active ETFs. He says when Vanguard first contemplated entering the ETF space more than a decade ago, it decided against creating stand-alone products like those of iShares or State Street. Instead, it sought to leverage the mutual funds it already had by creating a separate ETF share class. "It would be more cost-efficient from both trading and management standpoints," Woerth says. "We thought it was a novel idea, so we decided to protect it with a patent."

Vanguard now has 64 ETFs--all of them cap-weighted index funds.

Woerth believes two issues are precluding active ETFs from taking off. One is the aforementioned portfolio disclosure requirements. The other relates to the growing popularity of low-cost, broadly-diversified and tax-efficient index-based funds.

"If you look at the flows into traditional mutual funds on the equity side, they've been predominantly going to the index side," he says, adding that the trend toward index-based funds probably won't change even if mutual fund companies start rolling out actively-traded ETFs.

--Jeff Schlegel

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