In an ideal world an actively managed mutual fund would have low expenses, a smart manager who could invest and trade without having to work around shareholder purchases and redemptions and little or no capital gains taxes during the holding period. That vision moved a step closer to reality this spring when, after over seven years of SEC evaluation and paper shuffling, a handful of actively managed ETFs finally debuted.

The new offerings differ from their predecessors, which track broad indexes or narrower indexes custom-designed for a particular product. The latter rules-based indexes bear a strong resemblance to quantitative techniques, but fall short of the fundamental analysis and human touch that distinguish active management. By contrast, actively managed ETFs do not seek to replicate an index or apply a consistent investment formula. Like managers of a mutual fund, managers of such ETFs might call or visit companies to discuss earnings reports, look among downtrodden stocks for value and, for better or worse, add a human touch to the investment process.

Such decision-making latitude means the full spectrum of actively managed mutual fund investments could now come to an ETF format, a possibility that has sponsors declaring a new future for the market. "We believe the advent of actively managed ETFs has the potential to change the way people invest in the future, and we are honored to participate in ushering in the actively managed ETF revolution," says Bruce Bond, president and CEO of Invesco PowerShares, after the April launch of the first actively managed equity ETFs.

So far, the products that some say have the potential to revolutionize the ETF world are at a low profile. There was little fanfare when Bear Stearns, embroiled in the controversy surrounding its excessive exposure to subprime mortgage debt and its acquisition by JP Morgan Chase, launched the first actively managed ETF, the Bear Stearns Current Yield ETF (YYY), in late March. A few weeks later, PowerShares Capital Management upped the ante with four active ETFs that include the first active equity investments. The firm's new funds are the PowerShares Active AlphaQ Fund (PQY), a portfolio of 50 Nasdaq-listed securities; the PowerShares Active Alpha Multi-Cap Fund (PQZ), a 50-stock multicap portfolio; the PowerShares Active Mega-Cap Fund (PMA), which invests in the largest public companies; and the PowerShares Active Low Duration Fund (PLK), which seeks to outperform its benchmark, the Lehman Brothers U.S. Treasury one- to three-year index.

The Active Low Duration and Active Mega-Cap funds are managed by Invesco, while Active AlphaQ and Active Alpha Multi-Cap are subadvised by AER Advisors. The expense ratios for the funds range from 0.29% for the fixed-income fund to 0.75% for the equity offering. Bond says that despite strong interest from financial advisors, many are holding back on investing until the products prove themselves. Other firms said to have actively managed ETFs in the works are Barclays Global Investors, Vanguard, WisdomTree Investments and XShares Advisors.

A Better Mousetrap?
    These and other actively managed ETFs promise to bring a number of interesting advantages to the table. Although investment management fees are inevitable in an actively managed portfolio, the fees on ETFs would likely be lower than those on traditional mutual funds because the managers do not have to service shareholder accounts. Unlike many mutual funds, which require a 30-day holding period, the ETFs would have no minimum holding time. And like index ETFs, the actively managed versions would allow buying on margin and short sales.

But the most intriguing advantage of actively managed ETFs would be a friendlier tax structure than those open-end mutual funds offer. The tax-inefficiency among actively managed funds has cast a long shadow over the industry for many years, and now that the tax-loss carry-forwards from the 2000 to 2002 market decline have been used up, the problem has only gotten worse. According to Lipper, mutual fund distributions hit a record high in 2007, with regulated investment companies distributing $581.6 billion, breaking the record set in 2006. In 2007, the estimated taxes paid by taxable mutual fund investors increased 42% from 2006, and buy-and-hold investors in taxable mutual funds surrendered a record-setting $33.8 billion to Uncle Sam, easily surpassing 2000's record amount of $31.3 billion.

Part of the problem is that traditional mutual funds must accommodate share redemptions from their coffers, and managers may need to sell securities to meet the withdrawals, which can create capital gains. Redemptions may also force managers to unload shares at unfavorable prices and may increase transaction costs. And investors who buy after a particularly active redemption period may incur taxes on gains they did not see.
Purchases and sales of ETF shares are typically handled through creation units involving arbitrage of the underlying portfolio by large institutions acting as authorized participants. These creation units make it unnecessary to sell securities to raise cash to meet redemptions, and thus lower the tax bite and the need for forced sales.

The underperformance of most actively managed funds against indexes has been well-publicized, and some researchers believe that buying and selling securities to accommodate fund flows plays a major role in that underperformance. A study by Scott Gibson, associate professor of finance at the College of William & Mary, indicates that when mutual fund managers are free to make decisions based solely on research, without the constraints posed by sales and redemptions, they beat the market by almost 3%. "The long-term investor in an open-end mutual fund bears the cost of everyone else's liquidity," he says. "Investors need a fund structure that frees portfolio managers to trade solely for information reasons."

But there also are a number of arguments against actively managed ETFs. It is possible that some of the advantages of a more efficient structure could be offset by wider premiums or discounts to net asset values if authorized participants are not able to manage the arbitrage process as efficiently as they do for index-based ETFs. And if some of the first generation of actively managed ETFs abandon in-kind exchanges and move to an all-cash approach, their tax situation may be similar to that of traditional mutual funds since they would need to sell securities to meet redemptions.

Parting The Curtain
    Because efficient arbitrage transactions are critical to an ETF's successful operation, authorized participants need to know the securities a portfolio contains. Mutual funds must only report their full holdings once every quarter, which gives portfolio managers plenty of time to execute trades discreetly. By contrast, actively managed ETFs must make public their portfolio holdings at the end of each day.

The transparency requirement essentially means that portfolio managers have one day to make trades before telegraphing their moves to the public. That may not be too much of a problem for ETFs that invest in large companies, where the portfolio manager will probably be able to establish a position quickly. Transparency may also not be a huge concern in a fixed-income fund, particularly one that invests in liquid securities such as Treasuries.

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