Actively Managed ETFs

It had to happen eventually: actively managed ETFs are in the works.  It’s no secret that ETFs have been the hottest investment product of the new millenium and it’s easy to see why.  Up until now, ETFs have all been index funds.  The best ETFs track broad market indices such as the S&P 500, MSCI US Broad Market index, Lehman Brothers Aggregate Bond index, or the EAFE developed markets index but there is no shortage of ETFs tracking indices for everything from Nanotechnology stocks to commodities to foreign currencies.  While such narrowly-focused ETFs presumably have their uses (for the life of me I can’t figure out what they might be.), such broad-market indices such as Vanguard’s VTI or VEU or iShare’s DVY have been a boon to investors as they provide broadly diversified exposure to their respective market segments at rock bottom prices.

But actively-managed funds are a different animal.  While index funds merely try to match the market return, actively-managed funds attempt to beat the market by means of superior stock picking, market timing, or both.  Sounds good on paper, right?  Unfortunately, over the long run over 70% of actively-managed funds will underperform the index and good luck trying to figure out which managers will be outperformers going forward.  Because of this, the wise investor is advised to put the majority of their portfolio in broadly diversified index funds.

 So what of actively-managed ETFs?  I cannot endorse them due to the same reasons I don’t endorse actively-managed mutual funds; however, for those who insist on trying to beat the market, actively-managed ETFs likely do have one advantage for taxable investors: tax efficiency.  Handling cash inflows and outflows is one of a mutual fund manager’s biggest challenges.  During bull markets, investors tend to pile in at the top and during bear markets, tend to sell out at the bottom.  With a traditional mutual fund, managers are often forced to sell stocks at a gain to meet redemptions by other investors, sticking YOU with a large capital-gains bill at the end of the year.  Under the ETF format, that will no longer be necessary since the basket of stocks will be sold directly to another investory, by-passing the manager completely.  Since the fund didn’t have to sell to raise funds, no capital gains will be realized.  Thus, actively-managed ETFs are likely to be slightly more tax-efficient than a comparable actively-managed mutual fund.  This is a small advantage, though, and probably not worth the large risk of greatly underperforming the market.  Most investors would be wise to stay away.