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Understanding Actively Managed Exchange
Traded Funds
With so many investors and their advisors questioning
traditional market thinking about index-based investing,
exchange traded funds (ETFs) are starting to move beyond their
traditional passive, index territory into more active
management.
To some, it's a fad. To others, it's a serious threat to the
territory traditionally held by mutual funds. Yet one thing so
far is clear. Many of the biggest names in the mutual fund world
are now seeking permission from the Securities and Exchange
Commission to offer actively managed ETFs. For advice on this
new generation of securities, investors should speak with a
qualified financial advisor such as a Certified Financial
Planner™ professional.
ETFs are baskets of securities that trade like stocks and
until recently have almost always tracked market indexes like
the Standard & Poor's 500. ETFs have certain advantages over
mutual funds — they generally have offered lower fees and
better tax
advantages than mutual funds, and clearer tracking of their
underlying investments because they are required to make that
disclosure daily.
Here's what's changing. The ETF industry won regulatory
approval for actively managed funds after a 10-year effort, and
so the first actively managed bond ETF surfaced last spring with
a few more based on stocks. What does active management mean?
That managers have more leeway to choose the underlying
investments within a fund, while indexed funds require holdings
to mirror its chosen index.
What will make things interesting in the new ETF world is the
continuing requirement that these active managers disclose every
step they make. This is why active management is a challenge,
because in the traditional mutual fund world, managers don't
have competitors looking over their shoulders when they try to
build or exit positions. In the ETF world, disclosure is made on
a daily basis, so managers have to worry about competitors
mimicking their strategy and foiling their efforts to get the
best price for their investments.
Some experts believe that as this category develops, the
first baby steps for investing will go toward major stocks that
are generally less volatile and therefore tougher for
competitors to mimic. Others believe that actively managed ETFs
will operate with a series of managers whose moves would be
tougher to spot on any particular ETF's disclosure list. However
actively managed ETFs evolve, it makes sense to ask the
following questions:
How will these investments fit into my overall portfolio? It
makes sense to look at how ETFs fit into one's overall portfolio
mix given particular retirement and investment objectives as
well as tax considerations.
How about fees? One of the chief advantages of index-based
ETFs was low expense ratios. Actively managed funds generally do
cost more. Try and get an idea of what the fee structure will be
before you invest, and compare them to similar investments in
the mutual fund arena.
What are the tax issues? Active ETFs have better tax
advantages because the fund manager can sell the lowest-basis
stocks via in-kind stock transfers through the creation and
redemption process. This helps systematically reduce the tax
exposure for investors.
What about the track record? This is a very good point,
because as a relatively new investment category, it's important
to realize that these new categories of ETFs won't have terribly
long investment records to compare to other investments. Do your
homework first.
August 2009 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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