Active ETF Investing: 3 Things To Consider

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While the bread-and-butter of the ETF industry has been index-tracking products, active ETFs are quickly growing in popularity as several funds have gained critical mass with investors. There are now more than 55 different active ETFs with a combined $13 billion and counting in total assets under management. More importantly, these funds have allowed retail investors to apply professional management to a variety of asset classes and strategies [see 10 Questions About ETFs You've Been Too Afraid To Ask].

What’s the Appeal?

For investors, there’s a lot to like about active ETFs. First, given the markets heavy volatility over the last few years, active ETFs–because they are managed by a professional–have the ability to shift allocations and positions according to the economic environment. Recent studies have shown that managers with high “active shares”–or the percentage of a fund’s weight-adjusted portfolio that differs from its benchmark–can produce extra returns for portfolios. Typically, active ETFs have an alpha-seeking objective and are designed to “beat the market.” Those extra returns can mean a great deal when the market is moving sideways.

Secondly, active ETFs make a great substitute for mutual funds. Active ETF fees are often less expensive

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Active ETFs
than mutual funds in the same Morningstar (MORN) category. This cheapness extends to esoteric asset classes normally reserved for high net worth individuals, which are only accessed through separate managed accounts [see our Mutual Fund To ETF Converter].

Finally, like index ETFs, investors can gain access to superstar managers with lower initial investments. For example, Bond King Bill Gross’s and PIMCO’s flagship Total Return Fund requires an initial investment of $1,000 or more depending on the share class. The PIMCO’s Total Return ETF (BOND, B-)–also managed by Bill Gross in a similar style–can be purchased for around $110. This lower initial investment makes it more widely available to smaller investors.

How Much Will It Cost?

Though active ETFs are typically more expensive than passive index ETFs- some broad market trackers are basically free at this point–they are still considerably cheaper than active managed mutual funds. According to the latest Investment Company Institute (ICI) report, the average mutual fund investor–including index funds–paid 1.07% in expenses last year. That doesn’t even include the average 5.73% sales load [see Actively-Managed ETF Portfolio].

For active ETF investors, these costs are much lower. For example, both the Guggenheim Enhanced Core Bond (GIY) and Guggenheim Enhanced Short Duration Bond ETF (GSY) can be had for only 0.27% in expenses. Below are the cheapest active ETFs in their respective asset class categories.

Asset Class Active ETFExpense Ratio
Alternatives WisdomTree Global Real Return (RRF) 0.60%
Bond FlexShares Ready Access Variable Income (RAVI) 0.25%
Currency WisdomTree Emerging Currency (CEW) 0.55%
Equity Columbia Large Cap Growth ETF (RPX) 0.89%
Multi-Asset SPDR SSgA Global Allocation ETF (GAL) 0.35%
Real Estate PowerShares Active U.S. Real Estate (PSR) 0.80%
Are They Worth It?

Actively managed ETFs have higher fees than your normal index fund expense ratios, so investors expect actively managed ETFs to outperform or beat the market. As with any fund, that potential outperformance comes down to just how good the underlying managers are. Just as in the mutual fund world, there are plenty of stinker funds. However, there are managers and active ETFs that have beaten their respective benchmark indexes consistently – some by a wide margin.

For example, the Peritus High Yield ETF (HYLD, B)–which bets on junk-bonds–beat its rival iShares iBoxx $ High Yield Corporate Bond (HYG, A-) by almost 3% in 2012. Not to mention, it also pays a much higher dividend [see 101 High Yielding ETFs For Every Dividend Investor].

Another example is the previously mentioned PIMCO Total Return ETF. The fund’s smaller size has allowed Bill Gross to be more nimble, which has translated to bigger returns. According to Morningstar, since its launch, BOND has posted a total return of roughly 12% versus just 3% for the iShares Core Total US Bond Market ETF (AGG, B+) over the same time frame. Additionally, it has also outperformed the PIMCO Total Return Mutual Fund by nearly 5% over the trailing one-year period (as of April 24, 2012).

The Bottom Line

For investors, there is a lot to like about active ETFs; these ETFs’ lower expense ratios, lower initial investments and professional management make them perfect substitutes for mutual funds. The active management can result in higher and benchmark-beating returns, but investors need to take a close look under the hood of all of their ETF options to find the perfect balance of risk, reward and costs before investing.

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Disclosure: No positions at time of writing.

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