Will 2014 Be The Tipping Point For Active ETFs? [PIMCO ETF Trust, Vanguard 500 Index Fund]

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September 12, 2014 4:52pm NYSE:BOND NYSE:MINT

etfs etfsDavid Fabian: The pace of new actively managed ETFs being released to the market has continued to heat up this year.  Of the 106 total ETFs that are designated as active by the SEC, 35 have been released this year and many more

are planned in the near future.

Active management has historically received a bad rap when compared to passive index funds that offer much lower costs, transparent holdings, and known risk parameters.  The higher fees and fluctuating performance variables of actively managed portfolios has largely kept these strategies subdued in the ETF world.

However, they appear to be inching their way further into the mainstream as investors seek out more innovative ways to lower risk or enhance returns.  This is likely the result of an overabundance of passive indexes already available.  There are only so many ways you can slice and dice the numerous Russell, Standard & Poors, NASDAQ, or MSCI indexes.

The next logical step is to quantify “smart beta” investment strategies that constantly select and rebalance their underlying holdings according to a strict methodology or move to a true actively managed ETF that allows for even greater flexibility.  The ETF providers are more frequently choosing the latter and doing so with the intent of luring more assets away from traditional open-ended mutual funds.

Interestingly enough, income investing appears to be the most desirable style of actively managed ETF.  Nine out of the top ten funds by asset size are focused on fixed-income, MLP, or floating rate notes.  This includes the PIMCO Enhanced Short Maturity ETF (NYSEARCA:MINT) and PIMCO Total Return Fund (NYSEARCA:BOND), which each have over $3.5 billion in total assets.  These are the only two actively managed ETFs that have managed to surpass and sustain assets above $1 billion.

In my opinion, there is still further room to grow in the income arena to include multi-sector bond funds, strategic income ETFs, and other flexible strategies.  Famed bond managers Jeffrey Gundlach and Bill Gross both have ETFs in registration to capitalize on these areas and they could be released as soon as this year.  The key to successfully attracting new assets and investor confidence in these strategies will be to leverage their existing mutual fund track records while offering competitive expense ratios.

On the equity side of the spectrum, the active management value proposition has yet to resonate with a landslide of inflows.  The PowerShares S&P 500 Downside Hedged Portfolio (NYSEARCA:PHDG) is one innovative strategy that uses a rules-based methodology to allocate assets between large-cap equities, volatility, and cash.  This risk-aware approach has lured more than $400 million in total assets and only charges an expense ratio of 0.39%.

However, this success story is in the minority when looking at various active equity competitors.  Many have yet to exceed $100 million in total assets and appear to be languishing despite continued demand for low-cost passive offerings.  Four of the top five ETFs for inflows this year are Vanguard ETFs with expenses of less than 0.10%.  In fact, the Vanguard S&P 500 ETF (NYSEARCA:VOO) is leading the pack with over $5 billion in new money for 2014.

In my opinion, the biggest risk to investors seeking an actively managed equity strategy is selecting a closet index fund with mediocre performance and expenses of 1.00% or higher.  To avoid this mistake, it’s key to closely examine the track record, portfolio makeup, manager value proposition, fees, and potential tax ramifications of any active strategy.  This will allow you to compare it against competitive alternatives to determine if its best suited to your risk tolerance and long-term investment objectives.

I continue to believe that a select group of actively managed ETFs offer excellent value for investors and should be strongly considered.  However, it’s important to be selective when analyzing these funds to complement your existing holdings.

In addition, as more active ETFs are released and the competition heats up, fund providers will likely have to lower expenses to fight for assets. This benefits the end users of ETFs and continues to move the industry in the right direction.

This article is brought to you courtesy of David Fabian from FMD Capital Management.

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