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By Scott Burns | 10-01-2009 02:38 AM

What Active Management in ETFs Means for Investors

Investors should cheer the rise of actively managed ETFs.

Scott Burns: What active management in ETFs means for investors. Hi there, I'm Scott Burns, director of ETF research here at Morningstar. This week Grail Advisors launched four new actively managed ETFs bringing the total of actively managed ETFs in the ETF space to 10. These four new funds are notable because they have single managers in them unlike Grail's previous product, which was more of a fund of funds structure.

These funds are also going to have established veterans from the mutual fund industry who have returned from a stint in hedge fund land to come back and help draw them assets.

When we look at the ETF structure, there's nothing inherent about the ETF structure that it says that it has to be passive. Although the preponderance of assets today are actually in passive funds and funds that serve as more of substitutes for single stock trading or single fixed income trading, the reality is that the ETF structure is one that just says that this fund is traded on an exchange as opposed to an open-end structure, which is bought or sold through the fund company or through a wholesaler.

So what that means is that active management in an ETF is perfectly acceptable and actually something investors should look forward to. ETFs provide the same promises--whether it's passive or active--to investors in terms of tax efficiency, liquidity, and transparency.

It's widely known that ETFs are more tax efficient than even their very tax efficient index open-end cousins. The reality is when we put active management in the ETF structure, those tax efficiency benefits we expect to actually multiply. The reason being that active management is actually just less tax efficient than index management. There's a lot more trading and transacting that goes on.

That tax efficiency will remain for active management ETFs due to the fact that the creation-redemption process will be the same, and managers will even have the benefit of doing things called "custom baskets" in which they are not actually trading out in the market. That is, if they wanted to add one of a security and less in the portfolio's holdings of another security, they can just create baskets that reflect that change in their holdings.

When we look at costs, ETFs are going to provide a huge benefit to investors in terms of how the ETF is actually distributed. So we can get in a fund with active management traded on the exchange where you have to pay a transaction cost, but what an investor will be able to do is go around the wholesalers and what's known as the mutual fund supermarkets out there to buy this fund.

What that means is that an investor should be able to save anywhere from 15 to 30 basis points off the cost of that fund rather than going through those channels, because they are cutting out that middle man.

So the fund company gets to charge the same amount, pay their cost, pay their managers, the investors get to save money--that's a win for them--and really the only losers in this situation are the wholesalers and the supermarkets.

So, when we look at the landscape and the future for active ETFs we actually expect to see quite a bit of growth. We know that PIMCO has already filed to launch some active management, PowerShares has an established line of five funds--although their performance in asset gathering have probably been a little less than the PowerShares' team would like. And Grail has announced that they expect to launch anywhere from 20 to 30 funds over the next year.

To top it all off we have BlackRock, which is traditionally known as active management shop buy the largest ETF provider out there, iShares.

So even though there's only 10 actively managed ETFs out there in a universe that's greater then 850 ETFs products right now, we can see that this number is definitely going to increase going forward.

And we actually think that for investors who want active management, who are in taxable accounts and also want that liquidity and transparency that ETFs offer. Actively managed ETFs are going to help fit the bill.

Thanks. I'm Scott Burns. For this and other ETF information please check out Morningstar's ETF Center at morningstar.com and Morningstar ETF newsletter.

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