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The Time Isn't Right for Actively Managed ETFs

Don't expect exchange-traded funds with active management to catch on any time soon.

With Barclays and Vanguard in the midst of rolling out a series of exchange-traded index funds, plenty of investors are asking: Why not actively managed ETFs?

Indeed, why not? Like index ETFs, such shares could be traded throughout the day, appealing to the growing number of people who think any holding period exceeding one week is unfashionably long-term.

Moreover, because of the way they would handle redemptions, actively managed ETFs have some potential tax advantages for long-term investors. When ETFs trade at discounts to net asset value, institutional arbitrageurs buy up shares, then redeem them for some of the portfolio's underlying stocks, netting a small profit. (This typically prevents them from trading at huge discounts, as traditional closed-end funds frequently do.)

Because the arbitrageur, rather than the fund, ultimately has to sell the shares, redemptions are less likely to force the ETF to sell stocks at a profit, triggering taxable gains.

But don't hold your breath waiting for a bunch of actively managed ETFs to appear.

One impediment is large fund companies' unwillingness to make frequent portfolio disclosures. For the arbitrage process to work, funds might need to make more or less continuous disclosures of their holdings. At a minimum, they would have to update their NAVs constantly for the arbitrageurs, and that information could be used to infer a fund's holdings. Based on this alone, it is probably safe to assume that Fidelity--which makes public just two complete portfolios per year--won't be launching an actively managed ETF any time soon.

The tax advantages of actively managed ETFs may also prove illusory. Shareholder redemptions aren't the main reason so many actively managed funds are tax-inefficient. Rather, fund managers' hyperactive trading is the main culprit. (The average holding period for diversified stock funds is just 14 months.) Unless managers cut down on their trading, an actively managed ETF would simply be yet another tax-inefficient vehicle in a different wrapper.

When actively managed ETFs do appear, the sponsors will likely be second- and third-tier fund companies, who would welcome the media attention and have less to fear from frequent portfolio disclosure. This will further limit their appeal.

The bottom line? Don't expect actively managed ETFs to take the industry by storm.

Have a question about ETFs? Brad Zigler, who heads up Barclays' ETF investor-education effort, is now taking questions in ourExpert Q&A forum.

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