New Changes Make Investing in ETFs More Appealing

PHOTO: Investors view bonds in general as being less risky than stocks because they are less volatileJoseph De Sciose/Getty Images
Investors view bonds in general as being less risky than stocks because they are less volatile

Over the past decade, exchange-traded funds (ETFs) have become popular because of their advantages over mutual funds. Now, a new breed of ETF is seeking to mount a greater challenge to mutual funds.

Like a mutual fund, an ETF is a pooled investment vehicle that tracks an index, commodity or group of assets. But unlike mutual fund shares, shares of ETFs are traded on an exchange throughout the day at a market-determined price. So like stocks, ETFs register price changes throughout the day as sellers offer these investments for sale and buyers bid on them.

Most ETFs are based on some kind of stock index. An ETF affords investors the asset diversification of the particular index that it tracks. For example, the Spider (SPY) ETF gives investors the diversification of the S&P 500 index.

This is an example of ETFs in their passive form. In recent years, ETFs have broadened their market territory as some investment companies have begun offering them in active form. Investment managers trade them with the goal of increasing value for investors based upon specific investment objectives. These investment managers trade ETFs to execute a strategy, much as active mutual fund managers do with stocks. Strategies include growth, investing long, investing short and domestic and international securities.

Active ETFs are not only often less expensive than mutual funds in terms of fees and expenses but also hold appeal for investors who don't have enough money to qualify for the minimum investment levels required by managers of separately managed stock portfolios.

Like regular ETFs, the active variety has distinct advantages over mutual funds, including:

• Lower costs. Fees and expenses for active ETFs are slightly higher than those of their passive counterparts, but far lower than those of actively managed mutual funds. The average active ETF charges a little over .7 percent annually, compared with about 1.4 percent for the average mutual fund.

• Greater flexibility. You can sell an ETF during the trading day just as you can a stock. But with a typical mutual fund, you buy from and sell to an investment company, and the value of shares in the fund is calculated at the end of each trading day. This isn't the case with ETFs, which allow investors to sell short and buy on margin.

• Potentially greater tax efficiency. Shareholder activity and portfolio turnover doesn't affect ETFs to the same extent that it does with mutual funds, where investors can end up losing money but paying taxes on earlier gains enjoyed by others. This can result in a substantial difference in after-tax returns.

• Transparency. Active ETFs publish their holdings daily, so you can see exactly what stocks underlie them. This can benefit shareholders, especially during turbulent times. For example, if you held an ETF during the market meltdown of 2008, you might have noticed just how much exposure you had to shares of now-departed Lehman Brothers – and sold the ETF. By contrast, mutual funds only report holdings on a quarterly basis, usually with a 30-day lag.

Yet the transparency of ETF holdings can be a double-edged sword. The downside of the daily disclosures is that savvy investors will see what shares active ETF managers are acquiring, and then buy these same stocks, increasing prices that managers must pay as they continue to accumulate shares.

Active ETFs managers like Eaton Vance are exploring ways to limit this transparency so managers can build up large blocks of ETFs without telegraphing their strategies to the market. Even if these efforts don't succeed, active ETFs would still likely have more transparency than mutual funds.

Unlike most mutual funds, ETFs do not necessarily trade at the total value of their underlying holdings. Instead, the market price of an ETF is determined by the forces of supply and demand. So ETF shares sometimes trade at prices above or below the value of their holdings. This may pose a problem for investors in less-liquid ETFs if they want to dump them in a sell-off.

Investment companies that offer active ETFs include those that have suffered damage from the flight of cash out of mutual funds and into regular, passive EFTs. These companies are seeking to capitalize on their investment management skills while capturing ETF market share.

Examples of ETFs on the market include:

WisdomTree's Japan Hedged Equity ETF (DXJ) offers investors the opportunity to invest in Japan while providing a hedge against the yen.

PIMCO's Total Return (BOND), an actively managed bond ETF that seeks performance correlated with Barclays Capital Aggregate Index.

Advisorshares' recently launched Pring Turner Business Cycle ETF (DBIZ), managed by PringTurner Capital Management, uses the firm's unique investing process, geared to different stages of the business cycle. This has appeal for investors who believe that, like the last decade, this one will be one of low average annual returns.

• A variety of active ETFs from State Street Global Advisors, including SSga Income Allocation ETF, a total return fund focused on investment in income and yield-generating assets such as corporate bonds, dividends and preferred stocks.

Little did many investors know 20 years ago that the then-fledgling ETF industry would become what it is today. Expect to see a wave of active managers enter the ETF arena over the next few years as the industry comes up with innovative solutions to the disclosure requirements that sometimes bedevil their strategy execution. In 10 years, active ETFs might be as popular as the passive form is today.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

Craig J. Coletta has 20 years of experience in the financial industry. He is president of C.J. Coletta & Co., a Registered Investment Advisor firm, and president of Coletta Investment Research Inc. Coletta is a Chartered Financial Analyst charterholder, a Chartered Market Technician and a Certified Hedge Fund Professional. He holds a B.S. in accounting and business administration from Rider University, and is a member of the American Institute of Certified Public Accountants.