Actively Managed ETFs Close to Getting SEC Go Ahead

Last Friday, the Securities & Exchange Commission filed a notice that appeared to clear the way for a quartet of "actively managed" ETFs from PowerShares. (They are now waiting for a short public comment period to end later this month.) It's big news for PowerShares, which filed a preliminary prospectus with the agency last November. The approval could also signal that similar offerings from Vanguard, Bear Stearns and iShares are close to getting the green light, too.

The emergence of actively managed ETFs would push the boundaries of the $600 billion ETF industry, which was initially forged on the back of simple index fund-like products. The concept combines the low costs and trading flexibility of an ETF with the stock-picking savvy of a fund manager. To many prospective investors, it's the best of both worlds. And should these ETFs be successful, they could potentially take a much bigger chunk out of the $12 trillion that's invested in traditional funds.

"The ETF industry has been talking about this for years," says J.D. Steinhilber, president of Agile Investments, a money-management firm that specializes in ETF portfolios. "This is a big deal."

ETFs and mutual funds have long had their share of loyalists. Some financial pros favor ETFs because they trade throughout the day, a distinct advantage when they are trying to get in and out of tricky markets. ETFs also tend to be more tax efficient and charge cheaper fees than the average mutual fund. However, investors who favor mutual funds point to the experienced fund managers who beat their benchmarks every year. This group is willing to pay higher fees and capital gains in return for the opportunity to reap those big gains.

Both camps make some good arguments. The goal of actively managed funds is try to take the best attributes of ETFs and mutual funds and marry them. But while the concept looks great on paper, getting these ETFs to actually work is another thing altogether.

The biggest hurdle is transparency. Fund managers are reluctant to reveal what they're buying for fear speculators will front-run their trades, a tactic that can artificially boost the prices of their best ideas. ETFs, though, have to be transparent because they trade throughout the day. Market makers must constantly know what's in their portfolios in order to match buyers with sellers.

So the question is just how much transparency can actively managed ETFs afford? Fund companies have gotten around this debate by using computer formulas that don't involve manager egos or stick to an area of the investing world that is somewhat immune to front-running. Such tactics could serve as one possible solution to the transparency issue, but it will nevertheless be an ongoing problem.

Vanguard has filed for four fixed income actively managed ETFs that are just additional share classes of the company's Inflation-Protected Securities (VIPSX), Short-Term U.S. Treasury (VFISX), Intermediate-Term U.S. Treasury (VFITX), and Vanguard Long-Term U.S. Treasury (VUSTX) funds. This strategy has worked well for the company. It relieves them of spending big bucks on creating and launching a whole new fund and it gives investors an instant performance track record — a luxury most competitors can't offer. There's "no word" yet on whether SEC approval is imminent, according to a Vanguard spokesperson.