Things to Look for in Actively Managed ETFs

A good number of ETFs in registration with the SEC are going to be hitting the market shortly (presuming they get the approval they seek). Of these, some will likely be issued by long-standing and respected companies, such as PIMCO (which has already entered the fray with a handful of both passive and actively managed bond ETFs) and T. Rowe Price.

You may be inclined to choose one of these actively managed funds. After all, if you’re going to go active, there’s no reason not to do it with an ETF. The active ETFs will probably wind up being less expensive and more tax efficient than their corresponding mutual funds.

But keep in mind that historically, actively managed funds as a group have not done nearly as well as index funds. That being said, active management may sometimes have an edge, especially in some areas of the investment world (such as commodities and non-Treasury bonds). And much of the advantage of index investing has been in its ultra-low costs — something that actively managed ETFs could possibly emulate.

If you want to go with an actively managed fund, at least to keep in mind the lessons learned from indexing and what has made indexing so effective over time. Basically, you want certain index-like qualities in any actively managed fund you pick:

  • Choose a fund with low costs. With so many ETFs allowing you to tap into stocks or bonds for less than one-quarter of a percentage point a year, you do not need or want any fund that charges much more.

    Any U.S. stock or bond fund that charges more than a percentage point, or any foreign fund or commodity fund that charges more than 1.5 percent, is asking too much, and the odds that such a fund will outperform are very, very slim. Go elsewhere.

  • Watch your style. Make sure that any fund you choose fits into your overall portfolio. Studies show that index funds tend to do better than active funds in both large caps and small caps, but you have a better chance in small caps that your active fund will beat the indexes.

  • Check the manager’s track record — carefully. Make sure that the track record you’re buying is long-term. (Any fool can beat the S&P 500 in a year. Doing so for ten years is immensely more difficult.) Look at performance in both bull and bear markets, but your emphasis should be on average annual returns over time compared with the performance of the fund’s most representative market index over the same period.

  • Don’t go overboard with active management. Studies show so conclusively that index investing kicks butt that you should be very hesitant to build anything but a largely indexed portfolio, using the low-cost indexed ETFs.

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