Active ETFs Are Hamstrung

The first five are out. Expect a flood of additional funds despite their limitations.

To most investors, the beauty of exchange-traded funds is that they're simple to analyze, dirt-cheap to own and immune from manager mistakes -- all the things that most mutual funds are not. The introduction of actively run ETFs hacks away at all three of these advantages plus introduces some new problems. You'd be advised to avoid them until they prove their value.

Unlike all previous ETFs, the new funds -- four from PowerShares and one bearing the untimely Bear Stearns brand -- try to beat their benchmarks rather than merely match them. But doing that is easier said than done. By nature, ETFs require managers to change their portfolio in a very public way. That opens the door to speculators who could anticipate a fund's moves, accumulate shares of a stock on the fund's buy list and drive up the cost to the fund and its shareholders.

The new funds have adopted cautious strategies to guard against such front running and have placed a number of restrictions on themselves to try to minimize it. But these restrictions raise the question of whether ETFs will ever be suitable for a freewheeling manager, such as Ken Heebner of CGM Focus.

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For example, PowerShares Active AlphaQ (symbol PQY) and PowerShares Active Alpha Multi-Cap (PQZ) rely on computer-generated rankings to buy and sell stocks. The ETFs change their portfolios only once a week, on the last business day of the week (changes will be announced before the next day's trading begins). Moreover, Multi-Cap won't replace more than three stocks in a week. In following a computer-driven strategy, the two funds don't differ much from some existing ETFs, such as PowerShares Dynamic Market Portfolio (PWC), which tracks an index that changes quarterly according to a proprietary formula.

The manager of PowerShares Active Mega Cap (PMA) has more freedom to buy and sell. But the fund is unlikely to deviate much from its benchmark, the Russell Top 200 index, which tracks the largest of large-company stocks.

In addition, all of these funds, plus two active bond ETFs -- PowerShares Active Low Duration (PLK) and Bear Stearns Current Yield (YYY) -- are designed to hold frequently traded securities. So even if front running takes place, the impact on stock and bond prices should be minimal. "As we get more comfortable with how these funds operate, you will find funds based on less-liquid areas of the market down the road," says Bruce Bond, chief executive of PowerShares, a unit of money-management giant Invesco. Ultimately, Bond says, active ETFs will accommodate a go-anywhere kind of manager. But the threat of front running may prove to be too inhibiting.

The managers of the new PowerShares ETFs have experience using similar strategies. But they've tweaked the ETF versions -- by adopting a different benchmark index, for example -- to avoid tipping off speculators about moves managers make in their non-ETF portfolios. That means these new ETFs have no records to speak of. Interested investors should give them a few years to develop before jumping in.

Contributing Editor, Kiplinger's Personal Finance