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When Is an Index Fund Not an Index Fund?

At first glance, it seems like an unlikely marriage. Mutual fund leader BlackRock announced last week that it was purchasing Barclays Global Investors , which holds 49 percent of the exchange-traded fund market, for $13.5 billion. These have long been the opposite poles of investing: Most mutual funds try to make money by picking stocks, while ETFs try to make money by simply mimicking the market.

Perhaps the new megagroup will preserve both strategies. But it seems just as likely that BlackRock wants in on the business's quiet but growing trend called the actively managed ETF. If that sounds like a contradiction in terms, well, it is.

In simplest terms, ETFs are index funds—passive, diversified portfolios that trade like a stock. For the past decade, ETF providers like BGI have touted their products as the antidote to the overpriced, underperforming actively managed mutual fund. Over the past six years, investors invested fewer assets in mutual funds and more into ETFs. The trend accelerated during the financial crisis, as investors grew disgusted at the inability of their active mutual funds to protect their assets. Last year, equity mutual funds saw net cash outflows of $245 billion, according to TrimTabs Investment Research, while equity ETFs posted net cash inflows of $140 billion, even as asset values tanked. With all the negative feeling around actively managed mutual funds, why would the ETF industry step backward to make a big push for the actively managed ETFs?

For the money.

Index funds charge lower fees compared with active funds, which means less money in the manager's pocket. ETFs charge even less than comparable index mutual funds and offer the additional benefits of greater tax efficiency and transparency because they're structured differently. In addition, ETFs offer the ability to buy or sell shares during market hours. These reasons led ETFs to capture more than $500 million in assets and grab a significant market share from the $9 trillion mutual fund industry.

The first active ETF appeared early last year in an inauspicious start. Bear Stearns launched the ETF just weeks before the bank went belly up. The fund closed soon afterward. A short time later, Invesco PowerShares launched a family of five active ETFs. But they have found it difficult to gain wide acceptance and attract assets. The financial crisis effectively took these funds off most investors' radar.

However, a thaw in the financial blizzard shows that the industry had been waiting for the right moment to revive what many consider the industry's Holy Grail. Coincidentally, a new entrant in the field named Grail Advisors launched the first post-financial-crisis active ETF last month.

"We are operating the ETF just like a fundamental mutual fund," said Grail Chief Executive Officer Bill Thomas in an interview. This ETF, he added, is "similar to traditional actively managed mutual funds ... because it allows portfolio managers unrestricted trading."

And in a little-reported move that BlackRock didn't miss, iShares, the brand name for BGI's ETF family, last month began the registration process to launch two active ETFs.

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Is this a good thing for the ETF industry? Possibly. Is it a good thing for investors? Definitely not.

Most ETFs offer greater tax efficiency because, unlike mutual funds, they don't buy or sell the shares they own. Every time a mutual fund sells shares, it creates a taxable event, which its shareholders must pay taxes on. However, ETFs receive their securities in a tax-free swap. An institutional investor known as an authorized participant gives a basket of all the securities in the index to the ETF in exchange for ETF shares. With no shares traded inside the fund, there are no taxable gains to pass onto shareholders.

By contrast, the whole point of an active fund is to actively trade stocks. In this case, the ETF could incur significant capital gains, which shareholders would pay taxes on. Grail's Thomas countered that the subadvisers running its fund don't trade a lot and have a reputation for tax efficiency.

So, why do it?

Obviously, to make more money. Grail's American Beacon Large Cap Value ETF charges a management fee of 0.79 percent, 44 percent more than the average ETF expense ratio of 0.55 percent, according to Lipper. But it's still cheaper than a mutual fund; Morningstar lists the average expense ratio for active mutual funds at 1.25 percent. The active ETF is definitely a cheaper choice.

The active management track record

But do investors really prefer active management? Probably a third of the investors in active funds want a manager who can give them market-beating returns. Another third have no choice. They're locked up in 401(k) plans with maybe one index option. The final third probably don't even know indexing is an option. They're put into active funds by financial advisers who have an incentive to do so.

Whatever investors' reasons, active management has no great track record. Recent data from Standard & Poor's again suggest why investors should use index funds. Over the five years ended December 2008, the S&P 500 beat 72 percent of actively managed large-cap funds; the S&P MidCap 400 outperformed 79 percent of active midcap funds; and the S&P SmallCap 600 topped an astounding 85.5 percent of small-cap funds. Theoretically, you want an active manager even more in a bear market, but here again, they don't perform well. In eight out of nine equity styles, the indexes performed better than managers over the past year.

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Still, you can't blame the ETF industry for trying to squeeze more money out of investors. It's not easy to create an index that captures investors' imagination. In addition, the first ETF to track an index typically gets all the attention and assets. Thus, it's hard for more than one company to sell the same index. For example, compare the only two ETFs tracking the S&P 500. The SPDR holds $63.7 billion in assets under management versus $17.7 billion in the iShares S&P 500 Index .

At a certain point, you can't keep creating more index funds. Eventually, investors will become overwhelmed with new ideas and gravitate to the better-known offerings. Over the past year, nearly 100 ETFs have closed and liquidated their assets. That's partly a reaction to a bad market, but it could also mean there's a limit to the number of indexes investors are willing to use.

When demand for new index funds becomes sated, the only way the ETF industry can grow is to offer more actively managed ETFs. With more mutual fund companies planning to enter the space, there will be even more pressure to create active ETFs. It's just hard to see why investors should be excited by an active manager who still can't beat a 37 percent plunge in the S&P 500.

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