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Active ETFs add a new spin to a low-cost product

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Almost all the things you don't like about mutual funds have been fixed in a new investing product called the actively managed exchange-traded fund.

Wait a moment - aren't ETFs the anti-mutual fund?

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Yes, to many investors they're just that thanks to their mandate to track stock and bond indexes rather than trying to out-guess the market by choosing individual securities. But now there's a different type of ETF - one that does exactly what conventional mutual funds do, but without the high cost and impediments to convenient buying and selling.

Actively managed ETFs were introduced in Canada by Horizons AlphaPro in early 2009 and the reception was unenthusiastic. I wrote a column dissing them on the basis that many fund managers can't beat their benchmark indexes, a point that highlights the benefit of the traditional index-tracking ETF.

The actively managed ETF market has evolved in 2010, and so has my view. With some quality managers being recruited to run these ETFs, I think they have the potential to be one of the most significant retail investing developments in years.

To understand why, take a look at the HAP North American Value, Dividend and Managed S&P/TSX 60 ETFs. The value ETF is run by Vito Maida, whose safety-first approach to investing in stocks has until recently been available only to high-net-worth investors. Managing the dividend ETF is Lyle Stein, a fund industry veteran who now runs the venerable investment firm Leon Frazer & Associates. The managed S&P/TSX 60 fund is run by a team from Front Street Investment Management that includes Frank Mersch, a mutual fund industry star in his days at Altamira Investment Services.

"These guys are different in how they do things," said fund analyst Dan Hallett of HighView Financial Group. "But all three are quite good."

The 2010 Investor Education series for beginner investors:

  • Part 1: Want to invest? Learn to save first
  • Part 2: Mutual funds: A good place to start
  • Part 3: Why ETFs are booming
  • Part 4: Sleeping well with GICs
  • Part 5: Why buy and hold is (still) the best approach
  • Part 6: Death, yes. Taxes? Not necessarily.

Subpar managers are easy to find in the mutual fund world - that's precisely why conventional index-tracking ETFs have become such a fast-growing product. But savvy investors know there are some managers who are worth putting to work in your portfolio. Actively managed ETFs are a smarter way to access these managers.

Ken McCord, president of AlphaPro Management, summed up the benefits of actively managed ETFs as follows: "Lower fees, they're way more convenient and they're way more flexible."

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Let's start with fees. The management expense ratios for five of the AlphaPro active ETFs is 1 per cent, while two others come in around 1.25 per cent. In addition, performance fees are charged if the funds beat specific benchmarks.

You can buy core index-tracking ETFs with MERs of 0.17 to 0.6 per cent or so, but mutual funds can easily charge 2 to 2.4 per cent. Although he's a little leery of the impact that performance fees could have, Mr. Hallett calls AlphaPro's pricing a fair deal.

"It's kind of hard to get a lot lower than that and make it worthwhile for the manager," he said.

A major reason why active ETFs cost less to own than mutual funds is that their fees do not include a component that is intended to compensate investment advisers for the counsel they provide clients. This so-called trailing commission accounts for one percentage point of the typical equity fund's MER and 0.5 points for the average bond fund.

For do-it-yourself investors, actively managed ETFs are a revelation. The reason is that DIY types that own mutual funds face the same MERs as investors using advisers, even though there's no advice to justify the trailing commissions.

Fund companies actually offer a special version of their funds, called F-class, with trailing commissions stripped out. But they're strictly for fee-based advisers who charge separately for their services and off limits to do-it-yourself investors. No wonder DIY types are often so scathingly critical of mutual funds.

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In fact, self-directed investors are considered by Mr. McCord to be a prime market for actively managed ETFs. He's also targeting the fee-based advisers for whom F-class mutual funds were designed.

Clients of these advisers will pay close to mutual fund prices for active ETFs, with advice and ETF fees combined. But they'll still benefit from conveniences like being able to buy or sell at any time during the trading day. By contrast, mutual fund trades are always executed at an end-of-day price.

Imagine you want to sell a fund with the market soaring at midday. You can do that with an actively managed ETF, whereas a fund exposes you to the risk that the market will pull back or even decline later in the day. When buying, you can take advantage of a dip to place your order.

One more benefit is that there are no short-term trading penalties with active ETFs, like there are with some funds. It's conceivable you would have to pay a 2-per-cent penalty for selling a fund within 90 days of buying.

Brokerage fees apply when buying actively managed ETFs, which means you'll generally pay a minimum of $5 to $29 for online orders, depending on which broker you use. Still, there's an advantage to investors in being able to trade active ETFs like a stock instead of a mutual fund.

When buying a fund, there's no way to customize your order. You simply say how much you want to buy or sell, and that's that. Because active ETFs are traded like stocks, you can use a limit order to set a ceiling on what you'll pay and a floor on what you'll accept when selling. You can also use a stop-loss order to liquidate your holding if the price falls through a certain threshold.

Alone, convenience and low fees don't make active ETFs something you need to own. The real appeal is having these benefits along with the services of a top manager who brings something different than a cheaper index-tracking ETF. Expertise in a particular sector, for example, or a lower-risk approach to investing.

Be sure you're getting something unique before you buy because not every active ETF is worthy. AlphaPro itself has already replaced the original manager of Managed S&P/TSX 60 ETF, which made about half of the S&P/TSX composite index's gain of the past 12 months.

Mr. McCord plans to build his firm's $160-million in assets by assembling a varied lineup of active ETFs that rivals what a mutual fund company offers. If he recruits the right managers, active ETFs will go far.

Here's a list of TSX-listed ETFs that use a manager to pick securities rather than following the traditional ETF strategy of tracking an index. All are part of the Horizons AlphaPro family.

HAP Seasonal Rotation MER: 1% Description: Exploits seasonal trends in stock, bond, commodity and currency markets Managers: Don Vialoux and Brooke Thackray

HAP S&P/TSX 60 130/30 MER: 1.25% Description: Tracks the S&P/TSX 60 130/30 Strategy Index, which mixes long and short positions in stocks (bets that stocks will rise and fall in price) Manager: JovInvestments

HAP Gartman MER: 1.25% Description: Mixes long and short positions in global stocks, bonds, commodities and currencies. Manager: The Gartman Letter, founded by Dennis Gartman

HAP Dividend MER: 1% Description: Aims to provide dividend income plus modest long-term capital growth by investing in stocks with above-average yields Manager: Lyle Stein, Leon Frazer & Associates

HAP North American Value MER: 1% Description: A value fund (seeks undervalued stocks) that focuses on the U.S. market; will initially use currency hedging. Manager: Vito Maida, Patient Capital Management

HAP North American Growth MER: 1% Description: A growth fund (seeks stocks with fast-growing revenues and profits) that invests in North American stocks and hedges its U.S. exposure Manager: Steve Rogers

HAP Managed S&P/TSX 60 MER: 1% Description: Active management of stocks in the S&P/TSX 60 index of big blue chips or similar indexes Manager: Frank Mersch and Prakash Hariharan, Front Street Investment Management

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