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Investor Clinic

Actively managed ETFs: Look before you leap Add to ...

First came mutual funds, with their active management and high fees. Then came ETFs, which keep their costs low by passively tracking an index.

Now, get ready for actively-managed exchange-traded funds. They're supposed to offer investors the best of both worlds - professional management and low costs.

Let's lift the hood on these hybrid products and see if they live up to the hype.

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We'll focus on three new ETFs from AlphaPro Management Inc. - the Horizons AlphaPro North American Growth ETF, North American Value ETF and Dividend ETF.

THE ADVANTAGES

ETFs - whether they're active or passive - have a big advantage in that they can be bought and sold throughout the day. When you buy or sell a mutual fund, you get the closing price, even if you submitted your order at 9:30 a.m. So ETFs give you more control.

The way ETFs are structured gives them a cost advantage over mutual funds, and the lack of embedded "trailer commissions" also keeps fees down. The popular iShares CDN LargeCap 60 Index Fund, for instance, has a management expense ratio of 0.17 per cent, although MERs of 0.5 per cent or more aren't uncommon.

"I think the ETF delivery mechanism is a better, more cost-effective, more convenient and more flexible delivery mechanism than any other out there," says Ken McCord, president of AlphaPro Management.

A CLOSER LOOK AT FEES

AlphaPro has enlisted some high-profile managers for its funds, including Vito Maida, Stephen Rogers and Lyle Stein. They don't work for free. The management fee for each ETF is 0.7 per cent, which is higher than most ETFs, but still less than active equity mutual funds that charge anywhere from 1 per cent to more than 2.5 per cent in total fees.

But that 0.7 per cent management fee isn't the whole story. To get a complete picture of the ETF's costs, you have to add in operating expenses such as audit fees, trustee and custodial expenses, accounting and record-keeping costs, legal, brokerage and other charges.



Investor Education:

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  • Related contentHow do Exchange-Traded Funds (ETFs) work?




AlphaPro doesn't yet know the precise total of these operating costs, but Mr. McCord says they'll add about 0.3 percentage points in fees. Combined with the 0.7 per cent management fee, the total management expense ratio will be closer to 1 per cent.

That's not all. Two of the new ETFs - namely the value and growth funds - will pay the manager a performance fee equal to 20 per cent of the amount by which the ETF outperforms its benchmark (the S&P 500). Even if the ETF declines, as long as it beats the benchmark, a performance fee may still apply, according to the prospectus.

And let's not forget that you have to pay brokerage fees to buy and sell an ETF. Once you add in all these extra fees, active ETFs suddenly don't look like such a screaming bargain.

ACTIVE V. PASSIVE John De Goey, investment adviser with Burgeonvest Bick Securities, says the new ETFs "are fine for people who believe in active management. They are still generally cheaper than the actively-managed mutual funds they are competing against."

Problem is, Mr. De Goey doesn't believe in active management. Index-tracking ETFs are a better choice, he says, because they have lower fees and are more diversified than active mutual funds or ETFs. Index ETFs are also more tax efficient, because they don't engage in a lot of trading that triggers capital gains taxes, he says.

RISK CUTS BOTH WAYS

Because the managers are essentially betting on what stocks will do well - focusing on just 20 or so companies in some cases - they may smash the benchmark one year, but badly trail it the next. AlphaPro's growth and value funds can also short up to 20 per cent of the portfolio.

"They are going to try to get those extra returns by adding risk," says Garth Rustand, executive director of the Investors-Aid Co-operative of Canada. "That's why it's called risk, because it doesn't work all the time."

Like Mr. De Goey, Mr. Rustand believes low-cost, index ETFs are a better option because the vast majority of managers fail to beat the index on a consistent basis.

Mr. McCord disagrees.

"I really want to challenge people on the notion that a lot of managers can't beat the index," he says.

"Most managers don't beat the index because of the 2.5-per-cent management fees ... they're up against a serious headwind."

THE DANGERS

If you want proof that active management can backfire, look no further than AlphaPro's first offering, the HAP Managed S&P/TSX 60 ETF. The ETF, which was managed by technical analyst Ron Meisels, who also writes for The Globe, gained just 6.6 per cent for the year ended Jan. 31, compared with 24 per cent for the benchmark S&P/TSX 60 index. Mr. Meisels is no longer running the ETF.

THE VERDICT

Actively-managed ETFs may offer a cost advantage over the most expensive mutual funds, but there are plenty of solid managed equity funds with MERs of not much more than 1 per cent (Check out the funds from Mawer Investment Management and Phillips, Hager & North, for instance.)

However, if you want to cut your costs to the bone, and if you believe that trying to outsmart the market is a mug's game, there is no substitute for passive ETFs.

"Wall Street and Bay Street have a way of probing at the greed glands of investors," says Mitch Tuchman, chief executive officer of MarketRiders.com, a website that helps investors create ETF portfolios.

"But for most investors I say ... just be one with the benchmark, be one with the indexes. And over long periods of time you'll be the turtle that wins the race."

******

AlphaPro's active ETFs

Horizons AlphaPro North American Value ETF

Manager: Vito Maida, founder, Patient Capital Management

Quote: "There is a universe of several thousand stocks and we're only looking for 20 ... We're always making sure that we're buying things at a dramatic discount to what we think they're worth."

Horizons AlphaPro North American Growth ETF

Manager: Stephen Rogers, vice-president, JovInvestment Management

Quote: "I try to identify companies that are growing at above-average rates. I buy a company that is experiencing continued growth and participate in that growth. It's as simple as that."

Horizons AlphaPro Dividend Growth ETF

Manager: Lyle Stein, CEO, Leon Frazer & Associates

Quote: "Markets should return between 6 per cent and 8 per cent over the next few years ... If you can get half of that return by holding a bird in your hand - income from dividends - why chase the growth?"

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