Exchange-traded funds for the active-minded

With the growing popularity of exchange-traded funds, the industry is churning out new products targeted at investors’ needs, fears and greed.

Many of these innovations are simply being ignored, and although it is still too early to tell for sure, actively traded ETFs have fallen into that category.

Actively traded ETFs have yet to burn up the track with mainstream investors, who mostly cling to passive funds that mirror indexes that are benchmarks for stocks, bonds and other investments. Unlike their passive cousins, active ETFs feature a hands-on manager who can take the reins of a portfolio and make daily decisions on how to best invest, much as in a traditional mutual fund.

As a relatively new product, such active funds have been evolving over the last seven years. Of the 10 largest funds in this category, six manage bond portfolios.

To date, though, this approach has had little appeal. Slightly more than $20 billion is spread across 133 active exchange-traded funds, according to Morningstar. That is about 1 percent of the total market for ETFs.

Within this group, there’s no superstar fund with megabillions in investor dollars. The largest active fund is the Pimco Enhanced Short Maturity Active ETF, or MINT, with about $3.5 billion in assets. That’s a flea compared with its flagship sister Pimco Total Return Bond fund, PTTAX, which holds more than $107 billion. One of the largest U.S. stock exchange-traded funds is the SPDR S&P 500 index fund, SPY, with more than $180 billion as of June 19.

The main argument for active funds is that a dynamic manager can reach beyond a static portfolio to add value by moving in and out of investments. With bonds and stocks becoming skittish as the Federal Reserve comes closer to raising interest rates, active managers may be able to provide an extra measure of flexibility that will dodge market downturns.

Ideally, an active fund can combine low costs, daily transparency of fund holdings and the nimbleness of a capable manager who can spot trouble in the market — or seize profitable opportunities.

“Although cost is one of best determinants of success,” says Robert Goldsborough, exchange-traded fund analyst for Morningstar, “good managers can add value.”

Active funds also may invest in specialized niches or alternative strategies that are bypassed by larger index funds that cover broad sections of particular markets.

The First Trust North American Energy Infrastructure fund, or EMLP — the third-largest active ETF by assets — invests in publicly traded energy companies and master limited partnerships, which are complicated vehicles known for their high yields and tax complexity.

The First Trust fund yields 3 percent and returned nearly 24 percent last year compared with a broad-based energy stock benchmark, which lost 18 percent. If you were looking for a specialized play on the companies benefiting most from the North American shale oil and gas boom, this fund would be worth considering.

Although it is still early to see how well active funds will do over time, some new entrants have posted notable performances in recent months as the bond market swoons in anticipation of higher rates in the United States.

The SPDR DoubleLine Total Return Tactical ETF, or TOTL, a bond fund, has edged out a general bond index, returning 0.20 percent in the last three months through June 19, compared with a loss of about 1 percent for the Barclays U.S. Aggregate Bond index, a gauge for the U.S. bond market. While that is hardly impressive, it may be significant if the fund’s managers can make money as bond prices fall, which will be more pronounced if the Fed announces a rate increase.

“We’re seeing more interest in active bond ETFs,” notes Todd Rosenbluth, director of exchange-traded and mutual fund research with S&P Capital IQ in New York. “The DoubleLine fund is worth looking at because of low risk and management.”

As with any actively managed product, though, investors face the possibility of failing to beat benchmarks over time after subtracting market timing errors and fund expenses. Most funds cannot consistently beat their respective indexes over time. Over the five years through 2014, some 88 percent of large-stock funds failed to beat their benchmarks, according to S&P/Dow Jones Indices.

For long-maturity government bond funds, the record is even worse: 95 percent of funds tracked by S&P/Dow Jones did not outpace their peer index over the last decade.

Costs are also a concern with active funds, since hands-on management always adds to total expenses. The First Trust fund, for example, charges a hefty 0.95 percent for annual management, a relatively high expense level in the ETF world, where an investor can hold a broad-based stock index fund for as little as 0.04 percent.

Another difficulty is gauging precisely how well a fund is doing relative to its peers. Elisabeth Kashner, an analyst with ETF.com, notes that there is really no appropriate index for the portfolio managed by the Pimco Enhanced Short Maturity fund.

“Most of the top 10 active ETFs are difficult to benchmark,” Kashner said.

Of course, much of active investing is built on hope and the prospect that you can find a manager whose experience will help you beat the market in the future. It has happened with stellar managers such as Peter Lynch of Fidelity; Bill Miller of Legg Mason; and Bill Gross, late of Pimco, now with Janus Funds. But it may be a matter of pure luck to find a market-beating manager. You risk even more if you try to time the market.

“This is clearly a fund for trading,” John Bogle, the founder of the Vanguard Group, says of actively managed funds. “It involves being right twice — once when you get in and again when you get out.”