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Actively Managed ETFs Grow Quickly But Face Hurdles

Actively managed exchange traded funds are a small but fast-growing segment of the approximately $2 trillion ETF industry. But regulatory hurdles threaten to stunt their growth.

Like traditional mutual funds, actively managed ETFs harness the buy and sell ideas of professional money managers who aim to outperform a benchmark index. But, unlike mutual funds, the ETFs allow investors to manage short-term risks by trading intraday and using tools such as limit orders, which set maximum or minimum buy and sell prices. The ETFs also tend to have lower expenses than mutual funds.

The funds are a fairly new strategy in ETF investing, with most funds started in the last seven years. The active ETF industry has grown to 128 funds with some $19 billion in assets as of March 31, according to data provided by Morningstar. Nearly half of those funds have been launched since the start of 2014. New funds include the recently launched Innovator IBD 50 Fund (ARCA:FFTY), which invests in the 50 companies that make up the IBD 50 index.

“Because the active ETF space is still so small, I feel like there’s so much more room for growth,” said Noah Hamman, CEO of AdvisorShares, one of the industry’s largest players with 23 funds totaling about $1.3 billion in assets.

AdvisorShares’ active ETFs include high-yield bonds, international equities, global bonds and commodities. Last year, the company launched two currency-hedged gold funds that have allowed investors to buy the yellow metal in depreciating currencies such as the euro and yen.

“Instead of trading a strong dollar for gold, you can trade a weakening foreign currency for that gold exposure,” Hamman said.

The AdvisorShares Gartman Gold/Euro (ARCA:GEUR) ETF is up 14% this year while the Yen/Euro (ARCA:GYEN) ETF has risen 0.4%. By comparison, the SPDR Gold Trust (ARCA:GLD) is up 1%.

Pimco operates the biggest managed ETFs by assets: the Pimco Enhanced Short Maturity Active ETF (ARCA:MINT), with $3.7 billion in assets, and the Pimco Total Return Active ETF (ARCA:BOND), with $2.6 billion in assets. State Street (NYSE:STT), WisdomTree (NASDAQ:WETF), Fidelity and BlackRock (NYSE:BLK) are among other firms that offer actively managed ETFs.

Though active ETFs are growing quickly, about 99% of the $2 trillion in ETF assets remain in passive index products, such as those that track the S&P 500. Both types of ETF are still dwarfed by the $16 trillion U.S. mutual fund industry.

While active ETFs tend to charge lower fees than mutual funds, their growth is hampered by requirements that managers disclose their holdings each day. The fear is that others will be able to buy a stock just before the ETF manager can execute a trade, a practice known as front-running.

These 3 ETFs Are Topping Peers In 3 Top Categories

Three popular ETF categories saw massive growth in 2014. Strategic beta funds grew assets by 25.8%, sector-based funds 26.8% and currency hedged funds 51.5%. These exchange traded funds also saw positive net inflow as investors used them to boost returns and lower risk.

Strategic beta ETFs, also called smart beta ETFs, are the largest of the three categories. Among such funds, First Trust China AlphaDEX (ARCA:FCA) is outperforming. It’s up 27% year to date.

FCA screens and ranks stocks on growth factors such as price appreciation and sales growth. It has 50 holdings with the biggest allocations in real estate and financial services.

The fund has $24.2 million in assets. Its expense ratio is 0.80%.

Sector investing is also gaining popularity. Diversified U.S. equity ETFs have leaked billions this year on stock market news of soft earnings and expensive valuations. But their sector-based counterparts absorbed $5.77 billion in new money, according to Morningstar data.

Among sector-based ETFs, Guggenheim Solar’s (ARCA:TAN) 44.3% gain so far this year makes it a winner.

A passive fund, TAN holds 27 domestic and international solar stocks. It has $447.5 million in assets and a 0.71% expense ratio.

Among fast-growing hedged ETFs, iShares Currency Hedged MSCI Germany (ARCA:HEWG) is a standout. It’s soared 21.9% so far in 2015.

Investors have ratcheted up their stake in eurozone equities since the European Central Bank announced a massive stimulus program on Jan. 22.

HEWG especially benefited as the dollar surged vs. the euro. As the dollar rises, hedged products can be key to successful investing in foreign stocks.

These strategies don’t get hurt when the local currency falls. (See IBD’s Q&A with BlackRock iShares Managing Director Matt Raynor, who discusses investing in currency hedged ETFs, sector ETFs and ETF areas.)

HEWG invests in large- and mid-cap German stocks while mitigating exposure to a falling euro. It has $1.65 billion in assets. Its expense ratio is 0.53%, or $53 in fees per $10,000 invested.

Alternatives Open Whole New World For ETF Investors

Yes Virginia, you can have something besides chocolate and vanilla. In the ETF world, you can put your hard-earned money into something that invests in things besides traditional stocks and bonds.

Although they dominate the landscape, equity and fixed-income ETFs are not the only game in town.

A growing field of alternative ETFs invest in such areas as currencies, commodities, real estate and private equity, and employ such strategies as tapping mergers and acquisitions, asset arbitrage, inflation/deflation, leverage, and market neutral as well as multistrategies.

“The alternative investment ETF space is still relatively new, but the nascent industry is growing,” wrote Tom Lydon of ETF Trends.com in a Jan. 13 article.

Alternative ETFs can provide a number of benefits for investors. “In theory, they’re going to offer some of the same benefits that alternatives can provide in other formats, such as greater diversification to your portfolio, improving potentially risk-adjusted performance, Josh Charlson, Morningstar’s director of manager research for alternative strategies, told IBD. “But the benefit in an ETF would be doing so at a lower cost than what you might get in a mutual fund or a private fund.”

Diversification is one of the biggest benefits of alternative ETFs. When the stock market gets into trouble, you don’t want to be holding things that are highly correlated to each other — those that generally move in tandem. At times, these can include gold and real estate.

Some alternative ETFs also offer exposure to areas like hedge funds or private equity that would otherwise be open only to professional investors or individuals with deep pockets.

But alternative ETFs do have drawbacks. One is that many issues are thinly traded. Some only trade a few thousand shares a day. So if you need to get out of your position, you’ll likely need to lower your selling price in order to get a fill.

Another thing is that alternatives are new to the market, so there’s no record of long-term performance to gauge.

ProShares, Direxion, WisdomTree, iPath and IndexIQ are some of the more popular providers of alternative ETFs out there.

Bethesda, Md.-based ProShares offers about 139 products that run the gamut from leveraged equity and fixed income to private equity and short volatility. In October, it teamed with Morningstar to launch the ProShares Morningstar Alternative Solutions ETF (ARCA:ALTS), which combines a broad range of alternative strategies.

New York-based IndexIQ offers a number of products that use hedge fund strategies, commodities-based ETFs as well as an inflation-hedge ETF.

Last year, San Diego, Calif.-based Reality Shares introduced a unique twist on a dividend play with its Divs ETF (ARCA:DIVY). The fund doesn’t pay dividends, but is focused on long-term capital appreciation through the growth of dividends.

“Dividend payouts are below historical averages and activist investors are screaming for that capital to be returned to shareholders,” said Eric Ervin, co-founder, president and CEO of Reality Shares. “So we see some pretty good dividend increases in our future, and this would be a vehicle to capture those dividend increases without having to worry about a potential stock market correction here or there.”

According to data from Morningstar, the alternative ETFs seeing the most funds coming in over a three-year period are more trading-oriented, such as gold, oil and volatility ETFs.

10 Ways To Use ETFs To Deal With Rising Interest Rates

Time is money, as they say. And for once, ETF investors are on the winning end as they have more time to prepare for the Federal Reserve’s interest rate hikes, which are now expected to come later in the year. So, what income-producing ETFs are good investments in this environment?

If you hold traditional fixed-income ETFs, you know that their value will go down as rates rise. But all is not lost. There are quite a few alternatives to creatively position your ETF portfolio for success ahead of time:

• “Laddering” is one option, says Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ. In this case, investors are able to hold bonds with a specific target maturity.

Guggenheim Investments BulletShares ETFs give investors defined-maturity exposure in the investment-grade and high-yield markets, which target maturities between 2015 and 2024. IShares also has a similar product.

For example, Guggenheim BulletShares2018 High-Yield Corporate Bond ETF (ARCA:BSJI) provides a 4.56% yield and has a 3.04-year duration. “If interest rates rise by 100 basis points, the portfolio should decline 304 basis points. …. But because you have a higher yield, you’re offsetting that,” he explained.

• Another alternative is to buy a floating-rate fund, such as iShares Floating Rate Bond ETF (ARCA:FLOT). It invests in A-rated corporate floating-rate notes and only yields 0.45%, but it resets every 90 days, so “it protects you from rising interest rates, because maturities are so low,” said Rosenbluth. FLOT returned 0.08% last year and is up 0.32% year to date.

PowerShares Senior Loan ETF (ARCA:BKLN) has $5.5 billion in assets and a yield of 3.98%. It invests primarily in bank loans (75%) and corporate bonds. It is up 2.04% this year.

“As rates start to rise, some of those more esoteric, longer-duration ETFs are going to have more volatility,” said Kevin Blocker, senior quantitative strategist at Horizon Investments.

“That’s the reason we’ve held this ETF, as those senior loan portfolios are fairly short-term. You get the benefits of a lower duration, but you also get the benefits of the floating-rate aspect of it,” he added.

SPDR Nuveen S&P High Yield Muni Bond ETF (ARCA:HYMB), up 1.23% this year, has $452 million in assets and yields 4.42% with a 0.45% expense ratio. It invests in high-yield municipal bonds, providing investors with the usual tax advantages.

Pimco Total Return Active ETF (ARCA:BOND) has a yield of 4.31% and total assets of $2.6 billion. This actively managed ETF is run very similarly to its mutual fund sibling: Pimco Total Return Fund . Despite Pimco co-founder Bill Gross’ unexpected departure last year, the fund has done well, returning 6.62% in 2014 and 3.41% year to date.

Should ETFs Be In Your Investment Portfolio?

While ETFs have existed for several decades, their popularity and diversity have exploded in recent years. But many investors are just learning about them.
Those looking for tips on how to invest in ETFs just need some basic information to get started…

Investors’ Go-To ETF Websites

When investment adviser Bob Williams shops for an exchange traded fund, he often goes right to the horse’s mouth: the websites of such favored ETF providers as BlackRock, Invesco and IndexIQ.

Evidently, he knows the fund families. “I’ve been using these issuers’ ETFs for quite a while,” explains Williams, of Simmons First Investment Group, Little Rock, Ark. So, by going directly to their ETF sites, he feels, “I’ll get the freshest, most reliable information.”

But financial adviser Eddie Goepp prefers starting with independent sites, not tied to an ETF issuer, for winnowing down the universe to the best ETFs choices. Especially for retail investors, he suggests the sites of ETF.com and Morningstar for their data and “broad screening abilities.” In turn, Yahoo Finance and Google Finance “do a great job providing news on whichever ETF you’re interested in, holds Goepp, of Atlanta-based Wela Strategies.

But whether investors prefer a top-down or bottom-up approach to finding ETFs, one thing seems clear: A few online sites have emerged from the crowd as favored and/or recommended by the advisers and other financial pros IBD spoke with.

Among the most touted independent online ETF resources: the sites of Morningstar, ETF.com and ETF Database. In turn, oft-mentioned providers’ sites included those of BlackRock (NYSE:BLK), Vanguard, Charles Schwab (NYSE:SCHW) Invesco (NYSE:IVZ) and State Street (NYSE:STT).

Such preferences emerge at an important time: Especially in recent years, ETFs have been multiplying in number and growing in complexity. But though assets in ETFs have mushroomed to about $2 trillion, data show many people still are not using them. And evidently, even investing pros could use more ETF information.

Consider the data: According to a recently survey by Fidelity and BlackRock, the ETF industry has been growing at a record pace. Yet, only 32% of individual investors currently own ETFs in their portfolios, says the survey report. And, although the survey found 75% of advisers currently use ETFs in client portfolios, 76% of them want to learn more.

So what can investors expect from ETF websites? Of course, the content does vary by site. But broadly, the most popular sites offer a range of tools and information, from data points on individual funds — in providers’ case, on their own ETFs — to analytical tools and instructional information, and perhaps even news coverage on ETF investing.

A few examples of what site users can expect:

To various investing pros, Morningstar — known for its star-system for ranking investments — gets kudos for its extensive data on ETFs and its ability to search for ETFs across a range of providers. Broadly, its ETF information covers everything from ETFs’ performance to their portfolio composition, fees and risk ratings, says Jason Stipp, site editor of Morningstar.com. And articles on the free portion of its site cull from research on the roughly 300 ETFs that Morningstar analysts regularly track. Access to analysts’ reports and certain other features requires a $199 annual subscription. In addition, for $189 a year, investors can get a subscription to the monthly newsletter, Morningstar ETFInvestor.

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