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Do Active ETFs Belong in Your Portfolio?

Do Active ETFs Belong in Your Portfolio?
By Ron DeLegge, Editor
June 29, 2009

SAN DIEGO (ETFguide.com) Ė Today, the bulk of ETF money is invested in funds that follow traditional indexes. Yet, a wave of new product filings with the Securities and Exchange Commission along with new ETF product launches are fighting for their share of investorís assets. Do active ETFs belong inside your portfolio?

Of the 744 U.S. listed ETFs, just fifteen funds use full-blown active strategies attempting to beat the market.

This history of active ETFs has been abbreviated, literally. The very first actively managed ETF, the Bear Stearns Currency Yield Fund (YYY), was liquated within months after its March 2008 debut. It had around $50 million of assets but was never able to gain traction.

Letís analyze three active ETFs and then we'll evaluate factors to consider before investing in these types of funds.

PowerShares Active Alpha Multi-Cap Fund (NYSEArca: PQZ)
This active ETF rates the stocks of companies with more than $400 million market cap (about 3,000 stocks) that are traded in the United States. On a weekly basis the fundís manager generates a master stock list that ranks these stocks, segmented by market cap, based on its proprietary stock-ranking methodology. Stocks are selected based on factors such as strong earnings growth, low valuations and positive money flow. The equity selection universe is defined as the 2,000 largest stocks of companies with varying capitalizations from their master list. The fund then generally selects and purchases approximately 50 stocks.

For the one-year period ending May 30th, PQZ has fallen 46.64 percent compared to a 32.39 percent decline in the Dow Jones US Total Stock Market (NYSEArca: TMW).

PowerShares Active AlphaQ Fund (NYSEArca: PQY)
PQY rates the stocks of companies with more than $400 million market cap (about 3,000 stocks) that are traded in the United States. On a weekly basis the fundís manager devises a master stock list that ranks these stocks, segmented by market cap, based on its proprietary stock-ranking methodology. Stocks are selected based on factors such as strong earnings growth, low valuations and positive money flow. The equity selection universe is defined as the 100 largest Nasdaq-listed Global Market Securities from their master stock list. The fund then generally selects and purchases approximately 50 stocks.

For the one-year period ending May 30th, PQY has declined by 32.43 percent while the Nasdaq-100 (NasdaqGM: QQQQ) has fallen 29.01 percent.

Grail American Beacon Large Cap Value ETF (NYSEArca: GVT)
Grail Advisors, a San Francisco, CA-based money manager, is the brains behind this active ETF. GVT was launched in May and it holds 122 stocks with Microsoft, Royal Dutch Shell and Chevron among the top three holdings. GVTís investment strategy is virtually identical to the Grail Large Cap Value Mutual Fund (Nasdaq: AAGPX), which has established a respectable 10-year track record.

Brandywine Global Investment Management, Hotchkis and Wiley Capital Management and Metropolitan West Capital Management each share responsibilities in managing the fund. GVTís annual expense ratio is currently 0.79%.

The Catch 22
Will active ETFs deliver performance returns that beat the market? This question is partially answered by evaluating the performance of mutual fund managers, who in many instances have greater financial freedom and flexibility in the selection of securities they own. Plus too, they arenít handicapped by daily and weekly portfolio disclosures like active ETF managers.

Over the five-year period ending in 2008, Standard & Poorís research discovered the majority of active funds in 8 of 9 major stock categories failed to beat corresponding S&P stock indexes. The S&P 500 (NYSEArca: SPY) beat 71.9% of active managers while the S&P MidCap 400 (NYSEArca: MDY) and S&P SmallCap 600 (NYSEArca: IJR) outperformed 79.1% and 85.5% of managers in matching categories. Will putting active management in a different product shell (ETFs) suddenly make beating the major stock and benchmarks a cinch?

Most active ETFs are too new to have any substantial performance history behind them. Yet, active ETFs need money inside of them in order to survive, but without a track record, getting the money is a tough sell. Itís a Catch 22.

Other Considerations
The record of active managers is a wild card, even for money managers with a big name, lots of experience and a decent track record. Speaking about 2008 mutual fund performance, Bob Rodriguez, manager of the FPA Capital Fund (Nasdaq: FPPTX) said, ďWe stunk.Ē

ďThe belief that bear markets favor active management is a myth,Ē stated analysts in the above mentioned S&P report. Careful analysis by S&P also revealed similar results of bear market underperformance by mutual fund managers during the last downturn from 2000 to 2002. Have active funds really earned the investing publicís trust?

Building on a Strong Foundation
To resolve the issue of whether you should own active ETFs or not, consider a very simple, but time-tested strategy thatís worked.

Before you invest any of your serious money in individual stocks, active ETFs or active mutual funds, first start with broadly diversified mix of low-cost index ETFs that follow traditional benchmarks. A well-balanced portfolio should have market exposure, not just to U.S. stocks and bonds, but to international stocks (NYSEArca: EFA), emerging market stocks (NYSEArca: VWO), foreign real estate (NYSEArca: RWX) and commodities (NYSEArca: GSG). The superiority of market returns is well-established in both real life results along with academic studies. 

After youíve built the foundation of your portfolio on index funds and index ETFs and you have additional money (play money) you donít mind risking, consider owning active ETFs and whatever other crazy ideas come to mind. In other words, index your serious money to the market first and do everything else after. 

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