The big guns are now squaring off in one of the tiniest slices of the fund business.

This would be the slice known as actively managed exchange-traded funds.

As of April 26, there were 47 such ETFs, whose managers are committed to somehow seek and generate above market returns by actively managing the securities they buy, sell and hold.

This is the direct opposite of the principle that has driven ETFs into a $1.2 trillion industry in the past 20 years. They’ve gotten there by offering passive management of holdings that stick to benchmarks set by indices providers such as Russell Investments or Standard & Poor’s.

Indeed, by April 26, investors had placed just $5.9 billion in the actively managed variety of ETF. That’s less than half of one percent of assets held in ETFs.

And barely a hair of the more than $13 trillion that, combined, is placed in mutual funds, which only set prices for their shares once a day, and exchange-traded funds, which reset prices every moment of every minute of every trading session.

Yet, in March, Pacific Investment Management Company and its star founder, Bill Gross, moved into the actively managed space. Its move: Roll out an ETF version of its flagship Total Return Fund, which invests in fixed income securities and has become the world’s largest mutual fund. Assets under management? $242 billion.

Then, at the end of April, State Street Global Advisors rolled out its first three actively managed exchanged-traded funds. Christopher Goolgasian, the head of U.S. Portfolio Management, promised “tactical” management of the funds, depending on changing economic conditions and constant scouring of markets for ‘mispriced’ securities.

This, of course, is the outfit that started the entire exchange-traded alternative to mutual funds almost two decades ago. In January 1993, State Street launched the first of its SPDR exchange-traded funds, a fund designed to track the performance of the Standard & Poor’s 500.

Now known as SPY, this has become the most widely traded security of any type. According to NYSE Arca, the exchange with the greatest market share in the trading of ETFs, $19.2 billion worth of shares in SPY change hands every day. The most popular stock, Apple? $10.2 billion.

The seventh most widely traded security is also a State Street ETF, one that pioneered the concept of buying into a commodity such as a precious metal through shares. Its SPDR Gold Trust, also known as GLD, buys bullion and stores it so investors don’t have to. And now $2 billion worth of gold bars change hands, through trading on electronic exchanges.

Already active in the actively managed ETF business are BlackRock, now the biggest purveyor of ETFs of all types with its iShares products and Invesco PowerShares, Guggenheim Partners, Columbia Management, Russell and WisdomTree.

Looking to get into the game, according to NYSE Euronext, are players that include Charles Schwab, Deutsche Bank, J.P. Morgan, John Hancock, Janus Capital, T. Rowe Price and the biggest mutual fund player, Vanguard.

Interestingly, Jonathan Steinberg, the chief executive officer of Wisdom Tree, has a fairly simple standard for what amounts to success in actively managing the contents of an ETF.

For him, the benchmark is Vanguard, which has built its business on the premise that investors should simply put their money in an index fund and forget about it. Trying to beat the market, by its normal playbook, is folly.

So, to Steinberg, “alpha” – or an above-market return – is generated when an actively managed fund achieves a better return after adjusting results for taxes and risk than an equivalent Vanguard fund.

That, of course, is not the only standard. When State Street announced its first three actively managed funds, it enunciated a fairly straightforward measure of what that meant.

Its funds were to achieve a return that each year would be 1 to 2 percent above market returns or a custom-designed benchmark.

“The goal is obviously to outperform” market returns and market benchmarks, in general, said Jim Ross, president of SSgA Funds Management.

Similarly, Noah Hamman, founder and chief executive of AdvisorShares, which specializes in actively managed ETFs, said that such funds will succeed if the “distance” between their results and that of an underlying benchmark is great. And if not, not.

But he wouldn’t quantify what that distance should be, to make sure an actively managed ETF succeeds.

“It comes back to the investor experience. How are we managing risks within a portfolio?’’ said Donald Suskin, vice president at PIMCO.

For now, a big issue facing actively managed ETFs is “tradeability.’’

That is to say, you can’t get a lot of trading in an actively managed ETF, unless there is a lot of trading in that ETF. Trading begets trading.

And, right now, actively managed ETFs are thinly traded.

But those jumping into the field are convinced that will change. AdvisorShares’ Hamman expects that actively managed funds will be at least 1 percent of the ETF business within two years and probably more.

State Street’s Ross doesn’t see why ETFs won’t approach the mutual fund model more closely. There, actively managed funds outnumber passive funds, in terms of assets under management, by a factor of seven to one.

So the bet on actively managed exchange-traded funds is, in effect, two-fold.

First, exchange-traded funds already rival mutual funds in attracting new funds.

In the past 14 months, for instance, exchange-traded funds have attracted $184 billion in new investment, according to the Investment Company Institute.

By comparison, mutual funds of all types – domestic stock funds, foreign stock funds, bond funds, hybrid bunds – have attracted $122.9 billion of new funds, by the ICI’s counts.

Second, actively managed funds must prove they can … produce the above-market returns they promise. Hamman thinks that will take three years or more for each fund, to build a track record.

To State Street, it will mean a daily battle to determine which stocks to bet on and which to avoid. It has developed a “regime aware” system of investing, that looks at stock market volatility, using the CBOE S&P 500 Volatilty Index aka the VIX; credit sreads and swings in exchange rates for currencies to figure out which way to move.

Right now, it’s buying into equities, before investors, broadly speaking do, Coolgasian said.

Total return, after all, is what counts, he says. Yes, dividends have accounted for 40 percent of returns on stocks, for nearly a century. But it’s the combination of yield and return that matters.

“The best time to buy insurance is before you need it,’’ he says, “and before it gets expensive.”


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