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The Two Faces of ETFs

A debate is brewing in the municipal bond exchange-traded fund industry.

The question is whether a fund should be “passive” or “active” — respectively, whether a fund should try to mimic a benchmark index or beat it.

In the passive camp, at least for now, are BlackRock, State Street Global Advisors, Van Eck ­Global, and Invesco ­Powershares. So far, a commanding majority of investors has sided with the passive camp as well.

In the actively managed ETFs’ corner are Pacific Investment Management Co., Grail ­Advisors, and, most recently, Eaton Vance.

The crux of the debate is what an ETF should offer an investor: pure exposure to an asset, or the expertise of smart people.

There were 27 municipal bond ETFs managing $6.19 billion at the end of January, according to the Investment Company ­Institute.

Until late last year, all muni ETFs were passively managed. They typically purchased bonds in a target index and aimed for a 95% correlation with the ­benchmark.

For instance, the biggest ­municipal ETF — BlackRock’s iShares S&P National AMT-Free Municipal Bond Fund — manages $1.7 billion.

The fund’s portfolio managers — Lee Sterne, Joel Silva, and Peter Cramer — are not in the business of trying to beat the market. Instead, they try to ensure that their fund’s returns match as closely as possible the returns on the S&P National AMT-Free Municipal Index.

If that sounds easy, consider that this is a fund that owns 616 bonds worth $1.7 billion striving to offer the same performance as an index with 8,356 bonds worth $508.4 billion.

They aim to achieve this feat through a quantitative process known as representative sampling. This entails breaking the index into a number of categories such as credit risk, duration, and maturity, and populating the fund with bonds that collectively recreate the aggregate risk characteristics of the index.

The latest wave of municipal ETFs has rebelled against this strategy on the simple premise that a portfolio manager might as well devote his research and expertise to beating the market instead of replicating it.

Pimco launched the first actively managed ETF last year — the Pimco Intermediate Municipal Bond Strategy Fund.

The fund is run by the Newport Beach, Calif.-based company’s municipal maven,  John Cummings. It publishes a benchmark index but has no interest in matching it — the index is just for the sake of comparison.

Touting its “proven credit expertise,” Pimco followed with a short-term municipal ETF. Then, Grail Advisors launched an intermediate fund with McDonnell ­Investment Management as sub-­adviser.

Eaton Vance this month became the latest to chime in on the debate. The Boston-based company registered to launch a series of actively managed funds, including two municipal funds.

“We believe an actively managed ETF in the fixed-income area could provide investors with access to our investment expertise through another type of ­investment vehicle,” Eaton Vance said in a statement.

William Thomas, chief executive officer at Grail Advisors, said active ETFs can offer the investment acumen of an established manager for lower fees than mutual funds, which by nature have higher cost structures.

Grail’s intermediate ETF charges annual fees of 0.35% of assets. While higher than the iShares national fund’s 0.25% expense ratio, it is far lower than the average national intermediate municipal mutual fund fee of 0.9% a year, according to Morningstar.

Besides, Thomas pointed out, passive funds are no more guaranteed to replicate their indexes than active funds are to beat them.

The iShares S&P National AMT-Free Municipal Bond Fund’s total return in 2008 differed from its target index by nearly two percentage points. Last year it missed by more than a percentage point.

Compelling though the argument for actively managed funds may be, investors are yet to be impressed.

The three existing actively managed municipal funds have so far raised $36.4 million, or well less than 1% of the industry’s assets.

“I’m sort of against the actively ­managed ETF,” said Maury Fertig, chief investment officer at Relative Value ­Partners. “We’ve never given a serious look at them. Once you get into more ­actively managed securities, there can be deviations, there can be judgment calls. If you want that, you buy a mutual fund.”

Fertig, whose firm buys municipal ETFs when it judges closed-end funds unattractive, said he likes three things about muni ETFs: a pure play on a sector, low fees, and the ability to trade during market hours.

Actively managed ETFs can eliminate the first two, Fertig said.

Matthew Tucker, managing director of U.S. fixed-income strategy at BlackRock, said investors use ETFs as “targeted-exposure vehicles” as a part of an overall asset allocation.

One of the reasons actively managed funds have not caught on, Tucker said, is that investors seeking targeted exposure do not want an ETF manager suddenly shifting his strategy away from that target because he considers it overvalued.

An investor who buys a short-duration municipal ETF bought it because he wants short duration — not the manager’s ­opinion of where he should be, Tucker said.

Many investors have also balked at paying higher fees for active funds when managers’ ability to beat the market is often questionable, Tucker said.

Investors will probably wait to see actively managed ETFs establish a track record before committing substantial money to the sector, he said.

That said, Tucker believes BlackRock will likely launch actively managed ETFs eventually, once it finds the right structure and investors have signaled some ­interest.

James Colby, head of municipal ­strategy at Van Eck, does not interpret the slow trickle of money into active ETFs as a sign they will never attract substantial money.

It took some time for investors to grow comfortable with passive municipal ETFs, Colby said, and they by now are an established product.

Most of the impetus driving money into active exchange-traded funds will likely be the managing firm’s reputation and track record, Colby said.

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