The long-simmering debate over the utility of ETFs broke out into the open over the past couple weeks.  There were two distinct criticisms of the ETF industry.  The first was lodged by us here at Abnormal Returns, Matt Hougan at IndexUniverse.com, Scott Burns at Morningstar.com and the crowd FT Alphaville.  The gist of the argument being that some ETFs are either so poorly designed or simply too volatile for individual investors to trade.

A second line of attack came from John Bogle who noted that the large divergence between the underlying performance of ETFs and the actual results of investors.  The argument being that the ETF industry has created narrow, specialized funds that individuals are trading rather than investing in over the long run.  (One could easily argue that the same for the open-end mutual fund world as well.)

One can easily get caught up debating the motivations of the ETF industry.  For our purposes let’s just assume the industry is made of largely rational, profit-maxmizers.  However it is ironic that as the talk of more actively managed ETFs is hitting the wires just as institutional investors continue to turn their back on actively managed products and shifting to index funds.

In contrast to this skeptical viewpoint are those that believe the ETF industry is largely a beneficial force.  Yes, they create some products that are clunkers, but the market eventually sniffs them out.  Roger Nusbaum writing at greenfaucet.com ably represents this viewpoint.  In essence, there are no “bad” ETFs, just those that fail to make an impact on the marketplace.  He writes:

That the market voted that these funds were in fact useless doesn’t mean they were bad funds just that they were products for which there was no demand. Anyone willing to take the risk of bringing an ETF to market should be able to do so and then the market will decide. Sounds like capitalism to me.

The ETF debate is going to take on new life, as it is widely believed that the Blackrock-BGI deal is a precursor to the launch of more actively managed ETFs.  This raises a couple of big issues for investors.  The first issue is whether actively managed ETFs have any tangible benefits for investors.

Tom Lydon at ETF Trends does yeoman’s work covering the ETF industry.  He notes that there are three distinct advantages to actively managed ETFs over their competition, namely open-end mutual funds.

Why is the ETF industry moving into active management? Because active ETFs can do several things that mutual funds simply can’t: their fees are lower, they can trade all day on an exchange like a stock (as opposed to once a day for mutual funds) and holdings are disclosed daily (as opposed to the quarterly disclosure required of mutual funds).

In our estimation two of these advantages are advantages in theory, that the mutual fund industry could simply combat.  First, there is nothing stopping the purveyors of actively managed mutual funds from lowering their fees.  There is nothing about the ETF structure that requires low fees.  Indeed the reason why the mainstream money managers are moving into actively managed funds is to generate higher management fees.

Second in terms of transparency and disclosure there is nothing that prevents mutual funds from releasing their holdings in intervals shorter than a quarterly basis.  Some funds already release top holdings data on the monthly basis.  In the Internet age this sort of disclosure is trivial.  Added work aside, there may be good reasons why a mutual fund manager may not want to release data on a more timely basis and that is front-running.

So that really leaves the third reason Lydon cites, intraday liquidity as a true advantage of actively managed ETFs.  Two points.  The first is that liquidity is a moving target at best.   One need only look back into the teeth of the crisis in late 2008 to see that some ETFs were routinely trading out of line from their indicative net asset values (NAVs).  One could imagine how this problem could be worse for an actively traded ETFs as opposed to an index-based ETF.

The second issue is a more fundamental one.  What is the right time frame to, in essence, hire an active fund manager (ETF or open-end mutual fund)?  One would guess is that the optimal time frame is longer than a single day.   If you are seeking out specific exposures it is probably more efficient to find a sector ETF.  If you are really in for the long haul with a manager intraday liquidity is a luxury that comes with some performance costs.

We have not touched on the potential tax advantages of using ETFs.  Suffice it to say that some of those benefits will be negated by the use of higher turnover strategies within an ETF.

From this perspective, the structural advantages of an actively traded ETF are marginal, at best.  If that is the case, how should we approach the forthcoming launch of a slew of funds?  Skeptically. However, given that the fund companies have in place reasonable mechanisms by which shares can be created and redeemed so we see no compelling reason to slow (or stop) the launch of these funds.

As Roger Nusbaum writes, “this sounds like capitalism.”  Some funds will do well, the majority will likely lag their respective benchmarks.  Many of those funds will eventually go by the wayside.   There is nothing magical about the ETF structure.  It will not transform mediocre performance into outperformance.

Investor choice is a great thing.  However with the ability to choose comes a measure of responsibility.  Everyone in the industry needs to recognize that there are no magic bullets here.  Actively managed ETFs are funds, plain and simple.

As Lydon notes, and something we have written for some time.  ETFs are a tool.   In the right hands they can help create useful constructs, in the wrong hands accidents will happen.  Which begs the question:  What ETFs are in your toolbox?