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As ETFs Evolve, New Species Emerge

Tickers in this article: BLK STT
NEW YORK ( TheStreet) -- ETFs have grown 25% a year since 2002 and many experts see this growth continuing in the future. 1

In addition to taking over a larger share of the broad market, ETFs could also grow in terms of complexity and structure. As index-based trading becomes more popular, as in the ETF market, ETF sponsors and index providers will "push to develop new and interesting indexes," says Michael Mundt, a partner at the law firm Stradley Ronon Stevens & Young and a former assistant director at the SEC who worked on ETF issues.

Currently, ETFs track major indices, bonds, commodities, derivatives, industries or even specific market caps. As investors demand more ETFs, more differentiation will emerge in the baskets of securities that ETFs track.

One area that has the "greatest potential for growth" is in actively managed ETFs , according to Mundt.

Actively Managed ETFs

Unlike traditional ETFs, actively managed ETFs do not necessarily track an index, but instead the fund manager regularly trades the underlying securities to meet a specific investment objective. Actively managed ETFs take only 4% of the ETF market , and usually have higher expense ratios and active risk than passive ETFs.

The first actively managed ETF was launched in 2008, but growth in these ETFs did not take off until 2010, when net cash flow jumped to $1.59 billion from $110 million in 2009, according to a report by Morgan Stanley Smith Barney. 2

Within the past year, more funds have filed for actively managed ETFs, such as State Street Global Advisors and BlackRock.

Growth in these actively managed ETFs could further help the ETF market "emerge as a major competitor to mutual funds," says Mundt. Unlike mutual funds, actively managed ETFs have full transparency, so the manager must disclose the ETFs holdings on a daily basis.

Dave Mazza, a strategist in State Street Global Advisors' SPDR ETF Strategy & Consulting Group, has seen "increased conversations about innovation in active management" with customers. Mazza also expects the actively managed ETF market to take off, saying it has just taken the market "some time to understand the structure and benefits of actively managed ETFs."

Although actively managed ETFs may represent another investment tool with new benefits, investors should be aware of the different structure, risks and costs associated with these ETFs.

"These funds might outperform traditional market indexes, but they also carry the risk of performing worse than the market if the manager doesn't succeed in picking good investments," wrote Michael Iachini managing director of ETF research at Charles Schwab.

Actively managed ETFs "require a greater deal of research for investors to understand the manager's approach and objectives," says Mazza. To keep the risk and costs in line with their investment preferences, investors should understand the product they are buying and its investment strategy.

Nontransparent, Actively Managed ETFs