By Jane Bryant Quinn
Sunday, March 16, 2008

The first actively managed exchange-traded funds might show up on your broker's screen later this month or early in April. PowerShares Capital Management expects to launch four funds that will be attractive -- it hopes -- to retail investors who want to try their hand at beating the market.

The start date can't be graven in stone. All depends on when the funds are cleared by the Securities and Exchange Commission, which has been pondering active ETFs for eight years. Nevertheless, their day seems close. Other fund companies with active ETFs in registration include Bear Stearns, Barclays Global Investors and Vanguard Group.

The next question is going to be: What are these new investments good for? Will you want them or are there better ways to go?

There's nothing exotic about ETFs. They are merely an alternative way of delivering mutual funds.

With traditional, open-end vehicles, you buy shares from the fund itself, which redeems them when you sell. You can buy in one of two ways: Either deal directly with a no-load (no sales charge) fund at a low cost, or buy through a broker or commission-based adviser at a higher cost. Due to those higher expenses, broker-sold funds, on average, show poorer returns.

ETFs, by contrast, are available only through brokers. They are baskets of individual shares, like any other fund. But they are structured as stocks that you buy and sell on an exchange. You pay regular brokerage commissions, which means you can trade through discounters. ETFs' annual expense ratios (what to pay to maintain the investment) aren't as high as those in traditional, open-end funds. For customers of brokers, this makes them a better buy.

So far, ETFs have all been tied to an index of some sort. The most popular ones track two major indexes -- SPDRs and PowerShares QQQ. Many track unusual indexes that were designed for ETFs. Examples would be indexes for dividend strategies or global mega-caps. These indexes screen securities for specific details, making them managed funds in disguise.

The PowerShares Four -- three equity funds and one bond fund -- will be managed openly. Two are quant funds: PowerShares Active AlphaQ Fund, owning 50 Nasdaq stocks, and PowerShares Active Alpha Multi-Cap Fund, owning 50 U.S. large caps. Quant funds are essentially run by computers that trade stocks based on mathematical formulas.

The third equity fund, PowerShares Active Mega-Cap Portfolio, run by managers at Invesco Institutional, will hold U.S. mega-caps. Invesco will also manage the bond fund, PowerShares Active Low Duration Portfolio. All four funds hope to beat the markets they represent.

PowerShares won't comment on how much these funds will cost. Presumably, they will be cheaper than traditional actively managed funds. If you work with a broker and believe that active managers can beat the market over time, active ETFs will be the better buy.

But can these managers really beat the market over time? Years of research says that, on average, they probably can't, especially not in the large, liquid markets chosen by the PowerShares Four. There are no niches for clever managers to exploit, and no little-known stocks that analysts aren't covering.

"The dynamics of beating the market are harder today than ever," says Ron DeLegge, editor of ETFguide.com. The managers will be hard-pressed to add enough value to cover their extra costs.

If managers can't beat their markets, why pay them to lose? If you are working with a broker, you would be better off with a lower-cost, passively managed index ETF such as the PowerShares QQQ or an SPDR.

If you make your own investment decisions, this same logic says you would be smarter to stick with index funds. For a single lump sum that you will hold for years, an index ETF would be the smart choice -- for example, Vanguard Total Stock Market ETF. You will pay a tad less, even after counting the cost of the brokerage commission.

If you are making regular investments, however, the ETF's brokerage fees would mount up. You should look instead at a traditional no-load index fund.

ETFs have a special tax angle that attracts some investors. For technical reasons, they can often let taxable long- and short-term capital gains build up in the fund, without distributing them to investors. You aren't taxed until you sell. By contrast, open-end funds may distribute net taxable capital gains at year-end, even though you didn't sell your shares.

Sometimes, however, ETFs do hand out taxable gains, to their investors' chagrin. Last year, 98 of them -- 18 percent of the marketplace -- made distributions, according to Morningstar, which tracks fund returns. George Sauter, Vanguard's chief investment officer, says actively managed ETFs, in particular, are apt to distribute gains. Standard & Poor's index funds rarely do.

A final point: If you buy ETFs, stick with the big ones or those with the potential to be big. Funds that don't attract enough assets close. Claymore Securities, for example, last year shut down 11 funds that didn't grow large enough to be popular. The securities were sold, expenses deducted, and the net proceeds distributed to the shareholders. That's not how anyone wants an investment to end.

Alexis Leondis in New York contributed to this column. Jane Bryant Quinn, author of "Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist.