This is a special guest post from Shishir Nigam, author of Active ETFs in Focus.

That’s the question that Lee Conrad, blogging at the, asked last week in this post – where do actively-managed ETFs fit in?

Conrad holds that one basic area where active management in ETFs can add some value is in cases where indexing is not all that easy. In markets such as high yield bonds or emerging market bonds, it is not very easy for someone looking to replicate an index to minimize the tracking error because very often, the securities held by the index are not very liquid. In other words, the indices covering that particular segment of the market may not be very “investable”. Conrad provides an example of the SPDR Barclays High-Yield ETF (NYSEArca: JNK) which underperformed its benchmark by a whopping 13% in 2009 with a tracking error of 2.84%. Another example is the SPDR Barclays International Treasury Bond ETF (NYSEArca: BWX) which underperformed its benchmark by 2% with a tracking error of 3.18%, as of Sept 30, 2010. Certain segments of the fixed-income market are definitely hard to track through an index and investors should expect to see large tracking errors. And that is where active management of the ETF can come in, so that portfolio managers can decided which securities they want to own, as opposed to being obligated to purchase all the constituents of the index, regardless of liquidity constraints.

At the moment, there are no actively-managed ETFs for the high-yield bond market but AdvisorSharescurrently has one in the works that is being launched in conjunction with Peritus Asset Management, which will sub-advise the fund. The launch of that fund will provide a good indication of whether investors warm up to active management in ETFs within the high-yield space. RiverPark Advisors is another player which has a short-term high-yield bond Active ETF in filing with the SEC. RiverPark currently serves as the sub-advisor on several actively-managed equity ETFs launched by Grail Advisors.

This topic was also discussed at the recent Morningstar ETF Invest conference held in Chicago. The discussions on Active ETFs yielded two areas where actively-managed ETFs make sense for investors over passive cap-weighted ETFs – high yield bonds and commodities. The rational for active management in high-yield bonds has already been discussed above. Commodities are another such area for a very different reason – the negative roll yield in futures market resulting from contango. In the past year, many passive commodity ETFs, such as United States Natural Gas Fund (NYSEArca: UNG) have come under heavy fire for strongly underperforming the spot returns on the underlying asset. In many cases this has been due to a futures market for those commodities that are in a state of contango – where the longer-dated futures are more expensive than the near-month futures. Since most passive commodity ETFs get their commodity exposure by purchasing near-month futures and then rolling forward the contracts at expiry, they are exposed to losses because the contracts they are rolling into are more expensive than contracts they are closing out on.

ETF manufacturers have only recently made attempts to address this problem through new designs and structures. This is clearly another area that can benefit from active management to help avoid the obvious losses that result from a contango market. Again, at the moment there are no actively-managed commodity ETFs on the market and there are none that are planned or have been filed for either with the SEC. So this is definitely one area where issuers of actively-managed ETFs could find some investor interest – an actively-managed ETF providing pure commodity exposure.

Disclosure: No positions in above-mentioned names.

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