Active managers and ETFs
ETFs have important role for some

Exchange-traded funds (ETFs) offer pure asset class exposure with lower costs and greater tax efficiency than most mutual funds. The greater cost and tax efficiency are often cited as reasons why these should be used in place of active managers in many asset classes. That's an issue in perpetual debate that I will not explore in this article. Ironically, however, many active managers make significant use of these otherwise passive vehicles.

Reduce cash drag

There are many examples today of large cap managers having difficulty finding new investment ideas into which to deploy their bulging cash reserves. There is a school of thought in the money management industry that any cash level above 2 percent or so (i.e. fully invested) will inevitably be a drag on returns. So, when cash is flowing in quicker than it can be invested or when investment ideas aren't as abundant, some fund managers will use ETFs to put the money to work until the cash can be deployed.

BPI Global Asset Management has traditionally employed this approach. It is not uncommon to find, for instance, the BPI American Equity fund holding the S&P 500 Depository Receipts ETF - or Spiders for short (AMEX:SPDR). SPDR is managed by State Street Global Advisors with a mandate to track the S&P 500 stock index. And this makes sense given the BPI fund's growth stock picking style and historically high correlation with the popular index.

Gain asset class exposure

Interestingly other managers will simply use ETFs to gain exposure to a particular asset class. Motivations could range from a lack of expertise in, or the inability to apply a manager's investment process to a particular market segment. Or, a manager may simply want quick exposure to a basket of stocks in a particular sector with one purchase. With respect to investment process constraints, many money managers only feel comfortable investing in a firm's shares if they can obtain face-to-face access to senior executives.

However, a Canadian money management firm with a modest amount of money under management may have more difficulty getting access to firms (even smaller ones) based in the U.S., or elsewhere for that matter. Also, even if access were given to such money managers, it becomes expensive to fly across the continent or the world investigating stocks that may occupy a relatively small portion of total assets.

Talvest Millennium Next Generation is a Canadian small cap fund. Its foreign content varies, presumably based on the availability of opportunities in Canada. When it does hold foreign content, however, this fund will invest in iShares Russell 2000 Index fund and the S&P 400 Mid Cap Spiders. Both are ETFs that track U.S. small and mid-cap stock indexes, respectively.

Elliott and Page's Tax Managed portfolios make extensive use of both bond and equity ETFs, along with stock picks of other money managers. The tax efficiency of ETFs investing in stocks is what attracts E&P for this fund. However, it's rather puzzling that they would buy a bond ETF, rather than a bond directly given their access to institutional pricing. More than 27 percent of the E&P Manulife Tax-Managed Growth Portfolio is invested in a variety of ETFs. But don't expect any fee breaks here. This fund's MER is 2.68 percent per annum.

Market timing

As the ETF universe has blossomed, a new mutual fund product segment has emerged - one that is based on market timing these low cost instruments. CI Tactonics (a product originally created by Spectrum Investments a few years ago) is based on the body of academic research studying the persistence of recent past performance. Tactonics essentially uses a model based on price momentum and volatility to judge which ETFs should be bought, held, or sold.

The original creator of that fund, Karen Bleasby, has helped her current employer (Mackenzie Financial) launch a similar product using a combination of ETFs and Mackenzie mutual funds.

I think using ETFs for quick, efficient asset class exposure is fine inside of a mutual fund. However, when ETFs play a key role in the strategy of an active manager, I confess to having serious doubts about the ability for such managers to add any value to compensate for such funds' typical 2.5 percent annual fee.