Why Actively Managed ETFs Are the Next Big Thing for Your Portfolio

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Exchange Traded Funds (ETFs) have taken hold as one of the most popular investments on the market today. Now, with global assets in ETFs estimated to hit $1 trillion by 2010, a new class of actively managed ETFs is poised to become the next big thing for your portfolio.

Here’s a look at how these exciting new investments are gaining ground – and how you can get a piece of the action with an ignored small-cap fund…

ETFs – baskets of securities that trade on major exchanges – were introduced 15 years ago by State Street Global Advisors. The funds were originally designed to provide an easy way to invest in major indexes like the S&P 500 or Dow Jones U.S. Real Estate Index. What set this class of investments apart from the rest was the ease of investing in assets once deemed untouchable to retail investors. Today’s ETFs provide a portal to invest in everything from gold to oil to world currencies as easily as buying shares in GE or Wal-Mart.

But until recently, the major limitation of ETFs has been that the funds are relegated to tracking indexes.

That all changed in March 2008 when the first actively managed ETF launched on the American Stock Exchange. Unlike traditional index funds, which basically run on autopilot, changing their holdings to match their benchmark index, actively managed ETFs are run on a daily basis by investment managers – much like active mutual funds.

And while the current financial crisis has done a good job of stymieing growth of most investment products, actively managed ETFs have been introduced at a fast pace this year.

With close to a dozen actively managed ETFs on the market right now, every major ETF issuer has been scrambling to register new funds with the SEC. Over the course of the next year, there’s little question that the number of active ETFs will double.

Some of the most interesting actively ETFs on the market right now include the Grail American Beacon Large Cap Value ETF (NYSE: GVT ). PowerShares Active Alpha Fund (NYSE: PQZ ). and the IQ Hedge Macro Tracker ETF (NYSE: MCRO ) .

What you’ll find absent from that list, however, is an actively managed ETF for small-cap investors.

Right now, there isn’t a true actively managed small-cap ETF on the market. And there hasn’t been a whole lot of talk of introducing one this year. That’s largely because of transparency issues – right now, the SEC requires ETFs to provide their daily holdings to the investing public. That means that any large funds who take days to enter and exit positions will have to let everyone know their moves as they’re making them, offering investors a chance to front-run the moves. While that’s been a non-issue for the high-volume blue chips that promulgate most of the active ETFs right now, it could mean a huge problem for a small-cap actively managed ETF.

The SEC is currently considering proposed regulation changes that could make it easier for actively managed small-cap ETFs to operate, but until then we’re left without. But there is a way that you can invest in a sort of actively managed small-cap ETF right now…

The PowerShares Dynamic Small-Cap Portfolio ETF (NYSE: PJM ) is a small-cap index ETF that tracks the Dynamic Small-Cap Intellidex Index. But what sets this fund apart from other index-tracking funds is the way the Dynamic Small-Cap Intellidex operates. The index uses a proprietary quantitative method to select new small-caps quarterly to add to the index. That means that the index has a relatively high level of trading action (compared to a static, hand-picked index like the Dow Jones Industrial Average). And since its index is relatively obscure, the fund can deliver market outperformance more similar to an actively managed-fund.

Indeed, in the last month, PJM has beaten the S&P by 40%…

Things could get interesting when actively managed small-cap ETFs come around. They’ll provide investors who want a professionally managed portfolio with an incredibly simple – and inexpensive – option to invest in small-cap stocks. Until then, at least small-cap investors have options.