The next generation of ETFs

As investors flock to exchange-traded funds, index funds that trade like stocks, the roughly 15-year-old industry is branching into more complex instruments.

The line between ETFs and mutual funds is blurring as providers register to offer the first actively managed ETFs. Such ETFs might beat their benchmarks, but with higher expenses, just like actively managed mutual funds.

"When actively managed ETFs hit the market, they're going to hit with a great big thud," predicts Tom Lydon, editor of ETFtrends.com, who serves on the board of Rydex Investments. Most investors look to ETFs to simply track a market or sector, he says. Michael Iachini, a director at the Schwab Center for Financial Research, says investor interest will depend on the manager's record, which takes time to establish.

Another stumbling block is updates of holdings. Frequent disclosure might allow other investors to mimic a fund's moves. In its filing for active ETFs, PowerShares says it will update holdings daily, on its Web site. Mutual funds must do so quarterly.

Exchange-traded notes, which debuted last year, are also courting controversy. The notes promise an index's return, less management fees. Because they're debt securities, investors take on the risk the issuer will default. Unlike ETFs, ETNs do not hold stocks, bonds or commodity contracts directly; the providers do.

ETNs have tax advantages over ETFs, which themselves are more tax-friendly than mutual funds. With many ETNs, investors don't incur income or gain until they sell. Now, the government is looking into whether this is an unfair advantage. Congress may act in 2008, says Thomas Humphreys, a partner at the Morrison & Foerster law firm. "This is just sort of a symptom of a larger problem. ... We probably need a complete overhaul of how we tax these instruments."