The debut this year of the first actively managed equity exchange-traded funds hasn't exactly rocked the mutual fund establishment so far. A handful of funds have launched, but they've attracted relatively few new assets and, for the most part, appear to be little more than trumped-up quantitatively driven portfolios. Whether they eventually find a broader audience will be largely tied to how well they can perform against their passive competitors, and it will likely take years for them to attract any assets.

In the meantime, another, potentially more interesting area is emerging in the world of active ETFs as well: portfolios made up of bonds. In fact, the first actively managed ETF to launch was actually a bond fund, the Bear Stearns Current Yield Fund (AMEX: YYY), which launched on March 25. Its counterpart, the Invesco PowerShares Active Low Duration Portfolio (NYSEArca: PLK), began trading in mid-April.

Active Bond ETFs Face Challenges

Do prospects for bond ETF managers look any brighter than those of stock fund managers? After all, Treasuries and investment-grade corporate issues are highly liquid areas—in some cases, even more closely tracked and traded than stocks—and to the extent that active management works, it seems to work best in inefficient environments.

Early polling doesn't look promising: Neither active bond ETF has been pulling in big assets from investors.

Although its assets aren't readily available on Bear Stearns' Web sites, a May tally of top ETFs by IndexUniverse.com found YYY had about $50.2 million in assets. That's barely above the nearly $50.1 million it started out with (most likely through seed money that Bear Stearns figured it needed to create enough liquidity to launch an ultra-short bond fund).

PLK isn't doing much better, gathering just $2.5 million since its debut on April 11. Three other Invesco PowerShares active equity ETFs that launched the same day have fared similarly, gathering a combined $12.1 million.

To be fair, no doubt much of the rather sluggish response to YYY, PLK and the active stock ETFs is due to a woeful investing environment. But if the economy keeps sinking, YYY and PLK figure to catch at least a little more momentum. Moreover, any increase in headline shocks could actually make a unique opportunity for actively managed bond ETFs at a time when interest rates are still at relatively low levels.

"Active managers tend to outperform when there's a lot of volatility in the market and investors are seeking yield," said David Wong, a senior research analyst at Russell Investments.

Conversely, he added, "Active managers don't do as well when there's a flight to quality in bond markets."

That's just what happened from last summer through mid-March. The jolt of a mortgage meltdown sent Treasuries rallying to a point where PIMCO's star manager Bill Gross referred to them as the most overvalued security on the market. Since then, the rush into government-backed issues has slowed, blunting another headwind working against active bond ETFs earlier in the year.

"Depending on the period in question, it's quite possible to find some very cheap bonds relative to how the market's pricing them. But it also tends to be a very costly enterprise to research and find those bonds," Wong said.

In mutual funds, investors are more willing to pay higher fees to offset such research, Wong notes. "But with ETFs, which are competing in a much-lower-costing marketplace," he said, "it's going to be more difficult for active managers to charge as much as they do under a mutual fund structure."

"While it would appear that active managers should have more opportunities to outperform their respective indexes in more illiquid parts of the market, the data just doesn't bear that out at this point," said Jeffrey Ptak, a Morningstar analyst.

More than liquidity, he believes the success of ETF bond managers will come down to one word: costs.

"The real question facing actively managed ETFs is, how do they broaden their scope from very liquid market segments in a workable manner? I'm not sure that question has been resolved yet," Ptak added.

YYY May Be Pricey

In more liquid waters, active mutual fund managers have posted the best relative performance with short-term duration funds. In the past 10 years through mid-June, some 28.15 percent of all such managed funds were beating their respective index fund rival. Although hardly anything to brag about, short-term bond fund managers nearly doubled the outperformance of the next-best group, intermediate-term bond funds.

It's not surprising then that the two active bond ETFs introduced have been short term in focus. YYY has portfolio characteristics landing it somewhere between a money market fund and a short-term bond fund. In some circles, it's being categorized as an ultra-short bond ETF.

The most YYY's weighted average maturity will extend to is one year. But its average should, over time, be closer to 180 days. The ETF, which follows no benchmark, has been publishing its top 10 holdings at the end of each business day on its Web site, and the full list of the underlying components is available from a variety of services in real time as well. And whereas a typical retail money market fund or enhanced cash mutual fund's expense ratio is around 0.65 percent, YYY's annual fee is expected to wind up at 0.35 percent, says Bear Stearns.

However, index-based ETFs are known for having lower expenses than mutual funds. For example, the iShares Lehman 1-3 Year Treasury Bond (NYSEArca: SHY) has an 0.15 percent annual expense ratio. The Vanguard Short-Term Bond ETF (AMEX: BSV) has an 0.11 percent expense ratio.

So from the start, YYY opened with a higher-costing fee structure than its passive ETF competition. Besides SHY and BSV, at least four other indexed short-term bond ETFs are available, the most expensive charging 0.20 percent per year.

"There's no reason to think that actively managed bond ETFs will be any more immune to cost pressures than open-end mutual funds," said Ptak. "If a manager hopes to add alpha, he's going to have to figure out a way to keep his cost structures low."

Vanguard To Enter Field

An interesting development might be the coming launch of a new ETF share class of the actively managed Vanguard Treasury Inflation Protected Securities Fund (VIPSX). VIPSX, of course, is an extremely low-turnover portfolio. That's generally the case with Vanguard's entire bond lineup. And the indexing pioneer has a history of coming out with second-share class versions as ETFs with even lower expenses than their mutual funds. In the case of VIPSX, that's 0.20 percent—exactly how much the passive iShares Lehman TIPS Bond ETF (NYSEArca: TIP) charges.

So how does Vanguard expect its active management plan to succeed? Although unwilling to discuss the ETF version of VIPSX until after it comes out, the company is able to provide some insight based on a tried-and-true strategy implemented fairly consistently throughout all of its actively managed bond mutual funds.

"We feel that our managers can add value across all asset classes when we break it down by several different factors," said Bob Auwaerter, head of fixed income portfolio management at Vanguard.

The first one is by managing a fund's overall duration. "There we're adjusting the interest-rate sensitivity of portfolios," he said. "An example of that is when we shortened durations in our funds from the periods when [ex-Fed Chairman Alan] Greenspan first started raising rates in 2003, to the day he retired. That was based on the belief that he'd taken rates down really low on the concern over deflation."

But Auwaerter added that: "We only shortened our funds as much as we could take them according to their specific guidelines."

Another way a bond fund manager at Vanguard is allowed to add value is by yield-curve positioning. The third way is to overweight and underweight sectors. One more way, of course, is through security selection which differs from the underlying benchmark. "But we only do this in a risk-controlled manner," Auwaerter said. "We're not going to bet the farm on a conviction. I may add to a position, but there are definite limits. I can't just keep adding to positions in the belief that I'm right and everyone else is wrong."

Each Vanguard manager has a predetermined, narrow set of bands he's allowed to shift using any of these four methodologies. "At the end of the day, I can't adjust durations on a long-term Treasury fund, for example, so that it's not acting like a long-term Treasury portfolio," Auwaerter explained.

That's certainly going to be a challenge for active ETFs. In a less-disciplined environment, will they allow managers to drastically alter a fund's makeup to appease short-term interests?

Take a veteran manager such as Auwaerter. In 1998, despite panic surrounding a crumbling Asian fixed-income market, he held durations fairly steady. That came at a time when managers at other bond firms were making large moves based on bets that a worldwide credit crash was coming.

"In the short term, the fund's returns were poor on an absolute basis. Jack Brennan, our chairman, was getting letters that I should be fired. But I pointed out to investors that we wouldn't waver from our mandate," Auwaerter noted.

Brennan backed him, as did the fund's institutional clients, and long-term-minded investors continue to reap the benefits. But will smaller, less-experienced bond ETFs meet the needs of short-term traders?

PLK Is Truly Active

The best answer is likely to come from PLK, which implements a true-blue active management process. "When you're talking about U.S. government and agency securities, the managers have a lot of flexibility, since these are such liquid markets of fixed income," said Ed McRedmond, Invesco PowerShares' senior vice president of portfolio strategies.

While it doesn't follow any particular benchmark, the Invesco managers internally will be trying to outperform the Lehman Brothers 1-3 Year Treasury Index.

Here's how it works. PLK has no restrictions on trading. "If the manager chooses, he can trade every day," said McRedmond. "And any trades the managers make will be reported at the end of the day."

But those changes won't show up on PowerShares' site until the next morning. "If investors go on the Website or Bloomberg, they'll see what the portfolio is before the market opens the next day," McRedmond explained.

The creation/redemption mechanism will include a relatively small cash component in order to keep the basket of securities matched with PLK's NAV on a daily basis. "It's always going to have some small cash component to reflect interest payments accumulating within the portfolio," McRedmond said.

The fund's primary creation/redemption process will be in-kind. And that's similar to other ETFs. "It's pretty standard, with the flexibility to do all-cash creations if needed," added McRedmond.

While such strategies sound good at least on paper, only time will tell if they can outperform, says Chuck Bowes, a San Francisco-based advisor and principal with Runyon & Bowes Financial Advisors.

"Over shorter time periods, there are certainly going to be bond ETF managers who'll outperform," he said. "But identifying them in advance is going to be just as difficult as it is in the mutual funds world."

And like others, Bowes points out that even if an active bond ETF proves a long-term success, investors will probably have active bond mutual funds at competitive price points from low-cost families such as Vanguard, Fidelity and Dimensional Fund Advisors to consider.

But investors won't be the only ones with choices between traditional mutual fund shops and ETFs. So will managers, who are more likely to be highly compensated—at least in the short term—working on the mutual fund side of the fence, adds Bowes.

"When the higher fee structures for active bond ETFs are considered along with the competing factors driving active management's role in the market, we remain extremely skeptical that, over time, active management will prove to add any more value in fixed-income ETFs than they do in mutual funds."