Exchange-traded funds were supposed to be cheap, transparent, and simple. What went wrong?

Back in simpler times, everyone understood what an exchange-traded fund (ETF) was: a security which traded on a recognized stock exchange that tracked the performance of a benchmark index.

In those good old days (about a decade ago) there was a clear distinction between ETFs and closed-end funds. The latter also traded on stock exchanges but their portfolios were actively managed. ETFs, by contrast, were passive investments that were simply slaves to their benchmarks.

How times have changed. The distinction between ETFs and closed-end funds has now become so blurred as to be indistinguishable. Moreover, ETFs are no longer the clean, simple securities they used to be. We now have leveraged ETFs, long-short ETFs, and even actively-managed ETFs. How are investors supposed to make any sense out of this?

Actively-managed ETFs are being pioneered in Canada by Jovian Capital which has launched a new line of funds under the AlphaPro name. They've hired some top-notch managers to run these funds but come on - these are not ETFs at all! They're really mutual funds that trade on the TSX.

First out of the gate was the Horizons AlphaPro Managed S&P/TSX 60 ETF which trades on the TSX under the symbol HAX. It was launched in January 2009 and initially used technical analysis provided by Ron Meisels, president of Phases & Cycles Inc. The idea was to overweight sectors of the TSX that the manager believed would outperform while underweighting sectors that were expected to be weak.

So how did that work out? Not very well. As of Jan. 31, the fund showed a one-year gain of 6.9 per cent. By comparison, the S&P/TSX Total Return Index posted a gain of 31.7 per cent during the same period. Oops! Investors would have been much better off sticking with a plain vanilla index ETF.

Earlier this month, Jovian shuffled the managerial deck. Mr. Meisels has departed the scene and Front Street Investment Management has now been appointed to run the fund and decide which sectors to overweight and underweight. Front Street has some terrific managers, like Frank Mersch and Norm Lamarche, but their best performances have been delivered by small-cap resource stocks. This fund focuses on the large-cap stocks that make up the TSX 60 index. It doesn't look like a match made in heaven.

The lousy performance of HAX in its first year has not deterred Jovian, however. On Feb. 10, the company announced the launch of three new actively-managed ETFs, each run by a well-known investment expert. They are:

Horizons AlphaPro Dividend ETF (TSX: HAL). The mandate is to generate regular dividend income and modest long-term capital growth by investing in major North American companies with above-average dividend yield. The fund will be overseen by Lyle Stein, CEO of Leon Frazer & Associates which has a long and solid reputation as a conservative money management firm.

Horizons AlphaPro North American Value ETF (TSX: HAV). The other two actively-managed ETFs have been set up to offer investors a choice between value and growth investing, or to add both styles to their portfolios if they prefer. This one, as the name suggests, will use a value approach to choosing North American stocks. Vito Maida of Patient Capital Management, who I have always thought of as a sector rotator, will, in the words of the press release, "rely primarily on his distinct value investment style to identify companies for the ETF portfolio".

Horizons AlphaPro North American Growth ETF (TSX: HAW). This fund will be run by former AGF star manager Steve Rogers who will use a growth style of stock picking.

In announcing the new funds, AlphaPro president Ken McCord said: "ETFs have a lot more to offer than indexing." The question that I have is: Should they? The whole ETF concept was based on indexing. Now the AlphaPro series is going in a completely different direction, one which, based on their initial efforts with HAX, is of questionable value to investors. Perhaps the three new funds will outperform their peers (there are no benchmark indexes to compare them against). Only time will tell but in the meantime I don't feel any overwhelming urge to put my money here.

Eric Kirzner is a Professor of Finance and the holder of the John H. Watson Chair in Value Investing at the Rotman School of Management, University of Toronto. He has been writing about ETFs for years and he's dismayed at what is happening. "Manufacturers are doing what they do all the time  producing products people simply can't understand," he said in a conversation with me.

For years, Prof. Kirzner has advocated a change in labelling to distinguish genuine ETFs from closed-end funds, leveraged funds, etc. He tried to popularize the acronym ETIF (exchange-traded index fund) which would make clear the product was designed to replicate a specific index. It never caught on.

Like me, he is deeply concerned about another ETF trend which is the creation of new indexes specifically designed for one fund. A recent example is the S&P/TSX 60 130/30 Strategy Index, a long-short index from Standard & Poor's that is being used as a benchmark for a new Horizons AlphaPro fund that bears its name and which trades under the symbol HAH.

While it's true that S&P has created 130/30 index for other markets, this is the first time the concept has been employed in Canada so we have no history to tell us how well (or badly) the strategy will work when applied to the TSX 60.

"This approach of creating new indexes for specific funds is no good," Prof. Kirzner says. "It's time to restore transparency to the ETF sector. We should start classifying ETFs according to categories and by risk. Investors need to know exactly what they're buying."

In the meantime, he suggests going back to first principles. You can build a perfectly good, well-diversified portfolio using only four or five ETFs that track broad market indexes, he says. All the rest is froth.

Adapted from an article that originally appeared in Gordon Pape's weekly newsletter, the Internet Wealth Builder. Try it for one month (4 issues) for only $13.95 plus tax. Details at http://www.buildingwealth.ca/bookstore/productdetail.cfm?product_id=617