Exchange Traded Funds: Caveat Emptor

Some 1,476 exchange traded funds (ETFs) hold $1.2 trillion in assets, and this asset category has been among the fastest growing in the investment industry.  It's a category where the three leading ETF sponsors--BlackRock, Vanguard, and State Street--control about seventy-five percent of the assets in the funds.  The top ten ETFs comprise about one-third of the category's assets, suggesting an average of $40 billion per fund.

On the other end, one half of the funds have less than $50 million in assets, which is not a strong enough asset base to provide the infrastructure and analytical support to provide a sustained, superior value to the offerings of the Big Three.  It doesn't mean that there isn't a gem in here somewhere, but it's not very likely.  Most of these funds need to go away, and they probably will as the industry shakes out.

The emerging segment of active ETFs comprise a tiny sliver (0.6%) of assets under management, and it is this segment which really should be the playground for hedge funds and not for the individual investor facing informational disadvantages and mean-reverting market returns.

The Vanguard Standard and Poor's 500 Index ETF has about $102 billion in net assets at the end of 2011.  Its expense ratio is a pretty compelling five basis points! This product offering is the fulfillment of John's Bogle's gospel preached since he founded Vanguard.  The only thing an investor has to watch with this fund is the tracking error and some other simple statistics. Everything runs according to the manual, and there is a decent history over which the investor can monitor its performance.

Entering the land of active ETFs, there are plenty of mirages and land mines for the individual investor.  Pimco's actively managed Total Return Bond Fund (PTTRX) with assets of some $264 billion carries an expense ratio of 46 basis points.  Pimco's actively managed Total Return ETF (BOND) launched on March 1, and its assets are already at $2 billion from a standing start. An investor might reasonably assume that BOND would track PTTRX somewhat closely and that the portfolio composition and performance of the two funds should be close. 

The opposite seems to be true.  Since BOND is relatively tiny, Bill Gross who manages both funds, can be very nimble with the ETF, whereas with the Total Return Fund, he "is the market." As of July 16h, the Wall Street Journal reports that BOND returned 7.7% compared to an otherwise fine 4.2% for the open ended mutual fund PTTRX.  The correlation between the two funds is relatively low. 

The ETF is not permitted by the SEC to use derivatives, which are a big feature of PTTRX.  How should the investor compare the relative risk of the two funds?  In principle, PTTRX might be more or less risky, but the only picture the investor gets is a snapshot market value of all the swap, forwards, and futures positions as of the balance sheet date.  The out performance of the ETF could also reverse itself, since the portfolio compositions are meaningfully different enough. 

Also, the ETF reports its positions monthly, so this will lead to all manner of retail research advocating trading ETFs on some momentum-based strategies.  It will mean whipsawing the retail investor and raising her costs.  For hedge funds and portfolio lending, the ETF segment will provide some nice profit and arbitrage opportunities.

There is so much academic research and industry experience about the perverse, self-defeating behavior of individual investors in stocks and mutual funds.  With these new, more nuanced products, they need to take a cautious and jaundiced view.