New wave of ETFs lack diversification, low fees

Jan 15, 2007 @ 12:01 am

By David Hoffman

PHILADELPHIA — New exchange traded funds could cost the product some of its luster, according to some industry experts.

New versions of what has been considered an inexpensive, broadly diversified, transparent investment are more expensive, often concentrated and at times opaque — seemingly designed to attract “hot” money, they said.

“I have to say, the growth of the ETF industry does sort of remind me in some ways of the kind of marketing fervor the [mutual fund] industry practiced back in late 1990s,” said Sonya Morris, editor of the online newsletter Morningstar ETFInvestor.

And that’s not a good thing.

“I think it seems like the ETF industry is wandering further away from the key benefits ETFs have long been touted for: low cost, transparency and broad diversification,” Ms. Morris said. “Some of the new ones may not even be the cheapest in their category.”

For example, investors can find much better options than the $62 million PowerShares Zachs Small Cap Portfolio, according to a report from Chicago-based Morningstar Inc. on the ETF.

The ETF, which was rolled out last February by PowerShares Capital Management LLC of Wheaton, Ill., a subsidiary of Amvescap PLC of London, tracks a quasi-actively managed index and carries a 0.75% expense ratio that makes it one of the most costly ETFs available.

The average expense ratio for all ETFs was 0.45% at the end of 2006, according to Morningstar.

A better idea

According to the Morningstar report, investors looking for small-cap exposure would do better to look at the $13.8 billion Vanguard Small Cap ETF, which was introduced by The Vanguard Group Inc. of Malvern, Pa., at the beginning of 2004.

With an expense ratio of 0.10%, it’s one of the cheapest ETFs around and gives investors exposure to a transparent, broadly diversified index of small-cap stocks, according to the fund tracker.

Critics of PowerShares’ ETFs, however, don’t understand what they are designed to accomplish, said Bruce Bond, the company’s president.

Similar to actively managed funds, such ETFs, if done correctly, add value beyond that which can be obtained by investing in “commoditized, low cost, low value offerings,” he said.

And when compared with actively managed mutual funds, which try to do the same, “intelligent” ETFs are far less expensive, Mr. Bond said.

PowerShares, however, isn’t alone in offering relatively pricey ETFs.

Barclays Global Investors of San Francisco, the biggest ETF provider, with 120 — holding $246.4 billion in assets — at the end of 2006, has several relatively expensive iShares ETFs that focus on narrow segments of the market.

For example, the $2.1 billion iShares MSCI Taiwan Index Fund is the most expensive ETF available, with an expense ratio of 0.85%, according to Morningstar.

But while the expense ratio may seem high compared with the average expense ratio for all ETFs, the fund actually offers investors a relatively inexpensive way to get access to a market to which they otherwise would not have access, said Lee Kranefuss, chief executive of BGI’s intermediary and ETF businesses.

That may be true, but the industry may be favoring too many niche products, said industry experts.

A total of 156 ETFs were launched last year, according to State Street Global Advisors of Boston, adviser to the SPDR group of ETFs. The vast majority were specialty ETFs (71) or sector ETFs (41).

“There’s tons of funds coming out, many trying to find hot assets,” said Jim Wiandt, president of Index Publications LLC in New York.

It’s a similar situation to the one the mutual fund industry found itself in during the technology boom of the late 1990s, he said.

Anxious to capitalize on hot money, companies such as Denver-based Janus Capital Group Inc. loaded their funds with tech names, only to see once-stellar returns come tumbling down — along with their assets under management and their reputations, Mr. Wiandt said.

If they are not careful, some ETF providers could find themselves in a similar predicament, he said.

Another potential problem for the ETF industry is that many of new exchange traded products are being confused with ETFs even though they are not technically ETFs and do not directly invest in an underlying index, Mr. Wiandt said.

Something different

For example, PowerShares early this month launched eight commodities products that aim to replicate their underlying index by investing in futures.

Although they are very similar to ETFs — and are referred to as ETFs by PowerShares in a press statement — they are not true ETFs, because they are not registered under the Investment Company Act of 1940.

It is something investors should be aware of, because returns garnered by investing in commodities futures can vary from those earned by investing in the commodities themselves, Mr. Wiandt said.

PowerShares agrees and, notwithstanding its press statement about its commodities funds, tries to educate investors as best it can about the structure of its products, Mr. Bond said.

The development of new exchange traded structures, along with other developments criticized by some observers, merely represents a maturing of the ETF industry, said Jim Lowell, the Needham, Mass.-based editor of the Forbes ETF Advisor, a monthly newsletter.

What people are noticing about the ETF industry is that investors are now beginning to see a “second generation” of products, he said.

Those products aren’t necessarily bad, Mr. Lowell said; they merely serve different needs.

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