Brand-new exchange-traded funds are coming onto the market faster than most advisors can keep up with them.Issuers such as PowerShares and Barclay's Global Investors file for groups of new offerings in the double digits, and the total number has topped 216 funds with aggregate holdings of $334 billion. The flood of new products means advisors' mailboxes are stuffed with offering memoranda. Most end up in the circular file, but a few have made their way into clients' portfolios alongside some of the older issues.
Since most ETFs - which are not mutual funds, but offer some of the same advantages while trading like a stock - track an index, the instruments have found an appeal among passive investors.
ETFs offer access to market performance, with lower cost and slightly better tax efficiency than traditional mutual funds, and usually for the same commissions charged to buy an individual stock.
But how many ways do investors need to be able to buy the S&P 500?
"These are marketing organizations that get excited about selling whatever they can," said Jason Thomas, Ph.D, CFA and chief investment officer of Kochis, Fitz, Tracy, Fitzhugh & Gott Inc., in San Francisco. "But we take an Adam Smith approach to new products. These are created in their own self-interest, but some will satisfy a general good as well."
Exchange-traded notes
A slight shift from the ETFs, the ETN or exchange-traded note is a debt instrument with a 30-year maturity. The ETN has been described as a "new exchange-traded product that tracks the total return versions of the Goldman Sachs Commodity Index and the Dow Jones AIG Commodity Index."
"The ETN pays the return of a commodity index, but makes no distributions, so no tax consequences," said Thomas. "You take on a little credit risk, but transfer commodity returns into potentially long-term capital gains."
Industry watchers have expressed concern about many of the new offerings, however. Morningstar analysts point out that newer ETFs follow ever-narrower indexes. In a June report, their ETF expert warned that sector funds such as homebuilders, oil equipment makers, biotechs, and even nanotech and water industry indexes make up 40 percent of the total sectors, versus the traditional mutual fund universe with only 6 percent of sectors.
"Most ETFs are good for the individual investor, but sliced as thinly as something like the nanotech sector makes it ripe for abuse," said Sonia Morris, a mutual fund analyst who specializes in ETFs for the Chicago-based Morningstar. "Investors looking for the next hot thing are performance chasers, and too often they come too late to the party."
Since most of the monies chasing the sector funds seem to be coming from institutions, the concern for individual investors is not yet widespread.
Supporting the anecdotal evidence of the source of new monies for ETFs is the fact that assets in individual-investor-owned traditional mutual funds increased alongside those in ETFs. Total net assets of mutual funds gained over half a billion dollars through April 2006, from $8.9 trillion to $9.4 trillion.
"It's hard to predict where this is going to fall out because there's still so much innovation going on," Morris explained. "But I think the great goal of the ETF industry is to come up with actively managed vehicles. That's been elusive so far, but if they can figure that out, it might pose a challenge to traditional funds."
PowerShares filed recently to add 11 new funds to its roster of 37. Its Dynamic series employs what it calls a "rules-based selection process" that selects stocks from an index with greater potential for capital gains. The issuer offers the strategy in a variety of sectors, as well as across style and size classes of major indexes.
"Simply issuing a new sector index doesn't add much value for our clients," said Carl Kunhardt, a CFP at Quest Capital Management, in Dallas. "A computer can manage an index fund. But with actively managed funds we can add real value to the clients' portfolios."
Kunhardt is charged with surveying and recommending new vehicles as chair of the investment committee for his firm. He uses the PowerShares Dynamic series to satisfy the satellite allocations of the firm's investment approach. "There are lots of large-cap or mixed-blend funds we can use to allocate the core portion of portfolios," he explained.
At the periphery, he looks for less efficient classes like aggressive growth or smaller cap stocks. He found a solution in the Dynamic Small Cap Value Fund. "I'm not expecting higher alpha from this fund than its direct competition in a traditional fund," said Kunhardt. "I'm just expecting lower costs, which will naturally translate into higher returns."
The lower costs drive one decision for Quest: Clients who are especially fee-sensitive might be more likely to own ETFs. "We also use Vanguard funds, but where Vanguard might charge 40 basis points, the equivalent ETF comes in at half that," says Kunhardt.
Individual investors need to consider another disadvantage of ever-narrower slices of market indexes. Unlike institutions, individuals more likely pay annual taxes on investment returns. "Individuals should be going the other way, to the broadest possible index even within the U.S.," says Thomas. "That eliminates transactions as stocks migrate from size or style boxes into another."
On balance, individual investors experience another barrier to buying ETFs directly. Unlike most traditional mutual fund marketing, the ETFs have wrinkles that demand close scrutiny of the language in an offering document. "These are still pretty new and demand a careful read," says Kochis Fitz's Thomas. "The discussion of creation and redemption units might be a little over the capacity of the individual investor."
If the growing marketplace continues to gather assets at a breakneck pace, expect to see various changes. To facilitate approvals, some issuers are even coming together to help the Securities and Exchange Commission get more comfortable with both the standard and the more creative offerings.
Meanwhile, the lower costs, ease of transactions and quick exposure to various markets keep attracting investors.
Said Morningstar's Morris, "This story sort of changes by the minute."
