SAN DIEGO (ETFguide.com) - Haven’t we heard this story before?
Actively managed mutual funds beat the market.
Next, we were lectured that hedge funds, with an infinite number of investment strategies at their finger tips can also beat the market. Don’t mind the fact that some of the brightest hedgies on the planet have self-destructed and caused billions in financial damage.
And now, we hear the same beating drum, this time, from a new comer: Actively managed exchange-traded funds (ETFs). They declare, “We can beat the market.”
I haven’t yet bothered to see if the first launched actively managed ETF, the Bear Stearns Current Yield Fund (Ticker: YYY) has beaten the market since its March 25th debut. Doesn’t the maestro behind why, why, why have a long laundry list of other urgent matters that need immediate tending? Attempting to beat the market with an ETF nobody cares about seems so futile. A name change for this fund can’t come soon enough.
Now, next in line on the seemingly never ending conveyer belt of new fangled ETFs is Invesco PowerShares.
The Wheaton, IL-based company has introduced its own version of actively managed ETFs.
The four new PowerShares funds are:
--Active AlphaQ, benchmarked against the Nasdaq-100 index (PQY);
--Active Alpha Multi-Cap, benchmarked against the S&P 500 index (PQZ);
--Active Mega-Cap, benchmarked against the Russell Top 200 index (PMA);
--Active Low-Duration, benchmarked against the Lehman Brothers 1-3 year U.S. Treasury index (PLK)
If you read the prospectus, which I have the psychotic habit of doing, you’ll notice this first iteration of "active ETFs" aren't really all that active. In fact, they closely resemble PowerShares index ETFs that use quantitative investment strategies! What's so innovative about that? But that’s not all.
If the point of active ETFs is to beat market indexes, these funds have some major strikes against them.
The first issue deals with portfolio disclosure.
The rules for active ETFs are considerably more restrictive compared to actively managed mutual funds. For example, the Securities and Exchange Commission requires active ETFs to reveal portfolio changes the day after they’re made. In contrast, mutual funds can go a quarter without disclosing portfolio holdings.
Keeping portfolio changes secretive helps fund managers to avoid becoming the victims of front running by parasite traders attempting to snag quick profits. In this regard, the advantage seems to favor actively managed mutual funds over active ETFs. More frequent portfolio disclosure won’t help active ETFs in their attempt to beat the market and may end up costing shareholders some unknown future performance impact.
But PowerShares thought about this ahead of time.
Since this first set of active ETFs focuses on companies with multi-billion dollar market capitalizations, manipulating stock prices for traders by front running or other arbitrage techniques is probably too difficult to successfully execute. While PowerShares solves some of the problem by focusing on large cap stocks, it created another one for itself.
If you’re searching for elusive market beating returns, large company stocks are the last place you want to be looking. Academic studies have shown that most large cap fund managers consistently underperform corresponding indexes. Why? Because this particular market is extremely efficient with lots of investors rummaging the same garbage cans for market beating returns or alpha. It’s also within this same investment universe where extracting alpha, or as I like to call it alfalfa, is virtually impossible. More times than not, alpha turns out to be alfalfa.
According to PowerShares, the benefits of active ETFs include lower costs compared to actively managed mutual funds and the potential for greater tax savings.
Even though the three new active stock ETFs may cost less than comparable active mutual funds, they are still substantially more expensive than corresponding large cap index ETFs, which charge between 0.07 to 0.20 percent. The PowerShares funds carry annual expense ratios of 0.75 percent.
Many investors, too foolish to know any better, probably blow off 60 basis points as no big deal - but it is when you’re attempting to beat the market. Whether they realize it or not, this additional cost is likely to cause a future performance deficit and to bomb their plans of beating the market.
That’s why I’m convinced most investors are better off keeping their core large cap holdings in a true market index mutual fund or ETF. Funds that follow this simple strategy include the SPDRs S&P 500 (Ticker: SPY), iShares Russell 1000 (Ticker: IWB), SPDR DJ Wilshire Large Cap ETF (Ticker: ELR), and the Vanguard Large Cap ETF (Ticker: VV). If you hunger for the largest of large stocks, see the Vanguard Mega Cap 300 ETF (Ticker: MGC) or the Rydex Russell Top 50 (Ticker: XLG).
The only innovation I see in active ETFs is this: Old investment strategies that toot the alfalfa horn are being put into a relatively new product structure.
Other than that, the same dynamics of trying to beat the market and probably failing still apply.
Advantages of Active ETFs
--ETF product structure is tax efficient
--Potentially lower internal portfolio turnover vs. actively managed mutual funds
--Lower expense ratios vs. actively managed funds
Disadvantages of Active ETFs
--More frequent portfolio disclosure vs. actively managed mutual funds
--Higher costs vs. index ETFs
--Beating market indexes over the long-run is still a loser’s game
--No proven performance track record
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Our Part II coverage on Active ETFs will continue next week, be sure to check back.
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