The Value Line Mutual Fund Survey

ETFs… Have they gone too far?

Wall Street is filled with smart people. Often these smart people come up with new products that turn out to be industry-altering. The list is long, and includes such things as leveraged buyouts and derivatives. More recently, one of the big new products has been exchange-traded funds (ETFs). Although these investments are still a long way from replacing open-end mutual funds, they are probably the first legitimate threat to the open-end industry. Wall Street also is filled with greedy people. When a “hot new product” becomes available, very often it either is recommended to its intended audience or sold to inappropriate customers. A case in point culminated in the savings & loan debacle, which was largely caused by high-yield debt issued in conjunction with leveraged buyouts. And there have been numerous instances of banks and other institutions taking huge losses, or worse, going bankrupt because of derivative contracts that didn’t pan out as planned.

Clearly, history has a way of repeating itself, and ETFs are no different. Indeed, as the popularity of ETFs has increased, more and more obscure ETFs are being introduced.

The basis of the exchange-traded funds is solid. They are, at heart, index mutual funds that trade all day on the exchanges. The reason this is possible is because of a complex structure that allows for “in-kind” payment when they are created and redeemed— which only large shareholders can do. Essentially, this creates an arbitrage possibility if there is a mispricing between the ETF and the underlying stocks. If the pricing is not aligned, a large shareholder will step in and do an inkind transfer (either buying the appropriate shares on the open market and using them to create ETF units for a quick and risk-free profit if the ETF is priced too highly, or taking ETF units and redeeming them for the underlying shares if the ETF is underpriced).

By using this structure, costs can be kept very low, so ETFs are much less expensive than actively managed open-end mutual funds and, often, less expensive than comparable index-based open-end funds. Moreover, because of the in-kind transfer, capital gains are reduced as the shares with the largest gains are usually used in the transfer, thus taking them off the books.

So, ETFs are clearly smart products that have many uses. The problem is that the model is being extended beyond established indexes. In fact, indexes are being added for the sole purpose of creating ETFs. This is acceptable if the newly created index is a logical subset of a pre-existing index or investment process (such as cutting up the Dividend Achievers list into domestic, foreign, high-yield, and high-dividend-growth segments), but causes problems when the new index is created out of thin air.

Recent examples of ETFs that come from the “gone too far” camp are based on illnesses. So, if you wanted to invest in companies that target obesity, you can buy an ETF and get a basket of appropriate companies. There could be some value in this ETF for highly experienced and well-f inanced investors, but for the average investor, it is inappropriate to concentrate on such a highly focused selection of companies. The concentration of risk goes against the logic of diversification.

Diversification, however, is likely to be one of the main points used to sell products such as this, even though you are getting a selection of companies that focuses on this one ailment. However, they are all still focusing on just one ailment. A better option would be a broadly diversified healthcare fund, either via an ETF or an open-end mutual fund.

The end of the story here is “buyer beware.” You have to know what you are buying and why. If the investment doesn’t make sense, don’t buy it. That’s the only way to protect yourself from a product that may be inappropriate.