You may have caught the recent article in The Wall Street Journal that sang the praises of “managed” exchange-traded funds (ETFs). But don’t be fooled. These “new” financial products are really just old-fashioned mutual funds disguised as ETFs.
You see, the mutual fund boys have been hemorrhaging cash, as the ETF market has exploded in popularity. ETFs have just a fraction of the cost of a mutual fund and are infinitely more flexible. You can sell an ETF short, and you can also buy or sell options against it. Additionally, ETFs have immediate liquidity and utter transparency.
In other words, an ETF is truly the perfect investment vehicle.
As such, the guys running the “evil empire” back in mutual fund land are mad as all get out and want to get their cut of the action. So, their brilliant solution is to create “stock-picking” ETFs that are managed by their fund managers.
A group out of San Francisco is introducing “actively managed” financial, large-cap technology and growth ETFs, although a few other groups have also made the foray into what I call this “Frankenstein ETF” market over the past year.
This is such a bad idea on so many levels that I don’t know where to begin, although the guys over at ETFdb.com summed it up nicely when they wrote, “If football is a game of inches, investing is a game of basis points, and a manager’s ability to execute trades at a favorable price may be just as important as his ability to pick stocks.”
Why You Should Stay Away From ‘Stock-Picking ETFs’
OK, let’s first take a look at costs. A typical ETF has a management fee of about 0.25%; some are a little more, and some are a little less. These new mutual fund “Frankenstein ETFs” will have fees that range from 0.79% to 1.5%!
The effect of those fees over the life of a retirement portfolio is MASSIVE. Make no mistake — if you are paying an extra point a year on a $100,000 portfolio over 30 years, it adds up.
Chew on this for a minute: $100,000 compounding at 11% for 30 years gives you $2,289,229.66.
But if you get clipped for an extra point a year in fees after 30 years, that number gets knocked all the way down to $1,744,940.23. That’s over a half-million-dollar hit!
Now imagine your account multiplied a several million. Are you starting to see why these mutual fund guys are licking their lips as they look at your portfolios?
As far as these guys are concerned, your account is just another sheep waiting to get sheared.
Why ETFs are so Great
It’s the uniform nature of ETFs that makes them so valuable. There is no discretion involved. If you want exposure to steel stocks, Internet stocks or oil producers, you can get it in a heartbeat in an ETF.
The majority of institutions buy and sell stocks by sectors, not on a one-by-one basis. Sector-specific ETFs give us the ability to ride the coattails of that massive institutional buying.
Imagine a slice of pie — sector-based investing would be the fattest side of the slice, whereas individual stock-picking would be the thinnest point of the slice.
The odds of making money in a stock go up dramatically if you are in the right sector. The odds of you making money go up even more if you own a basket of stocks in the right sector, rather than just one stock in the right sector. Studies have been written claiming that fully 68% of what goes into finding a winning stock is related to the sector it’s in, and whether this sector is in favor or out of favor.
My own experience has borne that out to be true. Sector investing is the absolute easiest way to invest, and sector-based ETFs are the most-efficient vehicle to use if you want to play sectors instead of stocks. Stock-picking ETFs remove the statistical edge that sector-based, non-discretionary ETFs provide.
A quick look will show you that the vast majority of money managers can’t even beat the S&P 500 (SPX)! Why the heck would we want them running a discretionary-based ETF? The short answer is, we don’t!
By buying a “Frankenstein ETF,” you give up every edge, every advantage that a well-diversified sector ETF provides.
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