Enter The High-Cost ETF

Herb Morgan (Efficient Market Advisors, LLC) submits: Despite an unrelenting multi-year unveiling of contemptible fund company behavior, ETF manufacturers are not thinking twice about finding new ways to burden unsuspecting investors. Last week we caught a glimpse of the coming scandal involving 27 fund companies stealing hundreds of millions of dollars from shareholders by secretly taking kickbacks from service providers. Now, a few manufacturers are beginning to quietly slip 12b-1 Mickey’s into our previously untainted ETFs.

For some product manufacturers the decision to create a new ETF seems to be based purely on what will sell, rather than on what will succeed as an investment. A new private equity ETF may sound sexy, but the opportunity to build a portfolio remotely close to 100% private equity is non existent. Barron’s correctly pointed to some suspicious activity in a single country ETF over the weekend, and I have been critical of funds launched that have a very low likelihood of ever tracking their target index.

When ETFs first experienced acceleration in their growth rate it was because the market was going through the natural evolutionary acceptance process associated with product innovation. ETFs are a vastly superior product to traditional mutual funds and the market rewarded early players State Street and Barclays with large inflows of cash.

The reasons the product class has succeeded are multiple but most would agree low cost is at the top the list. New participants entering the industry and wanting to compete would naturally follow the same blueprint for success. Interestingly, some are taking a slightly different approach. The acquisition of PowerShares by Amvescap (AVZ) created a metric that emboldened entrepreneurs who seek to build niche ETF businesses in hopes of cashing in by selling to a big money strategic buyer.

Several new ETFs including those from PowerShares and Claymore are including a 12b-1 fee as part of their eventual operating expenses. In both cases, the fund is not currently charging or collecting the 12b-1. This allows both firms to talk about and promote a “low cost structure”. I’d bet Cadillacs to Krispy Kremes that both companies will quietly and without fanfare begin charging those pesky 12b-1 fees as soon as the assets in the funds grow to a level of irresistible temptation. It’s the only way the business can work under their model which requires a very high cost, highly skilled sales force to distribute the shares.

Speaking of expenses, the standard Powershares prospectus says the Adviser will make sure expenses don’t exceed .50% excepting legal fees, SEC and state registration fees, and exchange listing fees. That’s like a 2,000 calorie dieter excluding a Snickers bar from his daily tally. Interestingly, the adviser can later charge back the fund for any expenses it absorbed. Same story at Claymore, but their expense cap is .60%.

The 12b-1 plan appears to be an attempt to saddle customers with the costs associated with distributing shares of the funds. High cost product based on nouveaux indexes won’t fly off the shelf on its own and the investing community certainly won’t beat a path to anyone’s door looking for it.

Comments

[DavidJackson]

There's an interesting potential trade here: arbitraging high-cost ETFs and low-cost ETFs. With straight index ETFs, it should be possible to combine a set of high-cost sector ETFs into a broader index which is tracked by a low-cost ETF. By shorting the basket of high-cost ETFs against a long position in the low-cost ETF, you can then arbitrage the difference in expense ratios. The challenge to this, however, may be the spreads: the narrower ETFs are more thinly traded, so the buy-sell spreads may be larger. Also, this may not work with some of the more exotic ETFs from PowerShares etc. which don't track standard indices.