ETF Duplication Lets You Choose Your Alpha -- But At What Price?

Includes: EEM, FVD, SPY, VWO
by: Market Participant

Roger Nusbaum has a post up on ETF Duplication, questioning how PowerShares seems to have duplicated funds. A number of "basic 10" sector funds are available in both RAFI and Intellidex formats.

My take is that PowerShares is letting people choose their alpha. You can get it from the Intellidex black box, or from the fundamental weighting hypothesis.

Some investors are going to want a strictly passive scheme to prevent "black box strategy" risk. This is an implicit problem with backtested strategies. There is a possibility that the underlying market structure that made the strategy work in the past no longer works in the future.

Another notable feature is that the duplicate funds expose the low quality of the NASDAQ market system for thinly traded securities. On the AMEX, the Intellidex ETF's have a dedicated specialist to provide liquidity, resulting in a quiet orderly market. On the NASDAQ, no one can hear you scream as you try to buy/sell RAFI sector ETFs.

However, I am now sour on PowerShares because of the bigger issues of realized fund expenses (in many funds expenses have been higher than 0.60%), and many new PowerShares have 0.70% expense ratios (subject to a confusing 0.60 cap). At that level, PowerShares are getting close to the expense ratios of active funds.

First Trust also gets a lump of coal for sponsoring high-expense funds. For example, the First Trust Value Line Dividend Index Fund (NYSEARCA:FVD) is based on an index of stocks Value Line gives a Safety Ranking of #1 or #2. Th stocks are then screened for size (>$1 Billion) and dividend yield (greater than the median yield of the S&P 500). This is a very appealing ETF tracking an index of low volatility stocks with strong balance sheets and high yields -- something that people would want to own, and should own. But FVD's 0.70% expense ratio sops up the excess yield, so the fund yields only 2.1%, same as S&P 500 Index (NYSEARCA:SPY). Thus my lack of desire.

Hopefully SSgA/Barclays/Rydex will take advantage of the situation to introduce new ETFs with lower expense ratios. For example Vanguards Emerging Markets ETF (NYSEARCA:VWO) (0.30% expense ratio) is slowly sucking up assets from iShares MSCI Emerging Markets (NYSEARCA:EEM) (0.75% expense ratio).