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BULLS & BEARS: Exchange-traded funds are a bonanza for Wall Street

February 26, 2007

"It slices! It dices!"

That was the claim of late-night pitchman Ron Popeil of his invention, the Veg-OMatic. He could very well have said the same about Wall Street and its penchant to carve up the stock market and repackage it for sale to investors.

The most visible evidence of this pursuit is the development of exchange-traded funds, or ETFs. An ETF is essentially an index mutual fund-an unmanaged pool of investor money that is invested in a select group of securities and priced with a net asset value. The major difference between ETFs and the original index mutual funds is that an ETF is traded on a stock exchange and thus can be bought and sold throughout the day.

When John Bogle of Vanguard mutual fund fame created the first index fund in the early 1970s, his intention was to offer a product that would provide investors the return of the stock market, minus a minimal fee.

Today, the purveyors of ETFs have taken the concept of indexing into a whole new realm. In what Bogle calls "mutants of the original investment form," ETFs have been constructed to represent a specific sector or industry, such as consumer goods, or a specific basket of stocks, like oil stocks. And as a result of their wild popularity, providers are carving the market into thinner and thinner slices. For example, there is a HealthShares Emerging Cancer ETF, or how about the PowerShares Lux Nanotech Portfolio?

As Bogle laments, these "nouveau" index funds contradict the principal concepts of the original index funds, which were broad diversification, low cost, and investing for the long term with minimal trading (which, in turn, minimized taxes). The traditional index fund investor is assured to achieve the average stock market return (less a small fee), an accomplishment many actively managed investment programs fail to meet.

In contrast, investors trade ETFs at a furious pace, with 400 million shares changing hands each day. And, in general, the more specialized the ETF, the higher the cost. For example, the nanotech ETF has a 0.7-percent annual management fee in addition to the commissions paid to buy and sell the shares. And because ETFs have become a common investment vehicle with many brokers, advisers and hedge funds, clients of these firms may pay additional fees over and above the fund's expenses.

One might take Bogle's comments as sour grapes over the faster-growing ETF industry. But unless an investor buys and holds one of the broadly diversified ETFs, he should not confuse an actively managed ETF portfolio with a low-cost passive index fund program. There are no assurances that such an ETF portfolio would meet the stock market return and, frankly, the odds are high that it would underperform the market.

ETFs are a hybrid between traditional index investing and individual stock selection, offering the ability to target specific slices of the stock market as easily as buying a stock. Hedge funds have become active traders of ETFs since they can be shorted, leveraged and arbitraged.

Ron Popeil always wrapped up his sales pitch with, "But wait, there's more. ... Now how much would you pay?" When it comes to Wall Street, you can be certain there will be more slicing and dicing of new ETFs since they are generating $1 billion in management fees.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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