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Exchange Traded Funds To Avoid

By: Investor Solutions

By: Investor Solutions, Inc.

How do you entice a broker to sell an index based product? You pay him! Until now, you’d be hard pressed to find a broker that would recommend an index fund or exchange traded fund for a client’s account. After all, for the investor they are tax efficient, cost effective and free of sales commissions! Now why would a broker recommend that!? Investors beware–Wall Street has finally figured out a way to capitalize on the growing popularity of index fund investing with a new breed of ETF’s. Don’t fall prey to this substandard ETF incarnation.

The Investment Company Institute reports that ETF’s issued $8.4 billion in net new shares in June, which brings the year-to-date total to $22.7 billion. Wall Street has obviously taken notice. PowerShares Capital Management has just rolled out two (out of a total of 25) ETF’s, specifically designed for brokers to sell.

There are a myriad of reasons for you to NOT by this product.

First, the PowerShares ETF’s are designed to track an actively managed index. The indexes are based on quantitative methodology (they call it “Intellidex methodology) is intended to generate alpha beyond the equivalent asset class represented by the funds. The models examine factors such as valuations and earnings growth, are rebalanced quarterly, and (unlike traditional ETF’s) have a high degree of turnover. Obviously, the higher the turnover in the product, the higher the tax the investor gets to pay. In addition to the higher turnover, the quantitative tinkering introduces a certain level of “manager risk” persistent in any active management strategy. In short, it’s not exactly a pure index exposure and they are not as tax efficient as other ETF’s.

Additionally, the PowerShares ETF’s (or XTF’s as PowerShares calls them) carry an up-front sales charge (or load) on shares purchased during an initial offering period. This is meant to incentivize brokers to sell the product, in the same way that front-end loads have worked for mutual funds. This is great for the broker, bad for the investor. No other ETF has ever levied an up front sales charge before this.

These new ETF’s will also carry a higher annual expense ratio relative to many of their ETF peers. For example, the PowerShares Dynamic Market fund (a large blend) carries an expense ratio of 0.60. The PowerShares Dynamic OTC portfolio (mid cap growth) also carries an expense of 0.60%. Compare that to the Barclay’s iShares S&P 500 ETF (large blend) and iShares Russell Mid Cap Growth ETF with fees of .09% and 0.25%, respectively.

What am I missing here? Despite the fact that PowerShares would cost me an extra .51% (that’s 0.60% for PowerShares minus .09% for the iShares) and .35% per year (that’s 0.60% for PowerShares minus .25% for the iShares), plus I get to pay a commission, and (in all likelihood) I’ll pay higher taxes for a quasi-actively managed index fund, does PowerShares really believe that these ETFs are supposed to improve my life!? Fat chance-the only lives they are improving are the lives of brokers who peddle them and their own. Any index fund investor with half a brain will run the other way.

Finally, imitation is the greatest form of flattery. The fact that Wall Street has introduced broker-sold ETFs further validates the idea that index fund investing is not only here to stay, but is the smartest approach to long term investing.