Naughty: The ETF Industry

When Santa makes his list and checks it twice, he will find out that some people in the exchange-traded fund (ETF) industry have been naughty. ETFs such as S&P 500 Depository Receipts (AMEX: SPY  ) have long been a part of the investing community. But when Barclays rolled out iShares ETFs a few years ago, the popularity of these passively managed products soared.

Not only do ETFs have extremely low annual costs -- Vanguard's Total Stock Market ETF (AMEX: VTI  ) has an annual expense ratio of 0.07% compared with the average domestic mutual fund's expense ratio of 1.5% -- but ETFs are also extremely tax-efficient and can help lower portfolio risk, too. I also like that since they trade during the day the way stocks do, they are immune to pricing manipulations such as late trading.

So ETFs were working great. And then the marketing gurus stormed the gate. At iShares, you can now choose from more than 100 ETFs. One of the strategies at iShares is "tactical rotation," which loosely translates into market timing. That's not very Foolish. It's a way for stockbrokers to generate more commissions or actively manage your account, thus justifying their wrap fees. Individual investors may be lured into trying their own hand at market timing, but I don't think that's a strategy that works over the long run. Further complicating matters is that many ETFs trade on very low volume, which can lead to pricing inefficiencies.

Many of the newcomers to the ETF entourage come with steeper annual costs. iPath's Commodity Tracking Exchange Traded Note and PowerShares Industry Rotation ETF (AMEX: PYH  ) have annual fees of 0.75% and 0.60%, respectively.

In the beginning, ETFs followed well-established indices such as the Standard and Poor's 500 or the Russell 3000. Now we have more nebulous and arbitrary groups. PowerShares has invented a new way to look at index construction -- to wit, dynamic indexing, which "can change on a quarterly basis and will use qualitative research for selecting component securities." An index that changes quarterly doesn't sound like passive investing to me.

Close to 400 ETFs are available, and more are in the pipeline for 2007. The industry should follow Vanguard's lead and offer a limited number of low-cost ETFs.

Let me look in my bag of goodies. Hmm. Ah, yes, here it is. This year, the ETF industry gets a lump of coal.

For more Foolishness on ETFs, check out:

There's a whole world of naughty and nice out there! Take a lookat the rest of the bunch.

Are you interested in learning more about ETFs? Check out The Motley Fool'sETF Center. And if you think mutual funds offer a better alternative, check out which funds Shannon Zimmerman likes in The Motley Fool'sChampion Fundsnewsletter.

Fool contributor Buz Livingston appreciates your feedback and believes investors will benefit from professional advice. His idea of a white Christmas is walking barefoot on a sandy beach. He doesn't own any of the securities mentioned here. The Fool has a disclosure policy.

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