Don't Buy This New Investment

You can always find promising ways to invest. But your portfolio can live without this particular new investment vehicle, even though many have anticipated it for years.

Earlier this month, a relatively small fund company, Grail Advisors, launched an actively managed exchange-traded fund named Grail American Beacon Large Cap Value ETF

Unlike previous active ETFs, which have investment objectives that require them to follow quantitative models without room for subjective thought, Grail's offering gives its managers latitude to buy whatever stocks they believe will help the ETF outperform the Russell 1000 Value index of large-cap value stocks.

Hey! It's just another fund!
The endless hype about ETFs amuses me. It seems like anytime a new ETF comes out, many investors hold their breath, hoping that they've stumbled onto the next great innovation in investing -- and will somehow capitalize by getting in on the ground floor.

But at least in this case, there's nothing particularly unusual about Grail's active ETF. Consider:

  • Like a typical actively managed mutual fund, the Grail ETF owns more than 100 different stocks, with megacap choices like JPMorgan Chase (NYSE: JPM  ) , Philip Morris International (NYSE: PM  ) , and Chevron (NYSE: CVX  ) among the top five stock holdings.
  • Unlike cheaper index-tracking ETFs, the Grail fund will charge an expense ratio of 0.79%. That's still fairly inexpensive in comparison with most active funds, but a big premium over the most popular ETFs. Higher fees add up over time.
  • As one commentator noted, the Grail ETF shares a lot in common with a similarly named mutual fund, American Beacon Large Cap Value Fund (AAGPX), including many of the same fund managers and subadvisors, and a similar expense ratio. The two funds don't have identical portfolios -- the mutual fund appears to have larger allocations to companies like IBM (NYSE: IBM  ) , Verizon (NYSE: VZ  ) , and Home Depot (NYSE: HD  ) -- but they have a lot of common holdings.

At least from that view, the new ETF looks like just another mutual fund.

Giving up their advantage
Moreover, although many ETFs do carry a number of advantages over traditional mutual funds, an active ETF structure could actually prove destructive to those advantages. For instance, one advantage that many ETFs have is that they tend to be more tax-efficient. Because creation of new ETF shares and redemptions of old shares can be settled in-kind using stock holdings, ETFs don't necessarily have to buy and sell shares as often as traditional mutual funds, which have to pay redeeming shareholders in cash on a daily basis.

An active ETF, however, will buy and sell its holdings much more often. That, in turn, will lead to more distributions of dividends and capital gains, causing those who invest in active ETFs to suffer many of the same problems that mutual fund shareholders have to deal with.

In addition, from a shareholder's perspective, one of the things that traders like most about ETFs is that you can actively manage your own investments using them. From a broad-market index ETF like the SPDR Trust (NYSE: SPY  ) to specialized ETFs giving you exposure to just about any sector you care to invest in, you have the power to jump in and out of the market any time you want.

In that light, an active ETF doesn't make much sense. If you trust an active manager over the long haul, then being able to buy or sell fund shares more than once a day wouldn't be very important. On the other hand, if you're using the ETF as a short-term trading vehicle, then you don't get much value from active management.

The next big thing?
Despite this apparent inconsistency, it's clear that more active ETFs are on their way. Before you automatically decide to be an early adopter of active ETFs, though, use the same judgment you would in evaluating any mutual fund. If you're patient, the ETF universe is certain to bring you a more interesting actively managed choice, eventually.

For more on smart fund investing, read about:

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Fool contributor Dan Caplinger sticks with index ETFs. He owns shares of Philip Morris International and SPDRs. Home Depot is a Motley Fool Inside Value selection. Philip Morris International is a Motley Fool Global Gains recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy gives you all you'll ever need.


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  • Report this Comment On May 11, 2009, at 10:56 AM, pondee619 wrote:

    "will somehow capitalize by getting in on the ground floor"

    I got in on the ground floor once. Then the building crashed in aroung me.

  • Report this Comment On May 11, 2009, at 11:09 AM, slidexperto wrote:

    Watch out for Wendy's (symbol = WEN) is an undervalued stock, I can say shud be at least $8.00 before the Fall comes and against today's price of $4.40 trying to reach the $5.00 resistance level base. Also note Vonage Holdings (symbol = VG) is making waves in Canada right now, its a penny stock but its future is immense, trying to reach the $1.00 resistance level, I just bought VG 5,000 shares last week @ $0.50 cents. Take care and good luck guys you know what to do..

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