Exchange-traded funds have become one of the most popular new investments of the past decade. As the industry evolves, however, it's producing some new offerings that just don't make any sense. Perhaps the most puzzling new product is one that tries to combine the ease of ETFs with the benefits of active management.
Is this really the future of investing?
Take one new ETF, for instance. The Dent Tactical ETF (DENT) is managed by former super-bull Harry Dent, famous for his prediction of Dow 40,000 back in 2004. Unlike most ETFs, however, whose holdings are tied to a particular index that the ETF follows, Dent Tactical is an actively managed ETF with complete latitude to change its investments without reference to any benchmark.
On its surface, Dent Tactical has some attractive features. Its investment strategy involves trying to predict future investing trends based on demographics and other economic analysis. With that information, the managers determine which types of assets are most likely to perform well, and then choose ETFs that give them exposure to those assets.
Of course, if you don't think Dent's methods are credible, then you won't have any interest in any ETF he runs. But even if you believe Dent knows what he's doing, the fundamental structure of an active ETF puts Dent Tactical at a severe disadvantage both to index ETFs and active mutual funds.
Does transparency destroy value?
One of the biggest benefits of ETFs is their transparency. Every day, you can see exactly which stocks your ETF owns. That way, you can avoid one nasty surprise that investors in traditional mutual funds often have to deal with: finding out that your fund happened to own a stock whose shares fell sharply.
But the ETF's transparency advantage also reduces the value of the proprietary advice that the ETF manager provides. After all, if an ETF reports its holdings every day, you can just go in and buy the same investments that the ETF owns. If there are any changes, you can make the same moves the following day.
For instance, Dent Tactical started out last month with a portfolio of roughly a dozen different ETFs. The portfolio had broad exposure to stocks worldwide, with an emphasis on value stocks. The only sector-specific investment was in a technology fund that owns shares of companies like IBM (NYSE:IBM), Apple (NASDAQ:AAPL), and Cisco Systems (NASDAQ:CSCO).
Less than a month later, Dent Tactical has already made substantial changes to its holdings. Gone are many of the value-focused ETFs. In their place are more concentrated plays, including ETFs that focus on emerging-market stocks like Brazil's Vale (NYSE:VALE) and India's Infosys Technologies. In addition, Dent Tactical has devoted almost 20% of its assets to ETFs investing in preferred shares of stocks like Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC), and Ford Motor (NYSE:F). If this high turnover continues, investors can expect it to wipe out the tax advantages that index ETFs enjoy.
Why pay for free information?
Again, I'm not passing judgment on whether Dent's strategy is sound. What I am questioning, though, is why you should pay a total expense ratio of more than 1.5% annually for a fund whose holdings are made public each and every day. At least with a mutual fund, managers can typically go for months before filing quarterly reports revealing where they've invested their (your) money. The same goes for investors like Warren Buffett, whose companies reveal holdings through Form 13F filings.
So unless Dent Tactical is doing a lot of profitable intraday trading, one day's lead time simply isn't likely to give the fund enough of an edge to make it worth paying Dent a management fee of 0.95%. Just buying the underlying ETFs that Dent invests in yourself will save you that 0.95%. You may end up buying a day later than Dent does, but one day will rarely make a huge difference.
This problem isn't unique to Dent Tactical. All actively managed ETFs face the same dilemma: how to reconcile the desire for transparency with the value of keeping proprietary investment methods confidential. As long as active ETFs keep disclosing their holdings on a daily basis, it'll be tough for them to justify charging shareholders excessive management fees.
Excessive fees aren't the only way Wall Street is trying to take your money. Paul Elliott can tell you other ways that you're being set up to fail.
