Exchange-traded funds have gone from being the new kid on the block to becoming a $1 trillion market force. As money managers try to cash in on the ETF money train, though, you're going to start seeing a bunch of funds that could do you more harm than good.
The new style in ETFs
One of the latest innovations in the ETF world is a new PowerShares fund that will invest in various types of closed-end funds. As this recent article examined in more depth, closed-end funds are like ETFs in that they trade on exchanges. But because the number of shares is arbitrarily fixed, closed-end fund shares can trade at big premiums or discounts to the actual net value of the assets the fund holds.
This particular ETF, the PowerShares CEF Income Composite Portfolio (PCEF), has a conservative bent to its investments, with more than half of its money invested in fixed-income closed-end funds. Another 9% is devoted to funds that focus on total return, while the remaining 35%-40% is held in stock-based closed-ends.
What's right
Looking more closely at the ETF's investments, it's clear that the ETF manager is paying closer attention to premiums and discounts than many average investors in closed-end funds do. The top five funds in the current income category all trade at a discount to their net asset value. Unfortunately, that's not the case for the ETF's top equity fund holdings, many of which trade at premiums to NAV.
Still, the ETF has picked some interesting funds. The NFJ Premium & Dividend (NFJ), for instance, is an unleveraged fund trading at a discount of almost 15% to NAV. Its fees are less than 1%, and the fund owns shares of stocks such as Windstream (Nasdaq: WIN), GlaxoSmithKline (NYSE: GSK), and Diamond Offshore (NYSE: DO). Its yield is currently around 4% -- far less than you can get from other, riskier funds, but a level that seems much more sustainable over the long haul.
The ETF is allowed to pick from an index that covers a wide swath of the closed-end world, though. To qualify, a fund must concentrate on generating income, have a $100 million market cap, have daily trading volume of at least $500,000, trade at less than a 20% premium, and charge no more than 2% in fees. That leaves roughly 350 eligible funds, from which the ETF has chosen about 70.
Fund of funds = fees + fees
One thing you have to do with ETFs, though, is to look at their costs. Because of this ETF's structure as a fund of funds, investors in the PowerShares ETF effectively have to pay two separate sets of fees: 0.5% to PowerShares for managing the ETF, along with the expenses of whichever closed-end funds the ETF chooses to buy. All told, the fund anticipates annual expenses of 1.81% -- and that figure could go still higher depending on which closed-end funds the ETF's manager chooses in the future.
Moreover, it looks as though in selecting funds, the ETF manager may well be chasing performance. A big holding in its total return category, Nuveen Multi-Strategy Income & Growth (JPC), saw its shares jump around 85% in 2009, due in large part to owning big bounce-back stocks like Apple (Nasdaq: AAPL) and Mosaic (NYSE: MOS), as well as convertibles on financials such as US Bancorp (NYSE: USB). But fund shareholders lost half their money in 2008, and the fund's five-year returns leave much to be desired.
Staying competitive
With all the growth in ETFs, the industry has become extremely competitive. BlackRock's (NYSE: BLK) recent agreement to offer a selection of 25 of its iShares ETFs to Fidelity accountholders with no commission was a bold move to try to grab more assets. PowerShares, along with other major ETF players like State Street and Vanguard, will have to keep coming up with innovative ideas to bring in new customers and maintain their assets under management.
Unfortunately, this latest PowerShares offering doesn't look like a step in the right direction. You shouldn't pay two sets of pricey fees just to make a single investment. If you like some of the closed-ends you see among the ETF's holdings, you'd be better off buying shares on your own.
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