Don't Pay Up for These Untested ETFs

In the world of exchange-traded funds, a few firms dominate. Out of the nearly 150 ETFs that trade in the United States, Barclays Global Investors runs 94. Barclays was also the first firm to seriously market ETFs to retail investors and financial advisors. Moreover, between Barclays and the other ETF firms, the ETF universe is getting saturated--if you want to invest in a sector, region, country, or style with an ETF, you can already do it cheaply and efficiently. In short, it's hard to launch a new ETF and get investors to notice it.

Powershares is trying to change that. The firm currently offers two ETFs to investors, and unlike other ETFs, which are based on fairly static indexes, both are based on indexes that are put together almost as an actively managed, quantitative fund would be. The indexes are based on quantitative models that examine factors such as valuations and earnings growth, are rebalanced quarterly, and have a high degree of turnover. Now, the firm has filed to offer 26 more ETFs--using the same quasi-active index approach for the most part, but covering different slices of the market (21 of the new ETFs will be based on the new-breed indexes).

The real kicker is how the new ETFs will be sold. Given its lack of name-recognition and marketing muscle, the firm had to find a way to persuade investors to buy its ETFs. To do that, Powershares is trying something completely new in the ETF world: motivating brokers to sell its new funds by charging up to a 2% load on shares bought during the subscription period.

Investors have to pay brokerage commissions when they buy and sell ETFs, but no other ETF has ever levied an up-front sales charge. That's for good reason--investors buy ETFs in part because they can be less expensive to own than mutual funds. Paying 2% off the top would obliterate that advantage for many investors, except perhaps those who want to make relatively small investments and would pay high commission rates after the subscription period. If the two existing Powershares are any guide, the new ETFs are also likely to carry higher annual expense ratios than many of their competitors.

To us, the subscription-period proposition is unattractive: The new funds are untested, and many of them are based on indexes that are little known. Granted, the two existing Powershares ETFs have racked up good returns since their May 2003 launch, but that isn't much to go on. We'd want to see how the new funds behave in different market environments before diving in, and we wouldn't pay 2% for the dubious privilege of buying early.

ETFs Continue to Pull in Money
According to the latest data from the Investment Company Institute (ICI) and the Financial Research Corp. (FRC), ETFs are continuing to pull in cash. Recent ICI data show that ETFs issued $8.4 billion in net new shares in June, bringing the total net new issuance to $22.7 billion for the year to date through June 30. In contrast, over the first six months of 2003, ETFs had net new issuance of only $5.3 billion.

According to FRC, Barclays Global Investors (advisor to the iShares ETFs) had the fourth largest net inflow of any fund complex in June, and the third largest net inflow over the first six months of 2004. FRC data also shows that the SPDRs (SPY) had by far the largest net inflow, $4.5 billion, of any mutual fund or ETF in June. Three other ETFs also ranked among the top 20 asset gatherers that month: iShares Russell 2000 (IWM) ($821 million), iShares S&P 500 (IVV) ($625 million), and the  Nasdaq 100 Trust (QQQ) ($407 million).

Disclosure: Barclays Global Investors (BGI), which is owned by Barclays, currently licenses Morningstar's 16 style-based indexes for use in BGI's iShares exchange-traded funds. iShares are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in iShares.