ETF Expert

When 3 or 4 members of the media start calling me for comments in a single day, I know that there's an effort to get a "scoop." More specifically, different news providers are looking to get a story out before the other publications.

Last week, I received a fair amount of phone and e-mail contact over what I thought about a TARP-themed ETF. This week, the media are asking for my opinion on the Grail Advisors creation of the Grail American Beacon Large Value ETF and the Grail American Beacon International Equity ETF.

Why all of the buzz over yet another large cap exchange-traded fund? Or for that matter, a broad market international ETF? For the simple reason that they will be actively managed, stock picker investments, not index-tracking funds.

Okay… so that makes the potential newbies much different from the other 700 ETFs in existence. There's only a few other actively-managed ETFs in existence today, such as the PowerShares Active Mega-Cap Fund (PMA) and the PowerShares Active Alpha Multi-Cap Fund (PQY). Yet the institutional managers from Invesco-backed Powershares estimate that they only trade on a monthly basis, whereas the Grail folks maintain that their managers will have complete freedom.

So what do I think about these developments? I am unimpressed… and the reasons that I am unimpressed go back to the heart and soul of why investors should use ETFs in the first place.

Let's review:

1. Transparency: ETFs are better than traditional mutual funds because you know all of the investments that an ETF holds/tracks. The holdings are the same as the indexes themselves. With mutual funds, you get quarterly updates on what a fund manager may be doing, but for the most part, you're investing in the track record of the person/team managing the mutual fund.
 
On transparency, this is the big break-through that Grail American Beacon Large Value ETF and the Grail American Beacon International Equity ETF are supposedly offering over traditional mutual funds. Yet even though Grail Advisors is promising a completely open book, there isn't an established track record for doing so. What's more, many believe that these ETF managers will be operating at  competitive disadvantage to their peer stock pickers.

2. Trade-ability: ETFs are better than traditional mutual funds because ETFs trade like individual stocks. If you want to hold them for the so-called long-term, you can. If you want to manage downside risk by employing stop-losses, you can do that at any price point you want. You can even set a pre-determined buy price that is attractive.

On trade-ability, Grail American Beacon Large Value ETF and the Grail American Beacon International Equity ETFwill have the benefit that all ETFs have. Yet the likely inauguration of these instruments will be met with enough skepticism and low volume, that the bid-ask spread will be wide. In all probability, it will at least be .5%-.75%, much like the PowerShares Active Mega-Cap Fund(PMA) and the PowerShares Active Alpha Multi-Cap Fund (PQY). So an investor will likely lose up to 1.5% in round-trip trading. One needs high volume ETFs to trade at beneficial price points.

3. Tax-Efficiency. Exchange-traded funds are better than traditional mutual funds because most ETFs do not "phantom tax" you with pass-through capital gains distributions. That's because ETFs typically track indexes that aren't changing that frequently. With low turnover, indexing means less taxation.

On tax efficiency, Grail American Beacon Large Value ETF and the Grail American Beacon International Equity ETFpropose to be buying and selling frequently, even more flexible in turnover trading than the current PowerShares products. These new ETFs won't be tax-efficient.

Are we starting to get the picture? These new actively managed ETFs may or may not benefit from their potential transparency, they will hurt the investor who wishes to trade them actively and they probably won't provide a benefit on the tax-efficiency front.

What about things like cost, performance and indexing? Grail American Beacon Large Value ETF and the Grail American Beacon International Equity ETF will cost less than traditional mutual funds at .75%. Most traditional funds clock in at approx 1.3%. And lower costs typically mean better performance.

However, the fact that lower cost ETFs and lower cost mutual funds outperform traditional mutual funds over time is a function of the benefits of indexing. In the domestic large-cap arena, I've seen scores of studies that show that 85% of actively managed mutual funds do not beat their corresponding index. Index ETFs are outperformers because stock picking skill, particularly that which is adjusted for risk, simply does not exist over the long-term.

If 85% of active fund managers can't beat the Russell 100 Value Index Fund (IWD), why on earth would I choose an unproven, low volume, higher expense ratio product like Grail American Beacon?

Some maintain that there's evidence that international stock picking has some merit. Even if I believed that were true… that half of international managers might do as well as the Vanguard MSCI EAFE Index Fund (VEA), Grail American Beacon International would still not win my vote at this stage. For one thing, they are only going toinvest in the ADRs listed on U.S. exchanges. This alone limits and minimizes the field of potential companies that might help an international stock picker outperform.

What's more, Vanguard MSCI EAFE Index Fund (VEA) only costs 0.12 whereas Grail American Beacon International Equity ETF will cost .75%. VEA will be tax-efficient a la indexing, whereas American Beacon International will likely be passing along taxable cap gains. VEA trades millions of shares for solid entry and exit price points, whereas American Beacon International will likely cost 1%-to 1.5% to get in and out.

Need I really say more? Perhaps if there's significant outperformance and significant volume in 3 years, I might take another gander.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.