These Newfangled Funds Might Be Dumbest Investment Ever

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The ingenuity of the securities industry is truly remarkable. Players in it seem to have a special expertise for creating a seemingly endless supply of complex investment vehicles. Almost all of them share this common trait: They fatten the wallets of those selling them and deplete the assets of gullible buyers.

A critical component of the sales strategy for these investments is their names. Who can forget the "collateralized mortgage obligations" of a few years ago? It conjures up an image of protection and security through the combination a mortgage product made even safer by the reference to "collateral." As we know now, the reality was quite different. The complexity of these investments successfully hid meaningful risks to purchasers. The use of collateralized mortgage obligations and other collateralized debt is generally regarded as a precipitating factor in the 2007–2008 financial crisis.

Fortunately for the securities industry, investors have notoriously short memories. There continues to be a market for almost every kind of new, gimmicky investment. How else can you explain the continued appeal of hedge funds, despite their staggeringly poor record of underperformance?

A Really Bad Idea from Wall Street

Here's my new candidate for the dumbest investment ever: Non-transparent, active exchange-traded funds.

Think about that name for a moment. What do ETFs tend to represent in your mind? Most likely, your first thought is low cost, high liquidity and tax efficiency. Indeed, traditional ETFs permit you to track market indexes and capture the return of those indexes in an extremely cost-efficient way. These favorable characteristics have been primary factors in the phenomenal growth of assets under management invested in ETFs. By some estimates, more than $2 trillion is currently invested in ETFs, representing a massive increase from a minuscule $100 million in 2002.

Unfortunately for investors, non-transparent, active ETFs bear little resemblance to traditional ETFs. The combination of active management and lack of transparency is a double dose of potential poison.

Investors in actively managed ETFs are betting on the ability of the fund manager to engage successfully in stock-picking, market-timing and even short-selling or buying on margin in an effort to "beat the market." The track record of actively managed mutual funds should be a sobering reminder to investors considering a roll of the dice with actively managed ETFs. Over a five-year period, only 25 percent of actively managed mutual funds outperform their benchmark. Investors in the balance of actively managed funds would have achieved higher returns by investing in low-cost index funds (including ETFs) that simply tracked an index. Over longer periods of time, the odds of outperformance for actively managed mutual funds declines significantly. For example, over a 15-year period, only about 15 percent of actively managed U.S. equity funds actually beat the U.S. equity market.

They Want to Keep Trading Strategies Secret

There's no reason to believe the returns of actively managed ETFs will be any better than their mutual fund counterparts.

The lack of transparency should be another red flag for investors. "Non-transparency" means these ETFs will not have to disclose their portfolio holdings, making it impossible for investors to understand what fund managers are doing with their money and how much risk they are taking. Lack of transparency is justified by the claim that it permits fund managers to keep their trading strategies proprietary.

The problem with this argument, as noted by Wesley Gray, who holds a doctorate, is that the lack of transparency is being used to justify higher fees, and there is no evidence of a positive correlation to better returns. Gray believes the securities industry is "pushing [an] overpriced average performance product through their massive sales distribution pipelines." He could not be more right.

Some fund families have secured SEC approval to issue non-transparent ETFs, while approval has been denied to others. No doubt, the industry will persevere. If your broker recommends this new investment product, run for the door and don't look back.

Daniel Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."
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