The Shot Heard ‘Round the ETF World

I’m not much of a country music fan. But I’ve always liked David Allan Coe’s rendition of You Never Even Called Me By My Name. As the lyrics tell us, the song was written by the late, great Steve Goodman, who considered it the perfect Country & Western song.

But Coe argued that it fell short. After all, the song said nothing about mama, or trucks, or prison — topics that no self-respecting country ballad could do without. That critique prompted Goodman to add a final verse about mama’s unfortunate demise in the rain, the perfect ending to what both agreed was the perfect song.

I’m reminded of this because exchange-traded funds (ETFs) just got their own final verse and may now be the perfect investment vehicle. These funds have always offered razor-thin fees, transparent portfolios, intra-day liquidity, and stellar tax efficiency. But until now, they haven’t had a true portfolio manager calling the shots.

And in my book, the greatest funds usually have a captain at the helm, particularly in inefficient emerging markets that require careful navigation.

Fans of passive management might view this as heresy: How can an ETF newsletter editor prefer an active portfolio manager to a fixed index? Wasn’t the entire industry built from the Bogle-esque notion that investors could do just fine sticking with low-cost funds tied to static benchmarks like the S&P 500? Answer: Yes, it was.

But once upon a time, Apple (Nasdaq: AAPL) was just an obscure PC company, and ESPN was created to broadcast University of Connecticut basketball games. Clearly, times change, and the ETF world continues to evolve and branch out from its roots on an almost daily basis.

Sure, you can still track the S&P or the good-old Dow Jones if you like. But you can get the same thing with a low-cost mutual fund from Vanguard and save yourself the commissions and trading fees. Limiting your ETF exposure to these plain-vanilla indexes is like dining at an extravagant seafood buffet and nibbling on a cracker.

I’m not sure where or how it first became fashionable to base key market barometers on size alone. We would never walk into an auto dealership and ask for the heaviest car on the lot. But there are trillions of dollars in assets linked to a small handful of behemoths like Exxon Mobil (NYSE: XOM) simply because of their market cap girth — with no regard for valuation, profit margins, returns on equity or any other fundamental measure.

Years ago Wisdom Tree recognized that traditional indexing methodology systematically pumped more dollars into overvalued stocks that had risen and less into undervalued stocks that had fallen. So much for “buy low, sell high.” To sidestep that fundamental flaw, the company began weighting index components by more intuitive metrics like earnings and dividends.

Others have followed. RevenueShares, for example, assigns weightings based on sales — the more cash a company brings in, the louder its voice in the index. Last I checked, the firm’s funds were clobbering the market at the small, mid and large-cap levels through both growth and value-led market cycles.

Still other issuers like PowerShares have used powerful quantitative tools to develop narrow, quasi-active indexes that cherry pick potential leaders and weed out laggards. And we’ve even seen ETFs that target stock buybacks, profit from M&A arbitrage, and replicate hedge fund strategies.

We’ve come a long way from the pioneer days in the mid-1990s.

But this latest step in the evolutionary process is arguably the biggest — true active ETFs.

This group of funds is still in its infancy, but the 20 or so active funds now on the market have already attracted more than $340 million in assets. Expect that total to be measured in the billions in the near future.
I’ve warned time and again that most fund managers charge exorbitant fees for the privilege of delivering mediocre performance. And indeed they do. But some stand head and shoulders above the crowd.

Look at guys like Bill Gross, whose Pimco Total Return has topped 96% of all bond funds during the past 15 years, or Brian Rogers, who has steered T. Rowe Price Equity Income to a cumulative gain of +1,259% since the fund’s inception in 1985.

These seasoned pros more than earn their paychecks and they’re a big reason why mutual fund assets still dwarf ETF assets by a wide margin. But evolution is usually a slow process. The tide is turning, forcing Pimco and T. Rowe Price (among others) to throw their hats into the ETF ring. Even staunch indexers like iShares will soon be testing the active waters.

I’m not sure how David Allan Coe feels — but adding professional, alpha generating portfolio managers to the steady rhythm of an ETF sure sounds like music to my ears.

P.S. — I’ll keep tabs on these funds going forward, highlighting favorites for my newsletter, The ETF Authority. To learn more about the newsletter, click here. And to sign up for my free ETF course, go here.