The "Holy Grail" of ETFs Looks Like a Dead End to Me

Today's comment is by Mike Burnick, Global Markets Analyst and editor of Market Shock Trader for The Sovereign Society.

Dear A-Letter Reader,

The world's first actively managed exchange traded funds (ETFs) - the industry's long sought-after "Holy Grail" of ETFs - have finally made their debut in the markets. Or so the industry would have you believe.

After years of discussion between fund sponsors and regulators, the ETF industry finally has its first actively managed ETFs. Invesco PowerShares recently launched four new ETFs on the New York Stock Exchange after receiving SEC approval.

Since the very first ETF was launched 15 years ago, ETFs have quickly become one of the hottest investment vehicles of all time. Assets under management in ETFs soared 30% last year alone to nearly US$560 billion. ETFs have proven especially popular among affluent investors too.

It's worth noting that the very first ETF launched in 1993 was designed to track the S&P 500 Index. The fact that ALL ETFs (up until now) are designed to track indexes has been one of the key advantages to investing in ETFs. However, it's one key advantage that actively managed ETFs don't have in their favor.

Index Tracking ETFs Keep Costs Low

There are ETFs available today that track stock indexes, ETFs that follow bond indexes, ETFs that track commodities, real estate, specific sectors, overseas market indexes - you name it.

Index-tracking ETFs, like the Vanguard index mutual funds that came before them, are very low cost investments. No active management means no high management fees. As a result, the average expense ratio for ETFs is about 0.4%, while actively managed mutual fund expenses average 1.2% - three times higher!

Investors are attracted to ETFs for this very reason; low fees. Lower fees mean higher investment returns. Compound that over enough years in the market and it's easy to see why index ETFs are so appealing. In fact, they tend to consistently outperform most mutual funds.

Who Needs Actively Managed ETFs Anyway?

According to Bruce Bond, CEO of PowerShares, the introduction of actively managed ETFs "is a watershed event for the industry because people have not had access to active management within the ETF structure before now." Bond claims that active ETFs will transform the industry landscape.

Somehow, I seriously doubt that.

There are more than 10,000 conventional mutual funds in existence today. The vast majority of these are actively managed funds, with high-priced fund managers collecting fat fees for their investment management skills.

Unfortunately, investment "skills" are sadly lacking. In fact, over 90% of these actively managed mutual funds cannot beat the market index return. In fact, most fall well short of the benchmark. In other words, investors are paying higher management fees for nothing. No wonder index-tracking ETFs are so popular.

Other big advantages of ETFs are liquidity and transparency. Actively managed mutual funds can only be bought once a day, at the end of the day, when financial markets are closed. ETFs by contrast are listed on major stock exchanges and can be bought and sold throughout the trading day, minute by minute, and tick by tick.

Transparency: Another Key Advantage for ETFs is a
Roadblock for Active Managers

With ETFs you always know what you own. Regulators require ETF sponsors to disclose all their positions every day, so you can check out an ETF sponsor's website anytime in the trading day to find out what you're investing in. By contrast, mutual funds are only required to disclose fund holdings once every six months.

One of the stumbling blocks that PowerShares new actively managed ETFs had to overcome was this transparency issue. Active fund managers - that is the few ace managers who actually can beat the market - like to keep their investment strategies under wraps to some extent.

If other investors could plainly see what they're buying then those stocks would shoot higher, eliminating the active manager's edge.

According to one industry expert, if "you talk to any active manager that actually has skill, they don't want to disclose what they have every day...That's the last thing any money manager wants."

As a result, I very much doubt that actively managed ETFs will attract many talented money managers who could earn much more money by running traditional mutual funds (not to mention hedge funds). Far from being a "watershed event," the Holy Grail of actively managed ETFs just doesn't make much sense to me.

In my opinion, this new Holy Grail of ETFs won't come anywhere near "transforming the industry." Actively managed ETFs look dead on arrival.

MIKE BURNICK, Senior Editor & Global Markets Analyst

EDITOR'S NOTE: ETFs are safe, highly liquid investments that let you invest in entire countries, sectors and indexes with a single play. ETFs are also one of the easiest ways to invest abroad, without leaving the familiarity of the U.S. markets. That's why Mike buys options on ETFs -- it's an easy way to get a higher return on your investments abroad. In just the last year, Mike has used this strategy to make 51%, 111% and 159% for his Market Shock Trader subscribers using a combination of highly liquid ETFs and market-beating options. Click here to learn more about his strategy.

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This Big Stock Market Rally is Based on Nothing

Investors are mistakenly shifting from a credit stressed mindset to focusing on the general trend of the American economy. Friday's positive unemployment report throws more fuel to the big rally now underway since March.

I have been highly suspicious of this post-March 17 global stock market rally. World markets are now down just 3% in 2008. This rally has nearly erased their entire post-January losses in just six weeks of trading.

But, as I have commented here before over the last few weeks, this rally has dangerous undertones. Please remain cautious. Key credit market indicators remain clogged or still illiquid. In other words, the markets' fundamentals are highly bruised and unlikely to recover any time soon.

It's quite obvious that market participants have thrown caution to the wind at this point. They're lunging after stocks following five straight months of losses from October to March. Treasury bond yields, which benefited from their safe haven status, are now correcting heavily, from yielding just 3.31% in mid-March to 3.85% Friday morning.

Investors are unwinding their defensive hedges in T-bonds, foreign currencies and, of course, gold. Most commodities are also heading south after posting huge gains, including oil.

But there is also some serious unwinding occurring in the credit markets. And that process will take several years to complete. What these gung-ho investors fail to understand is the unwinding process just began last fall. Debt deflation is the most formidable policy challenge the Federal Reserve has faced since the Volcker Fed wrestled high inflation in 1981-82.

It's a big mistake to believe this will be a quick, V-shaped economic recovery. I'm betting the United States will endure a 12-18 month slowdown or a U-turn recession, lasting much longer than has been discounted by the markets. The lethal combinations of deflation in housing, a bank credit contraction and soaring food and energy prices will remain formidable hurdles for corporate earnings and domestic consumption. If I'm right, this rally will probably end in a very bad way before the summer is over. That event will probably mark the true bottom for stock prices worldwide.

Another point worth heeding: Bear market rallies are perfectly normal and expected following big declines. That is exactly what has been happening since March. And guess which sector is leading this recovery? The banks.

Though some segments of the credit markets have rallied, namely junk bonds and mortgage-backed securities, the rest of the complex is still stuck somewhere in cyberspace. Auction rate securities, LIBOR, commercial paper, leveraged loans and CDOs, or collateralized debt obligations, are still sitting on the books of major financial institutions. There is more bad news coming.

The stock market might be lighting firecrackers but most pundits and investors still fail to appreciate the severity of this crisis. I will not underestimate the consequences of two extreme economic anomalies now riding side by side for the first time since 2001: inflation and deflation.

I'm still invested, but my exposure remains the lowest since early 2002. I'm also still a big believer in gold.

ERIC ROSEMAN, Investment Director

P.S. I'm also still heavily invested in specific food and beverages that remain undervalued - even with food shortages around the world. Click here to get a glance at my new inflation portfolio.

Feds Now Have the Power to View Every File on Your Laptop - Without Any Probable Cause

It's bad enough that when you cross a U.S. border, you must consent to an intrusive search of your luggage. But now, courtesy of a decision from a federal appeals court, the government also has the right to copy everything on your laptop - and use it for whatever purpose authorities deem fit.

I wrote about an earlier decision along these lines over a year ago. As I then wrote, the ways this new authority can be misused are too numerous to count - whatever information you carry with you on your laptop-banking records, client data, personal journals you name it - now, in effect, must be shared with the U.S. government.

But now it's even worse: The 9th Circuit Court of Appeals has ruled that customs officials don't even need "reasonable suspicion" (much less "probable cause") to "search a laptop or other personal electronic storage devices at the border." That means in addition to your laptop, customs officials can search and copy data from your cell phone, Blackberry or any other electronic device without any evidence you've done anything wrong.

Searching your laptop is far more intrusive than searching your luggage. In some ways, it's even more intrusive than a body cavity search, which customs officials do require "reasonable suspicion" to conduct.

Your body cavities may (or more likely may not) reveal any contraband. But examining the data on your laptop may well reveal a detailed picture of your friends, your family, your professional associates, your interests, your financial status, and possibly much more. As one attorney noted, "It really is like looking into someone's mind, rather than looking into a box or a folder or a purse."

To avoid this, the obvious solution is to encrypt all the data on your laptop, or even the hard disk itself, using a program like PGP Desktop (www.pgp.com).

Unfortunately, that may not be an ideal solution, because customs officials may demand that you decrypt any encrypted files before they return your laptop. If you refuse, they can confiscate the laptop and/or detain you until you agree to provide access to the encrypted files.

A better solution may be to copy all the data on your laptop to a USB stick and send it via a courier service to your international destination. Encrypt the data, of course, before you send it. Then securely "wipe" any confidential information off your hard drive, along with the "free space," again using a program like PGP Desktop.

If you carry your laptop through Customs, be sure to "sanitize" it. After you encrypt and copy your data to a USB stick and send it to your destination, use a utility like KillDisk (www.killdisk.com) to securely wipe everything off your hard drive. Then reinstall the operating system according to the instructions in KillDisk or whatever utility you use for this purpose (there are other possible "sanitation" solutions but none as good as this one).

If Customs asks to inspect your laptop, let them. The inspector won't find anything but the operating system and standard system files.

(For more suggestions on protecting your privacy and wealth, click here.)

MARK NESTMANN, Privacy Expert &
President of The Nestmann Group
www.nestmann.com

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