Now Serving: ETF Wraps

by on August 10, 2009

Innovation is nothing new in the ETF industry, with countless never-before-seen products hitting the market each year. MacroShares up/down funds, FactorETFs leveraged funds, and faith-based ETFs are just a few examples of unique innovations that have hit the market in recent months. Now private banks have begun wrapping ETFs into complex structured products in an effort to boost slumping revenues following increased regulation that restricts the sale of many of their most profitable products.

What's in your ETF wrap?While the benefits for banks are clear, the impact on investors is less obvious. Ruth Sullivan of the Financial Times notes that “the move raises questions as to whether investors, who are turning to ETFs in a search of greater transparency and lower fees, are best served by banks bundling plain vanilla ETFs into costly complex products.” Somewhere John Bogle is cringing. The Vanguard founder is a huge fan of the ETF business model, but has some serious issues with the manner in which ETFs are actually being used by investors (specifically, the significant turnover in securities that are best-suited for long-term, buy-and-hold investing).

Bundling ETFs into complex financial products seems contrary to investors’ best interests. ETFs have become so popular in part because they offer significant cost advantages over traditional actively-managed mutual funds. Including ETFs as part of a structured product, which can charge annual fees of up to 1.8% according to some industry experts, eliminates any cost advantage and benefits primarily the bank selling the product.

The fact of the matter is that ETFs are a significant threat to a number of traditional financial firms, in large part because of their ability to deliver comparable returns to active management while charging significantly lower fees. As investors become increasingly interested in these funds, it seems banks have found a way to offer investors what they want (exposure to ETFs) without actually providing some of the major benefits of  such an investment strategy (reduced expenses and increased transparency). So beware crafty bankers: you don’t need some complex structured product to access the ETF market.

Disclosure: No positions at time of writing.