Pimco’s active ETF is an industry outlaw

Bill Gross and his Pimco gang came riding into Wall Street last week with guns blazing, like outlaws in a Clint Eastwood Western, launching the first formidable “active” exchange-traded fund.

The new Pimco Total Return ETF TRXT -0.23% is an outlaw in ETF-ville, because it represents the opposite of everything the townsfolk set out to do when ETFs were created.

ETFs freed investors from high mutual-fund fees, allowing allocations to about any type of asset class for a fraction of the cost. Most ETF investors have a point of view about investing that goes like this: “Let’s stop trying to beat the market. Let’s just ride the market, pay really low fees, get what the market delivers and drink to that!”

And while there are 1,300 ETFs and $1.1 trillion invested, most of these are irrelevant. The top 50 ETFs comprise well over 70% of money invested in ETFs and most remain “pure” in their original intent: built to be managed by computers to mimic a popular, widely understood index for less than a competitive mutual fund.

But now the mutual funds have morphed into a different kind of villain, ready to terrorize the townsfolk who like their funds cheap and their managers, well, high powered computers. Pimco’s ETF is expensive — 0.55% after a fee-waiver — relative to other bond ETFs such as Vanguard Total Bond Market BND -0.10% , at 0.11%, because it is “actively” managed.

Actively ETFs comprise less than 1% of the market today. Will Pimco’s arrival drive this new form of ETF “bastardization?”

For the newbie in ETF-land, understanding ETFs is about to get even more confusing. So here’s a little history:

The Good. In 1993, State Street Bank launched SPDR S&P 500 ETF Trust SPY +0.06%, the first ETF on the S&P 500 Index SPX +0.36% , known as SPDRs or “Spiders.”

Then a new company, iShares, discovered this territory and released indexes of all major countries in 1996. From EWC (Canada) to EWJ (Japan) to EWK (Belgium), investors could now cheaply invest in entire nations. Not to be outdone, State Street released indexes on all major U.S. sectors. Later, Vanguard, which invented the whole concept of index funds, woke up and released ETFs around their major index funds. And for most of us, the town was good. We had every index we needed to build and manage a great, diversified, inexpensive portfolio.

The Bad. But just when the townsfolk were cheering the arrival of every kind of useful ETFs, the ETF industry drifted from its sound mooring.

The SEC approved a redefinition of the term “index” in 2003. Before then, ETFs were limited to holding baskets of stocks that tracked broad market indices like the S&P 500. After 2003, the SEC allowed anyone to form newfangled “indices” based upon any rules they made up. This changed the definition of an index and allowed the Wall Street crowd to run wild, creating the latest, greatest “index” de jour and cluttering the universe of good ETFs.

New indexes began popping up, polluting the original purity of ETFs as suitable building blocks for asset allocation. A “sin” index of casinos, producers of beer and malt liquors, distillers, vintners, as well as cigarette manufacturers was created and later closed. Today, you can invent any “index” you want, and create an ETF based on it.

The Ugly. When leveraged ETFs got released, things got very risky.

These leveraged products would sometimes severely deviate from their underlying index over the long haul. And leverage is dangerous. For example, Direxion Daily Financial Bear 3X Shares FAZ -0.25% plunged 95%, earning it the ignominious title of worst performing ETF in 2009. And ETFs were offered that hold futures contracts and options, mostly to achieve commodity exposure. Futures-based funds can fail to track their target index and are vulnerable to all kinds of technical problems.

Law and order

When trying to make sense of the world of ETFs use these five simple principles to guide you to the good and away from the bad and ugly:

Holdings: Make sure your ETF holds only stocks or bonds. If you see options or futures contracts, options or leverage — run!

Fees: With few exceptions, don’t pay more than 0.5% in fund fees, and for a portfolio of ETFs the weighted average fee for the entire portfolio should be under 0.25%.

Billion: . Quality ETFs have more than $1 billion in net assets and substantial daily trading volume. This affords sufficient volume and liquidity so that the bid/ask spreads are narrow.

Turnover: Except with bond portfolios, which have expiring securities, make sure the stocks have annualized turnover of less than 20%. This means that there are no fancy algorithms trading in and out of positions.

For most of us, the new active ETFs from Pimco and others will either be bad or ugly. They surely will not be good as they will continue to confuse and dilute the purity of one of the greatest financial innovations ever created. Here’s hoping the new bandits are unable to find a willing market, leave town for good and stop peddling their expensive mutual funds dressed up as ETFs.