A Booming ETF that's More Expensive than a Mutual Fund

(Bloomberg) -- Out of more than 500 ETFs launched in the past three years, the one that has taken in the most cash charges an annual fee of 0.94 %.

Wait, what? 

That’s not a typo. The First Trust Dorsey Wright Focus 5 ETF has accumulated $4.2 billion in assets in a little more than a year and a half, taking in money every month. That's despite having a fee that is far higher than even the asset-weighted average mutual fund fee of 0.66 %.

FV’s success flies in the face of conventional wisdom that ETF investors sniff out only the cheapest products while rejecting the expensive ones. After all, while the average ETF fee is 0.61 %, the average asset-weighted ETF fee is just 0.30 %.

So why are they flocking to the fund?

One word: convenience. FV has essentially ETF-ized a popular sector rotation strategy from Dorsey, Wright & Associates, an investment firm with long expertise in technical analysis. Sector rotation strategies aim to ride the coattails of hot sectors. FV 's strategy is to select five of First Trust's sector and industry index ETFs based on their relative price momentum and to weight them equally.

Many advisers were already following Dorsey Wright’s sector rotation model—they had corporate subscriptions to Dorsey Wright's guided model portfolios—but apparently like the convenience of an ETF that does the work for them.

FV allows advisers to offer aggressive clients its sector rotation strategy in a tax-efficient, rules-based index ETF. The appeal of this to advisers explains the steady flows into the ETF. Advisers tend to invest money on a regular basis, despite market conditions, while institutional investors tend to jump in and out of ETFs, depending on what’s hot.

Why is the ETF so pricey? Because those underlying sector ETFs are pricey. The total cost of the five sibling funds that FV holds is 0.65 %. (The rest of the fees go toward paying for licensing the strategy, fund operations, and profit for First Trust.) 

FV is up 2.7 % this year, topping the S&P 500 Index, which is flat. Since inception, however, FV is up 13 % -- the same as with the S&P 500's return.  Currently, FV holds ETFs for biotech, health care, Internet, consumer staples, and consumer discretionary.

FV isn’t alone in being a pricey but successful ETF. There are 20 ETFs that have more than a billion in assets and charge a fee above the 0.66 % average mutual fund fee. They include iShares MSCI Emerging Market ETF, which charges 0.67 %, and the PureFunds ISE Cyber SecurityETF, which charges 0.75 %. Of those 20 ETFs, FV is the most expensive. 

Add up the fees collected by these 20 ETFs, and you get about $520 million a year. That's more than the revenue brought in by all 68 of Vanguard's ETFs combined, and those ETFs have six times more assets. 

Even so, advisers place a high value on convenience, something Tom Dorsey, founder of Dorsey Wright, is well aware of. He likes to quote legendary Harvard Business School professor Theodore Levitt, who once said, "People don't want to buy a quarter-inch drill. They want to buy a quarter-inch hole."

And they're willing to pay a premium price for it. The fund's prospectus notes that over 10 years, assuming a 5 % return each year, an investor with a $10,000 investment could pay as much as $1,417 in fees.

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