John Spence

E*Trade Gets Dinged by NASD for Tech Index Fund Ad

Remember those online broker television ads of yesteryear that led you to believe that stock picking was so easy that even ADD-afflicted office punks and altruistic truck drivers could point-and-click their way to fabulous wealth in their spare time? E*Trade appealed to the same greed instinct when it rolled out its Technology Index Fund (ETTIX) almost two years ago, and is now paying the price for not complying with NASD regulations.

The National Association of Securities Dealers (NASD) Regulation today announced that E*Trade was censured and fined $90,000 for NASD advertising rule and supervisory system violations. According to a statement released by NASD, E*Trade neither admitted nor denied NASD Regulation's allegations.

When E*Trade launched its tech index fund in August of 1999, it ran a print ad promoting the fund in four major major publications, including The Wall Street Journal. In the ad, E*Trade noted that the fund's benchmark, the Goldman Sachs Technology Index, had posted a 62.4% gain amidst the tech sector's dizzying climb. However, the ad didn't say that that ETTIX was a new fund without a track record. It also didn't clearly differentiate the past performance of the index from the future performance of the fund. All of this leads me to believe that the NASD folks must have pretty powerful magnifying glasses, because this stuff is usually in the really, really fine print.

NASD Regulation also took exception to the ad's claim that the fund was ranked by Morningstar as the lowest cost tech index fund. The problem is, NASD says Morningstar had never even ranked the fund when the ad was released. I asked Morningstar senior analyst Scott Cooley about the validity of the E*Trade claim.

"Even a couple of years ago, the A share class of the North Track PSE Tech 100 Index Fund had a lower expense ratio than the E*Trade fund had, though it also carries a load," said Cooley. "If the folks at E*Trade had simply said that the fund's expense ratio was then 'the lowest of any no-load, open-end fund, according to Morningstar,' I think they would have been on firm ground. Unfortunately, it sounds like they took a different course of action."

I went back and checked out the Morningstar report on the fund, which came out in June of 2000 and was written by Cooley. It does note that the fund is a relatively cheap way to gain exposure to the sector. However, as E*Trade failed to do, Cooley clearly states the disclaimer that goes along with investing in sector index funds:

"Historically speaking, this fund has posted fine returns, as its bogy has benefited from an unprecedented bull market for tech stocks. There are certainly no guarantees those fat gains will be repeated, but whatever the index's future returns, the fund should track them fairly closely . . . "

Of course, the lesson here is that sector funds, both active and index, are subject to swings as their concentrated holdings go in and out of favor. It's tempting to jump into the latest hot sector, and fund marketing departments are aware of this. But consider this: the E*Trade tech index fund is down 51.55% for the last year as of the end of June, according to Morningstar. In fairness to E*Trade, it was not the only firm to launch a sector fund and market it aggressively at the height of the tech boom, and many of those funds also post dreary returns since then.

Certainly, sector index funds can be useful for passive investors looking to round out their portfolio with low-cost exposure to industry segments. However, the danger is that less experienced investors will buy the marketing pitch and make them core holdings. In that case, they become low-cost tools for bankruptcy.