ETFs That Imitate Mutual Funds Are Imperfect Copies

Sometimes two sports cars with the same chassis, hubcaps and hood ornaments can have radically different engines. It's not just true for automobiles. Investments that are designed by the same company to look -- and act -- alike can end up performing in dramatically different ways.

Experts say that might turn out to be the case with exchange-traded-fund versions of mutual funds. An ETF, of course, is a product that bundles a bunch of investments and can be traded like a stock. Here, the ETF copies the holdings of a popular mutual fund. The Pimco Total Return ETF (BOND) has been a smash hit so far. Since debuting in February, the ETF, which follows the $261 billion Pimco flagship fund (PTTAX), has attracted more than $1.2 billion itself. Pimco wants to issue more ETFs that follow its funds; other fund firms like the idea of fund-tracking ETFs, because ETFs are cheaper to operate, says industry consultant James Pacetti.

There's only one hitch. So far, there's not much of a resemblance between the Pimco ETF and the mutual fund it purportedly tracks. Indeed, the mutual fund has around 18,000 holdings; the ETF, not even 500. The mutual fund has a slew of interest rate swaps, credit contracts and other derivatives that the ETF can't legally hold. The ETF also has a lower percentage of bonds from emerging markets than the mutual fund. There's a big gap performance-wise, too -- though, perhaps, not the one you'd expect: The ETF has yielded 5.5 percent since its debut, versus 2 percent for the fund. Although steering clear of derivatives seems to have helped the ETF so far, there's no guarantee that will always be the case, industry experts say. "Most people were under the impression it was the same portfolio. It's a different animal entirely," says J.D. Steinhilber, a Nashville money manager who has bought the mutual fund -- but not yet the ETF -- for his clients.

The two products follow the same investment strategy, Pimco says, but since the ETF can't own derivatives, the returns most likely won't match. The lesson, say experts: While mutual fund firms may get some extra mileage out of marketing sleek ETF models of their funds, investors would still be wise to check under the hood before they buy.