The Float

One Great Ad

You may have seen the spot, but if you haven't, or if you like it as much as we do, and therefore want to see it again, we recommend the "Love Sweet Love" ad from Barclays Global Investors' iShares unit, a clever spin on the Hal David/Burt Bacharach tune. You can see it here. Because they're so perfectly apt, we've transcribed the lyrics here:

What the world needs now, is clarity, a little tax-efficiency, and much more transparency. What the world needs now, is fresh ideas, more complete advice, and shelter from all the nonsense. They're the only things that there's just too little of.

There's plenty not to like about the financial services industry's advertising efforts. This one, however, is worth celebrating.

Funds and Taxes

Back on April 3rd, The Wall Street Journal ran its quarterly section on funds (mutual and exchange-traded), one part of which was the now-standard "How Well Do You Know" feature. These quizzes are generally interesting and useful, but they always seem to include passages that don't ring quite right. Two such items stood out this time.

First, there was question five: "True or false: ETFs are always more tax-efficient than comparable index-oriented mutual funds." The answer, of course, is false. ("Always" is a high bar to clear!)

In their explanation, authors William Power and Leslie Scism point to ETFs' creation-redemption process as a key reason for their superior tax-efficiency. But then they quote Morningstar's Jeff Ptak, who's been mentioned in this space before:

"Generally speaking, one would expect an ETF's arbitrage mechanism to make it more tax-efficient than a rival open-end index mutual fund," says Morningstar's Jeff Ptak. "However, one wouldn't ordinarily expect these differences to be enormous, as [indexed mutual] funds are low-turnover portfolios to begin with," meaning that they aren't typically racking up big realized capital gains.

There's certainly some truth to that. More or less by definition, low-turnover portfolios should realize fewer capital gains (and offsetting losses) than high-turnover portfolios. But we don't think Ptak's point gives enough weight to the fundamentally different processes driving mutual funds and ETFs. In the case of index-based mutual funds, the portfolio itself will be relatively low-turnover. But that's not the only thing that matters, because the redemption activity of some shareholders can create tax implications for all.

A hypothetical: Even if an S&P 500 index fund doesn't change its constituents at all from one year to the next, an open-end fund based on that index can still distribute capital gains to all shareholders due to the redemption activity of some shareholders. This is one reason we prefer ETFs to open-end funds. Not only is the vehicle itself better designed for tax-efficiency per se; it also puts the investor in charge of his or her tax destiny. Bottom line: With open-end funds, tax implications are functions of the fund manager's buying and selling and of other shareholders' buying and selling.*

Second, there was question seven: "What is the best way to avoid finding yourself in a mutual fund that makes big taxable distributions?" Answer: "Buy a fund that has investors pouring in new money." Here's the explanation from Power and Scism:

If you want to find a fund that's tax-efficient, look for one with big cash flowing in. Those big inflows mean that, by year end, the dividends and realized capital gains earned earlier in the year are distributed over a larger number of shares. By contrast, funds closed to new investors don't get the dilution effect that comes with all that new cash sloshing into a fund, so they often are tax-inefficient.

This strikes us as wrong on two levels: (1) it puts the tax cart in front of the investment horse and (2) it encourages a generally counter-productive brand of self-dilutive performance-chasing. After all, which funds are likely to have "investors pouring in new money"? The hottest funds most prone to mean-reversion. This notion of chasing new money into hot funds doesn't strike us as particularly logical or helpful for rank-and-file investors.

~~~~~~~~~~~~~~~~

* Savvy handling of tax lots can help fund managers minimize distributions, but that has its limits.

Source

William Power and Leslie Scism, "How Well Do You Know...Funds and Taxes?" Wall Street Journal, April 3, 2008

Closet Indexing: Worse Than We Thought?

We've used this space to draw attention to an under-appreciated problem in financial services: big, diversified mutual funds that behave more like their underlying benchmarks than true instruments of "active management." (Click here for an August post that links to a couple other items we've written on this topic.)

In the March issue of the Exchange-Traded Funds Report (subscription required), we ran across an intriguing passage in the edited transcript of a roundtable discussion of the ETF marketplace. Here's the exchange, between a questioner and panelist Joe Keenan of Bank of New York Mellon (emphasis added in bold):

Audience Member: It occurs to me that the traditional mutual fund industry--should they choose to monetize their cash position using ETFs--could double the size of the industry. I know some funds are indeed using ETFs as a vehicle they're investing in.

Keenan: I'll make one comment only because we do have some intelligence at The Bank of New York Mellon. Just for kicks we run reports as a custodial bank to see who's holding ETFs, and it is extraordinary how many traditional long-only mutual funds hold ETFs, either to equitize their cash or to get the market return and then just layer on fees. You may not see the ETFs held during the reporting periods, but certainly inside those periods. It's not uncommon.

A couple comments. First, it's not inherently wrong for mutual fund managers to equitize cash with ETFs. Depending on a manager's investment discipline and conditions in the relevant asset class, it can be perfectly sensible to combine a set of active opportunities and ETFs for portfolio completion (i.e., a fully- or almost fully-invested fund). We've done as much in our own active program.

But Keenan's remarks reveal a couple serious--and potentially related--problems: (1) reporting-period manipulation designed to conceal the fact that managers are equitizing assets using ETFs and (2) the cynical laziness of earning market returns and layering on active-management fees. To the extent that a manager is guilty of (2), he/she/they might use (1) to conceal the ruse.

To summarize: Using ETFs to equitize assets can be a perfectly sensible periodic/short-term tactic. But as ever in this business, we prefer more transparency to less, and thus less subterfuge to more. If managers are using ETFs in their active portfolios, they should freely acknowledge as much, explain their decision-making, and be accountable for their results. Anything less is a breach of managers' fiduciary duty to fund shareholders.

Source

"Past, Present & Future of Exchange-Traded Funds," Exchange-Traded Funds Report, March, 2008 (subscription required)

Morningstar ETF Research

A couple weeks ago we received an e-mail from Morningstar announcing a new type of ETF research. Here's a key passage from Morningstar's Jeffrey Ptak:

Our new Analyst Reports mark a novel approach to evaluating ETFs. We're harnessing the research that our 100-plus equity analysts conduct in order to estimate the fair value of stock ETFs.

By comparing our fair value estimate for an ETF's portfolio with the fund's market price, we can better gauge whether an ETF is cheap, dear, or reasonably priced. In so doing, we can help you profit from inviting opportunities as they arise.

Our ETF fair value estimates are based on our stock analysts' rigorous, bottom-up research. Our analysts are digging into company filings, questioning management, conferring with suppliers and competitors, and creating sophisticated financial models--all to estimate each firm's worth and risk. And they are conducting that research in accordance with a disciplined, consistently applied investment philosophy.

We think this is a vastly superior approach to the breathless macro-economic calls, technical analysis, or short-cut methods that often pass for fundamental analysis.

Vastly superior? That claim strikes us as a bit inflated. We make no case for breathlessness, of course, but we do think there's a...er...fundamental problem with this kind of "fair value" analysis. As ever, equity prices are functions of (more or less*) objective facts (earnings, revenue, margins, &c.) and investors' entirely subjective willingness to pay for such things. So not only are "future facts" difficult to project with precision, but who can say what traders and investors will pay for them?

Given this two-dimensional uncertainty, we think estimates of fair value--over what time frame? in what sort of broad market conditions? assuming current industry trends persist? or that they change?--are surrounded by such enormous error terms that they might more profitably be ignored than followed.

But if not estimates of fair value, if one doesn't have a "price target" for a given security or, in turn, a pool of securities such as an ETF, what's left? We'd say known fundamentals (i.e., recent "facts") and current price and volume action are the only serviceable sources of advantage in our relatively efficient, hyper-competitive, often random financial markets.

Now, this is a little too easy, but we can't resist. In a piece accompanying the item from which we pulled the above exceprt, Ptak concludes with this:

For example, as of this writing, we'd expect Financial Select SPDR (XLF) to generate a 22.4% annualized return based on a comparison of the fund's price to our estimate of its intrinsic worth. That ETF's hurdle rate is roughly 14% (sum of the fund's 10.8% cost of equity, 0.24% annual expense ratio, and an approximate 3% incremental risk premium). Given that the fund's 8.4% risk-adjusted excess return--22.4% expected return less its 14% hurdle rate--is greater than 3%, we're currently recommending it.

On February 27th, XLF closed at $27.56. At last check today it was changing hands at $24.23, a decline of 12.1% in two weeks. Which means that it'll have to gain 39.2% from here to reach Morningstar's "fair value" estimate of $33.73 in the next 50 weeks. We'd say that's possible. And exceedingly unlikely.

~~~~~~~~~~~~~~~~

* Yes, these "facts" can be fudged. And sometimes are. But let's just assume for the sake of this discussion that earnings are earnings.

ETFs and Index Funds: Still Modest in Most Categories

Last Tuesday we posted three charts showing that even after expanding at a much faster clip than open-end mutual fund assets for more than a decade, exchange-traded funds remain a modest part of the asset management business.

We closed that item by noting that the big question in the industry isn't so much the rise of ETFs per se (as interesting, important, and useful as they might be), but about the future prospects of long-only money management delivered through big, diversified, expensive mutual funds.

Today we have three more charts, each telling the same story in its own way.

First, a side-by-side comparison of open-end index fund and ETF assets (in blue) and non-indexed open-end fund assets (in red). All data are courtesy of the Investment Company Institute.

Next, the same data stacked to clarify the relative percentages of index-based (blue) and actively-managed (red) assets.

Finally, a year-end 2006 snapshot of indexed and non-indexed assets in six categories.

    

We first wrote about these data back in October. We still like what we wrote then:

Naturally, the largest percentage is in the "S&P 500" asset class of large-cap domestic equities, where investment vehicles like Vanguard 500 and SPY have accumulated tremendous assets over the last couple decades. But note how anemic the index/ETF percentages are in all the other categories. On a dollar-weighted basis, the average across all categories is 13.7%. Let's put that another way: 86.3% of investor assets incur significant fees to chase after a mirage.

And given what we know about investor behavior, the average investor's actual returns are significantly lower than those of the mediocre products in which they invest. That just isn't a pretty picture.

The introduction of actively-managed ETFs will require another level of subtlety in this kind of analysis.

As we see it, actively-managed ETFs should have some of the strengths that make index-based ETFs so attractive: trading flexibility, modest explicit expenses, and relative tax-efficiency. Rapid portfolio turnover could diminish this last advantage, depending on the effectiveness of specific ETFs' creation/redemption processes. On the other hand, actively-managed ETFs could suffer from some of the weaknesses that afflict open-end mutual funds: consequential implicit costs, non-trivial market impact, excessive diversification, benchmark-hugging, and, of course, the risk of sustained underperformance.

Savvy investors will do more than just decide between "active" and "passive." They'll pay for active management only in vehicles that have a plausible chance of delivering what successful active management offers (but can't guarantee): prudent risk management and attractive absolute returns over entire market cycles.

ETF and Mutual Fund Data: A Reality Check

Last Friday we noted Michael Sesit's Bloomberg column on the threat posed by ETFs (and indexation more generally) to conventional long-only investment vehicles such as actively-managed mutual funds.

As Jeff Miller noted over the weekend at A Dash of Insight, this is a significant development. There's just no doubt about it. That said, there remains a vast chasm between the open-end mutual fund business and the ETF business--both in numbers of funds and in assets under management. The other side of that coin, however, is that ETF assets continue to grow at a much faster clip than do open-end funds. Consider the following three charts, all produced using data (through year-end 2007) from The Investment Company Institute.

First, a comparison of the number of open-end funds (not counting multiple share classes of the same funds) and ETFs. The last points in the series are 8,017 and 629, respectively.

Next, a comparison of total assets under management. The final points in the series are $12.04 trillion and $608 billion. (And yes, there are entries for the ETF column in each year; they're just too small to show up until 2000--which is exactly the point.)

Finally, a comparison of growth rates in the two categories. Note that ETF growth has outstripped open-end fund growth every year since 1995, in each case by a wide margin.

Now, given the scale of each business, and the limits on investable assets in any given year, it's clearly easier to expand ETF assets at a faster clip. But given the enormous difference depicted in our second chart, it'll take a long, long time for ETFs to close the asset gap with open-end funds in any meaningful way.

Our next project: Assessing the changing share of open-end funds in indexed strategies. After all, the threat in question isn't so much to open-end funds per se as it is to long-only money management delivered through big, diversified, expensive mutual funds.

Sesit on ETFs

Over at Bloomberg, Michael Sesit has a relatively standard/predictable piece on the threat posed by ETFs to the conventional/actively-managed mutual fund industry.

Because we've written so much on ETFs--focusing primarily but not exclusively on their strengths--we thought this piece was worth noting. By our lights, Sesit doesn't offer any revolutionary insights here, but his basic point is certainly right: The ETF business is a big time growth industry (emphasis added in bold for reasons that we'll explain in the first bullet point below).

The global market for ETFs will zoom to $2 trillion in 2011 from almost $800 billion now, says Deborah Fuhr, a London-based managing director at Morgan Stanley who advises institutional investors on asset allocation, reiterating an earlier forecast. No doubt, the forecast says a lot about one of the world's fastest-growing asset classes. Yet its greater significance lies in the implied threat that ETFs pose to the global fund industry.

Lower expenses, the failure of most active-mutual fund managers to beat their benchmarks, the growing number of thematic and specialty ETFs, and the funds' flexibility suggest they will attract investment that otherwise would flow to actively managed mutual and hedge funds.

Three comments on this piece...

• As we wrote back in June, ETFs are not an asset class. Please, everyone--especially you columnists!--please stop referring to them as such. They're investment vehicles that provide access to asset classes.
• It's all well and good to cite the still-high costs of conventional, actively-managed mutual funds. We've done it here repeatedly. But every time someone suggests the story ends with a comparison of explicit expense ratios, tell 'em that might only be half the story. Implicit costs matter too.
• And when people emphasize the benefits of low-cost investment vehicles, celebrate their timeless wisdom. Then remind them that there's plenty more to long-term investment success than just using inexpensive tools. It's decision-making--getting a sound program in place and keeping it there--that distinguishes between long-term winners and long-term losers.

Source

Michael Sesit, "ETFs, Indexation Threaten Mutual, Hedge Funds," Bloomberg, February 1, 2008

CNBC on ETFs in 401(k) Plans

CNBC's Trish Regan just led a very shallow and uninformative discussion of ETFs in 401(k) plans.

The conversation--which involved personal finance author Alan Haft, Adam Bold of the Mutual Fund Store, and Jared Bernstein of the Economic Policy Institute--focused almost exclusively on whether actively managed mutual funds beat their benchmarks, with Bernstein injecting some concern about whether ETFs encourage plan participants to engage in unproductive trading activity.

Those concerns matter, of course, but the conversation seemed strangely disconnected from the operational concerns (per-trade commissions, fractional shares, T+3 settlement, intraday trading, &c.) that have slowed the adoption of ETFs in defined-contribution retirement plans. Similarly, there was no discussion of the operational advantages of ETFs (no sales loads or 12b-1 fees, no short-term redemption fees, minimal implicit costs, &c.).

Unfortunately, CNBC left its viewers with little more than the familiar (and very tired) argument between indexing and active management, which did essentially nothing to improve investors' understanding of the present characteristics and future potential of their retirement plans.

For a fuller discussion of ETFs in the 401(k) world, please see our Chief Investment Officer's recent column at IndexUniverse.com.

Index Universe Piece

We're pleased to note that our Chief Investment Officer Kevin Price had a piece on exchange-traded funds in 401(k) plans published at IndexUniverse.com this morning.

Note: Parts of today's column appeared previously in this space (primarily here and here).

401(k) Workshop

We're brutally late posting this afternoon because we spent the day preparing for and conducting a 401(k) workshop for a fascinating group of professionals here in Madison. The point of the event was to help plan sponsors and various trusted advisors better understand (1) the true costs of the typical defined contribution plan, (2) the current legal and regulatory environment, and (3) the core characteristics of a genuinely fiduciary plan.

Based on the questions and comments we received today, it's clear that plan sponsors very much want to do the right thing for their employees...not to mention for their own very legitimate risk management purposes. Sponsors are interested in fiduciary concepts, recent legislative and regulatory changes, and developments in the financial services industry that are opening up impressive new options for defined-constribution plans. The point: The retirement plan marketplace is poised for significant change, and we don't think that change can come fast enough.

As we've written repeatedly in this space, the typical 401(k) plan, in which participants are presented with a menu of mutual funds and encouraged to do their best, is a badly broken model that screams out for fundamental reform.

That reform incorporates lots of details, but the central objective is incredibly simple: Deliver plans that give participants the highest possible likelihood of capturing long-term returns that are as close to the efficient frontier as possible (see adjacent chart from Investopedia, with apologies for the inappropriate apostrophe in "portfolios"; see also this July comment from Mercer Bullard to the DOL for a similar argument). What sort of plan would actually locate participants' long-term outcomes near the line indicating optimal returns for given levels of risk?

We think fiduciary plans--plans that live up to the principle and promise of ERISA itself--will feature relatively few investment choices, all of which are fully diversified, pension-caliber portfolios incorporating multiple asset classes through the use of inexpensive index-based vehicles.

ERISA, the Pension Protection Act of 2006, and Department of Labor rulemaking provide both general encouragement and specific safe harbor provisions designed to push plan sponsors into a more paternalistic stance relative to their employee-participants.

By adopting plans with true fiduciary characteristics, sponsors can simplify lots of lives (their own and those of their employees), save lots of money (after all, sponsors are participants too), and, most importantly, improve participants' long-term investment outcomes--and thus not only their standards of living in retirement, but in some cases their ability to retire in the first place.

The stakes here are very high. And the path forward is plenty clear to anyone who cares to dig underneath the veneer--and false security--of the status quo.