The Float

The WSJ on ETFs in 401(k) Plans

This morning's Wall Street Journal includes an Ian Salisbury story on two of The Float's favorite subjects: exchange-traded funds and defined-contribution retirement plans. By our lights, Salisbury doesn't break much new ground, but he does a nice job of describing ETFs' small-but-growing share of the 401(k) market and the trade-offs involved in including ETFs in a plan's investment lineup. Here are a couple highlights:

According to estimates from BlackRock Inc., the largest sponsor of ETFs, investors hold at least $2 billion worth of its iShares ETFs in 401(k) plans after buying about $500 million in fund shares last year.

Since iShares controls about half the ETF market, the figure suggests that in total there may be something like $4 billion of ETF assets in 401(k)s.

That's just a tiny sliver of the more than $1 trillion in 401(k) assets invested in mutual funds, but it represents significant growth from several years ago, when ETFs were almost entirely absent from these plans.

...

Unlike other 401(k) options, ETFs don't accommodate "revenue-sharing," or using a portion of the fees investors pay to funds to support administrative costs of retirement plans.

Many financial advisers and consumer advocates think that's good news since it makes it easier to keep tabs on what investors are actually paying for.

That last point is especially important. We're no fans of revenue-sharing because of its inherent opacity. But there's another element in a plan's true-and-total cost structure that Salisbury doesn't mention: Bid-ask spreads paid in the trading of ETFs. Of course open-end mutual funds incur spread costs to trade positions in their portfolios as well, but that's exactly the point: The "trading costs" question doesn't resolve so clearly in favor of ETFs after all. When trading is frequent, as it is in the vast majority of 401(k) plans, spread costs add up, even when trades are aggregated within and across plans.

Salisbury mentions the ETF-based plans sponsored by BlackRock's iShares unit. We've looked into those options, and they might make sense for some plans. But we have to be honest: We have other programs at our disposal that impose lower total costs on sponsors and participants and provide easy access to complete portfolios that replicate (almost exactly) the best available ETF-based solutions.

We like ETFs. We use them extensively in our private client practice. We think they may well have a future in the defined-contribution world. But we haven't seen sufficient advantages in ETF-based options to make us abandon our current programs.

Source

Ian Salisbury, "ETFs Make Inroads with 401(k) Investors," Wall Street Journal, January 13, 2010

A New Slug of Active ETFs

This morning's Wall Street Journal features an Eleanor Laise article on a few new entrants in the category of actively-managed ETFs. We aren't crazy about the concept, largely because we think ETFs work best as part of a strategic asset allocation program with rock-bottom expenses. Here's a telling passage on that front:

Many investors are attracted to ETFs because of low costs. But the new Grail funds will each charge annual expenses of 0.89% of assets, making them pricier than three-fourths of the ETFs tracked by investment-research firm Morningstar. Grail American Beacon Large Cap Value charges 0.79%, only marginally cheaper than the 0.83% charge by investor shares of the nearly identical American Beacon Large Cap Value mutual fund. And the Dent Tactical ETF charges 1.56%. That is more than the average diversified U.S. stock mutual fund.

Roughly one quarter of ETFs have explicit annual expenses of more than 0.89%? Yikes. Then there's this:

Investors haven't flocked to actively managed ETFs. The Grail American Beacon Large Cap Value ETF has roughly $3 million in assets, and the five active PowerShares products have just over $24 million combined.

Brutal. If those numbers don't change soon, these little experiments won't last much longer. What about early returns from these things?

Performance that has lagged behind hasn't helped. PowerShares Active Alpha Multi-Cap Fund is down 21% in the year ending Monday, trailing the Standard & Poor's 500-stock index by 11 percentage points. PowerShares Active AlphaQ Fund is down 3.6% over that period, while its primary benchmark, the Nasdaq 100, gained nearly 4%.

Not a pretty picture. But some sponsors appear undaunted.

Despite the challenges, active ETF providers are aiming high. Grail aims to launch 24 to 30 new active ETFs over the next year or so, said Bill Thomas, the firm's chief executive. And over the past year, the firm has been talking to conventional actively managed mutual funds about converting to an ETF structure.

That's an interesting concept. Many of Vanguard's ETFs are simply different "share classes" of the firm's traditional mutual funds. We'll stay tuned to see if other open-end managers try to break in with ETF versions of their actively-managed funds.

UPDATE: ETFs are growing quickly, but they still occupy a small corner of the investment world. Here are a couple 2008 posts comparing ETFs and index-based vehicles to actively-managed, open-end funds:

• "ETF and Mutual Fund Data: A Reality Check"
• "ETFs and Index Funds: Still Modest in Most Categories"

Source

Eleanor Laise, "Grail's ETFs Take 'Active' Approach," Wall Street Journal, September 30^th, 2009

ETF Awareness

Yesterday's missive from InvestmentNews contained a short item on investors' relative levels of awareness of exchange-traded funds. The headline finding is that self-directed investors possess more knowledge of ETFs and ETF providers than do advised investors.

Two explanations seem obvious. First, advised investors are less likely to have extensive knowledge of insider-ish facts like which bank owns which family of ETFs for the same reason they're advised in the first place: They don't want or need to know such things. Second, even if they would want to know (if they knew there was something to know), many advised investors are advised by financial services types who don't/won't bring ETFs to the table because they (the financial services types) don't/won't get paid to do so. Instead, they bring mutual funds with sales loads, insurance products with big fat commissions, and managed accounts with generous revenue-sharing arrangements.

Of course there are plenty of exceptions, fee-based or (better yet) fee-only advisors who suffer no conflict of interest in brigning low-cost ETFs to their clients. But on the margin, for the product-pushers, ETFs just don't add up...and many of their clients are still in the dark.

Then there's this. In a piece on awareness, InvestmentNews blows the most basic fact in the ETF universe:

According to the survey, self-directed clients are three times as likely to stay with Barclays' ProShares ETFs as advised investors.

Which is great, but for the fact that Barclays runs (and might need to dump!) the iShares family of ETFs, not ProShares.

Sources

Jamie Burns, "Advised investors less aware of ETFs than self-directed peers," InvestmentNews, March 17, 2009

Sree Vidya Bhaktavatsalam, "Barclays Seeks Sale of iShares as ETF Assets Decline," Bloomberg, March 17, 2009

Fun with Exchange-Traded Funds

Last Thursday, Ian Salisbury's "Fund Track" item in the Journal included the following nugget:

There are 721 ETFs with about $478 billion in assets, according to the Investment Company Institute, a trade group.

That's a lot of ETFs.

So as we flipped through (i.e., recycled) some recently-arrived industry mags, we ran across the quarterly "ETF Reference Guide" put together by Research. That rapidly-expanding insert always seems to provide a few laughs. Here are our nominations for the funniest* ETFs in the marketplace, with award categories in bold and ticker symbols, expense ratios, and average daily trading volumes in parentheses. Data are through November 25, 2008. 

Shameless Name-Dropping
ELEMENTS Benjamin Graham Total Market Value (BVT; 0.75%; 164)

Cynical Exploitation of Something Genuinely Important (Unnecessarily Long Name Subcategory)
ELEMENTS Credit Suisse Global Warming Index ETN (GWO; 0.75%; 1,673)

Provocatively Indeterminate Fund Name
First Trust Nasdaq Clean Edge U.S. Liquid (QCLN; 0.60%; 26,452)

Obligatory HealthShares Nominee
HealthShares Diagnostics (HHD; 0.60%; 6,562)

Better Than Regressive Transportation
PowerShares Global Progressive Transportation Portfolio (PTRP; 0.75%; 445)

Not Necessarily Clinging to the Efficient Frontier
Claymore/AlphaShares China Small Cap Index (HAO; 0.70%; 54,856)

Taking a Bad Idea and Making It Worse
Claymore/Zacks Country Rotation (CRO; 0.65% 4,644)

Country-Specific Chocolate Yes, Country-Specific ETF No
iShares MSCI Belgium (EWK; 0.51%; 88,770)

Ticker Symbol Onomatopoeia (multiple winners)
First Trust Multi Cap AlphaDEX Fund (FAD; 0.70%; 4,818)
WisdomTree International Dividend Top 100 Fund (DOO; 0.58%; 41,933)
PowerShares DWA Developed Market Technical Leaders (PIZ; 0.80%; 27,030)

Dubious Ticker Symbol Expropriation of Ancient Cultural Concepts
Claymore/AlphaShares China Real Estate (TAO; 0.65%; 13,874)

Name That Will Not End
E-TRACS UBS Bloomberg CMCI Short Platinum ETN (PTD; 0.65%; 2,161)

Seemed Like a Good Idea at the Time
PowerShares Listed Private Equity (PSP; 0.60%; 99,265)

Pure Esoteric Delightfulness
Barclays Asian and Gulf Currency Revaluation ETN (PGD; 0.89%; 13,855)

We're written before on the silliness manifested in certain corners of the ETF universe (here, here, here, and here for example). That absurdity will continue, no doubt, but you might want to get your giggles in now. Given their trading volume, some of the winners listed above might not be around much longer.

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* On their investment merits, some of these are not irredeemably ridiculous. Some are. But for one reason or another, all of these struck us as funny. And in the midst of financial markets like these, we'll take funny where we can find it.

Source

Ian Salisbury, "New ETFs Bank On Social Themes," Wall Street Journal, January 8, 2009

Mutual Fund Tax Bills

In yesterday's Wall Street Journal, Tom Herman reminded us of one of our now-standard subjects: The woeful tax inefficiency of many open-end mutual funds. (See this April item for more from us on this problem.) Here's Herman's introductory take:

For most mutual-fund investors, it's been an abysmal year. The average U.S. diversified stock fund is down 33% through Monday, according to Morningstar Inc. Foreign stock funds have also posted steep declines, as have funds in most other categories.

And some investors may have to pay hefty tax bills on their losing funds anyway.

Much of Herman's advice is perfectly spot-on: Be aware of record and distribution dates, consider offsetting any gains with realized losses, &c. Our objection isn't with Herman. It's with the premise of using actively-managed open-end funds in taxable accounts in the first place. Here's a quotation from Greg Hinkle or T. Rowe Price:

"In markets with big daily moves, keep investment considerations foremost. If you stay out of a fund for one day to avoid a 5% distribution, but lose out on a 6% or 7% upward market move that day, you've lost ground."

Fair enough, but wouldn't it be much wiser still to participate in particular asset classes using vehicles that don't (generally, with vanishingly few important exceptions) suffer from these absurd tax implications? Consider the experience of the investor who unwittingly busy shares of the Oppenheimer Developing Markets fund, which Herman tells us will distribute roughly 20% of its net asset value in December. Ouch! Fund complex to investor: "Thanks for your $20,000 investment in our fund. Now, here's $4,000 of your money back. Capital gains taxes are due April 15th. Please consult your accountant."

Prudent taxable investors will consider establishing asset-class exposure with the obvious alternative: Inexpensive exchange-traded funds, which, due to their creation-redemption process, distribute vanishingly few (in fact, almost always no) capital gains.

Source

Tom Herman, "Fund Investors Face Risk of Tax Hit Despite Losses," Wall Street Journal, October 22, 2008

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.

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* 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.

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* 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.