Reading the fine print is a good start; you'd
better read between the lines, too.
The great promise of the exchange-traded fund (ETF)
industry has been to bring institutional-quality products to the
individual investor. That means low costs, low turnover, tax efficiency
and sector fidelity. It means opening up new areas of the market that
previously have been either inaccessible or prohibitively expensive. It
means putting into the hands of investors sharp-edged tools that they
can use to execute smart asset allocation policies.
I have been a huge celebrant of ETFs, singing the
praises of their transparency, innovation and applications. And I still
believe that ETFs represent a profound new tool for investors-a better
mousetrap, if you will-and that their future is incredibly bright.
But recent trends in the industry have me worried.
Average expense ratios are creeping up, average fund turnover is
increasing, and recently, many product launches look more like
reflections of marketing than reflections of the market.
You know the ones: Listed Private Equity ... Stealth ... ValueLine Timeliness ... BRIC.
The funds typically are launched with a fanfare of
public relations, and always -always-with a nice package of back-tested
data showing how, if you had only followed this peculiar investing
strategy for the past five years (which is to say, before the ETF
developers even thought of it), you'd be sitting pretty on a fat
cushion of compounded market-beating returns. This implicit message is
loud and clear: Get in now before it's too late!
Should you? Do these funds really help investors?
Here's the funny thing: I don't think it's an
open-and-shut case. In almost every situation, you could argue
convincingly for the value of an ETF.
Consider the aforementioned Listed Private Equity
fund, from PowerShares. If there ever was a fund designed to ride the
coattails of a media phenomenon, this is it. Anyone with a subscription
to the Wall Street Journal or the Financial Times knows that private
equity is the hottest thing on Wall Street. Fortune magazine recently
anointed the private equity players the new "Masters of the Universe,"
and everyone from Goldman Sachs to the California Public Employees
Retirement System (CalPERS) has been rushing to get into the private
equity game.
PowerShares would argue that this ETF offers
individual investors the first chance to tap into this red-hot private
equity market in a simple way. Private equity returns have a low
correlation to public market returns, so adding private equity exposure
to a portfolio should improve its risk/return profile. And if CalPERS
and Goldman Sachs are doing it, why not you?
Why not? Well, there are a number of reasons why not, and I'll explain why in a minute.
The editors here at Financial Advisor magazine asked
me to write about these newfangled "specialty ETFs," and about whether
or not they make sense for investors. I'd be happy to do that, because
I have enough opinions to fill a book.
But we are going to see a lot more of these ETFs hit
the market in coming months. The incremental cost of launching a new
ETF is tiny, so the incentive is for fund companies to launch anything
and everything and see what sticks.
Instead of focusing on the funds on the market
today, then, I thought I'd use the example of the private equity fund
and lay out five ground rules to help you evaluate whether these
newfangled ETFs make sense for your client's portfolios.
Rule Number 1: Check Your Commissions
The Achilles heel of the ETF industry-commission
costs-gains ever-larger importance when you are considering specialty
ETFs.
Commission costs are the one thing that keeps ETFs
from wiping out the traditional mutual fund industry. Generally
speaking, ETFs are cheaper, more tax-efficient and more transparent
than their traditional mutual fund cousins. But because investors must
pay a round-trip trading commission when they buy and sell ETFs,
investors who are not making large purchases, say, $10,000 or more, are
foolish to choose ETFs over traditional mutual funds when both are
available. Even at $10,000, one study found that an S&P 500
investor would wait six years before his "cheaper ETF" made up the
commission costs compared to a more expensive, traditional index fund.
The problem for specialty ETFs is that, by
definition, they should represent a small section of a well-structured
portfolio. Even the most aggressive pension plans, for instance, only
make 5% to 7% allocations to private equity. For an investor putting
$10,000 to work in the market, that would mean a $500 investment in the
private equity ETF. At that level, commissions will eat you alive. Even
investors creating a $100,000 portfolio in one fell swoop should think
twice about paying commissions for a $5,000 allocation. Remember: in
investing, you get what you don't pay for.
Rule Number 2: Check The Index
For the most part, ETFs track indexes that we have
heard of before: the S&P 500, the Wilshire 5000, etc. While there
are important differences between these indexes (I write about these
differences all the time at IndexUniverse.com), investors can at least
be sure that most of the indexes are reasonably diversified and
reasonably balanced, and that they follow a rules-based strategy that
is not susceptible to gross manager error.
Investors in specialty ETFs shouldn't make that
leap. Many times, these ETFs track unfamiliar indexes with unusual
methodologies.
"The more specialized the index, the greater the
possible difference between two indexes that may sound alike," said
Allan Roth, founder of Wealth Logic LLC, an investment advisory and
financial planning firm based in Colorado.
The private equity fund, for example, tracks an index from Red Rocks
Capital. Never heard of them? Neither had I. As it turns out, they are
a well-respected alternative asset manager based in Denver.
They are not, however, an index firm, and their
"index" of private equity names falls short on many levels. For one,
it's extraordinarily narrow, with only 34 components. And unlike the
30-stock Dow Jones Industrial Average, which holds some of the most
established, diversified businesses in America, the Red Rocks index
holds a number of volatile small-cap names that could jerk the index
around like a dog on a leash.
The choice of components is worth noting, too.
Typically, index investors don't worry about the actual companies
included in an index, since it's the aggregate statistics and
risk/reward ratio that matters. But with unusual and narrow indexes, it
pays to drill down to the constituent level.
In this case, the results are worrisome. The index
includes companies like Millennium Pharmaceuticals, an experimental
biotechnology company based in Cambridge, Mass. Millennium is
presumably included because it has investments in a few start-up
biotech firms. But I was a biotech analyst before I found indexing
religion, and I can tell you that Millennium's value is tied to its
drug development pipeline, not its investments. Investors looking for
private equity exposure won't find it in Millennium's stock (though it
represents 4.6% of the index).
There are flaws with other components, too. For
instance, as of October 31, the fund had a 3.5% stake in CMGI. In the
old days, CMGI was a private equity firm, holding a portfolio of mostly
Internet-based start-up firms. But today, the company has morphed into
a supply chain management firm with $1.1 billion in revenue. It still
holds stakes in a few venture start-ups, but it is not exactly a pure
play on the sector
Red Rocks seems to have been grasping at straws to
cobble together an index with at least a reasonable number of
components to "track" the private equity market. The vast bulk of
private equity firms are privately held, as partners like to divide the
spoils of their investments among themselves, and aren't inclined to
share them with the public. Red Rocks Capital may have done the best it
could, given the situation, but in this case that probably isn't good
enough. Either way, it pays to know what you're getting into.
Rule Number 3: Check The Tracking Error And Spread
Once you've got your index sorted out, the next
thing to test is whether the ETF tracks the index. Historically, ETFs
have done a phenomenal job at this-you're unlikely to see an S&P
500 ETF move more than a few basis points off of its underlying index,
once you adjust for expenses.
But in these specialty areas, tracking error can be
a real issue. Whether the ETF developer decides to try to outperform
the index, or whether liquidity issues in the underlying stocks make
close tracking impossible, we've seen some sizeable tracking errors in
the past year.
The iShares Dow Jones Select Dividend Index Fund
(NYSE: DVY), for instance, beat its benchmark in the third quarter by
50 basis points. That sounds great, of course, but past performance is
not guarantee of future returns. Investors who think they are getting
straight exposure to the Dow Jones index may be surprised to hear that
BGI "optimizes" the fund in the pursuit of higher yields.
On a different note, the iShares KLD Social Select
Index Fund (NYSE: ECO) has trailed its benchmark by 1.6% over the past
year.
The thing to do is to look through the prospectus
for three things. First, does the index hold a lot of companies? The
more companies, strangely enough, the more likely the tracking error
will be good, since the index's performance will be predictable and
liquidity concerns will be limited.
Second, look for an index that follows a
"replication" strategy. "Replication" funds buy all the stocks in the
underlying index at the appropriate weights, and generally track their
benchmarks very well. Funds that follow a "sampling" methodology have
more latitude, and can have more tracking error. You may want to see
some real-time performance data on these funds before you jump in.
Also beware of indexes with large positions in
small-cap stocks. Although the funds may track the indexes well, this
can create an "index effect," where money moving into the index forces
up the prices of the underlying stocks.
"Whatever the 'hot trend,' someone always seems to
roll out a new ETF that lets traders ride the wave," noted Edward von
der Linde, partner and portfolio manager at Lord Abbett, in a recent
position paper on the ETF industry. ("Blind Faith," 9/13/2006.)
"[But] large inflows of money can have an exaggerated effect on many of
these new products because small cap and mid-cap stocks are less liquid
than large caps."
On the flip side, when big money doesn't appear,
spreads can be an issue: Many of the specialized funds are thinly
traded, meaning investors can get hit when moving into and out of the
funds.
Rule Number 4: Check The Back-Test
All these specialty ETFs come packaged into the
market with shiny looking back-test results. It's no surprise, of
course-you'd hardly expect to see funds launched that performed poorly
in the rearview mirror. But it means you should be on guard.
"You have to be careful with the back-tests," said
Paul Mazzilli, director of the Exchange-Traded Funds Research Team at
Morgan Stanley. "You have to ask yourself: Did the product developers
cherry-pick factors to improve performance? Sometimes the index
criteria stand out as ... strange."
All back-test results are subject to manipulation.
But the general rule of thumb is that the more factors used to create
the index, and the more specific those factors are, the more suspect
the back-tested results become. If someone tells you that stocks with a
low P/E ratio have performed well, that's an investment thesis that is
worth considering. But if someone tells you that stocks with a P/E
ratio between 12.5 and 14.7, which had IPOs in April, performed well,
that may not be such a robust strategy.
It sounds absurd, but it happens every day. For
instance, the First Trust Dow Jones Select Microcap Index chooses
stocks in part based on "six-month total return." Six months? Who's
ever even heard of six-month return?
Ask yourself: Do these guidelines pass the smell test?
Rule Number 5: Check The Turnover
The final rule for evaluating a new index is to
examine the expected turnover. The general rule is that the further an
index strays from traditional market-cap weighting, the more likely it
is to have high turnover. Market-timing indexes that try to pick the
next hot sector have high turnover, as will equal-weighted funds that
must periodically buy and sell each component to keep weights in line.
Turnover and rebalancing is not necessarily bad; in
fact, most studies show a net benefit to regular rebalancing. But tax
issues and commission costs can take a bit out of total returns, and
you have to make sure that the added turnover is worth the risk.
"As Morningstar recently put it, ETFs are going
Hollywood," said Roth. "Turnover is rising, expense ratios are going up
and standard deviation is increasing. Some of these specialty ETFs look
more like active funds, in that they are so specialized that you are
betting on a particular piece of the market."
Lost Our Way? Maybe
As a by-the-book indexer, these funds do nothing for
me. Nanotechnology is absolutely fascinating, but investing in
nanotechnology ... yikes. These funds stray from the original purpose of
the ETF industry, which was to provide low-cost, robust,
institutional-quality funds to individual investors. Most of these
funds are neither robust nor institutional-grade, and increasingly,
they are not low-cost either. Expense ratios on these unusual funds can
hit 70 basis points, a fortune by index standards.
"The average ETF fee has actually gone up this
year," said Mazzilli, thanks in part to the rash of specialty ETFs.
"The range widened, but the average fee has come up."
Another worry is that these funds are being launched at the height of
different media manias-private equity, nanotechnology, clean energy,
etc. They may be valid investments, but by playing on hype they are
inviting investors to buy high and sell low.
Still, I'm not one to cast all these funds aside at
the drop of the hat. For small slivers of portfolios-mad money, if you
will-they may make sense. And I'm always in favor of product developers
pushing the boundaries of what's possible and trying to open up new
markets.
But this is certainly one of those
look-before-you-leap situations. Product developers are straining to
cobble together portfolios to fit the ETF format, and the new funds are
not necessarily as robust as the old-line indexing brethren. As always,
it pays to know what you're getting into.
Matt Hougan is assistant editor of
the Journal of Indexes, a bimonthly magazine that reports on news
relating to indexes and which is a sister publication of Financial
Advisor magazine.