ETFs
Actively Managed ETFs Are Coming. Should You Invest?
Rob Wherry at Smartmoney says that actively managed exchange traded funds could start appearing as early as this year. Actively managed ETFs are those in which fund managers actually decide which securities to buy, unlike existing ETFs that passively track an index like the S&P 500. But despite planned launches by some of the biggest names in the fund industry, questions about exactly how actively managed ETFs will work remain.
When and if these actively managed ETFs hit the Street, investors will need to ignore the hype and ask some tough questions about their construction, their costs and whether they make a good fit in their portfolios. 'I think it's the next logical step,' says Scot Stark, founder of Stark Strategic Capital Management outside Baltimore. 'But if the costs are too high it could be one of those crazes that hits the market and eventually falls off the radar screen.'
ETFs were first conceived almost 15 years ago, but fund families are just now pulling off an actively managed version. One major obstacle: How to provide a transparent portfolio that can be valued accurately at any point in a trading day. Existing ETFs can easily be priced because they track established benchmarks that rarely switch out their members. The manager of an active ETF, though, could decide to buy or sell a stock on any given day, making it much more difficult to track the fund's holdings and its value. The problem is only exacerbated by the fact that most managers don't like to tip their hands about their trades for fear that savvy investors could front run those bets and diminish their returns. That secrecy makes it hard for the active ETF's market makers — the entities that facilitate its trading — who need to know what has changed in the portfolio to create or redeem shares.
A possible solution is to use an intermediary to set up a kind of a tracking index that would reveal some of a fund's holdings while keeping other positions under wraps. But if that winds up keeping the portfolio secret for long periods of time it would eat away at one of the ETF's biggest benefits. Financial advisors like ETFs because they know exactly what's in a given fund's basket of stocks, allowing them to plug holes in a client portfolio that may need some added diversification. What's more, if managers are trading stocks when they rise or fall, that could lead to higher annual costs and less tax efficiency — two calling cards of the ETF industry."
Frankly, some current ETFs are so strange they are basically actively managed anyway. Some have higher turnover ratios (a measure of how often the holdings in the portfolio are changed) than actively managed funds. Many of these newfangled ETFs are based on custom or rule based indexes – not traditional indexes. If the company behind the ETF is designing the index the ETF mimics – isn’t it actively managed?
We currently use several old-fashioned passively managed exchange traded funds in our client portfolios and in the MAXadvisor Powerfund Portfolios, we're going to take a wait and see approach to these new actively managed ETFs. If we determine they offer a cheap and effective alternative to traditional mutual funds, we'll consider them.
ETFs Aplenty
The Boston Globe reports on the ridiculous number of new exchange traded funds being launched this year:
Exchange traded funds, or ETFs, have attracted hundreds of billions of dollars as an alternative to mutual fund investments in recent years. Mutual funds still pull in much more client money than exchange traded funds, but ETFs have established themselves this decade as competitive products that appeal to many investors. Their assets, just $130 billion at the end of 2003, had grown to $480 billion by May.
Investment management companies have responded to that kind of demand by burying investors in new products. A total of 150 new ETFs were created in the first five months of this year, according to research by the industry's two largest competitors. That's almost exactly the number of all the new ETFs created during the entire year in 2006, and three times the number formed in 2005. About half of all ETFs on the market today have arrived in the past 12 months."
This plague of ETFs brings to mind an important point about fund companies: they don't launch investment vehicles because they think those vehicles are particularly likely to perform well. In fact, we'd wager that most of the funds started by fund companies are not expected by their managers to be top performers. That's because fund companies are interested less in their funds posting big returns as they are with getting investors to buy them.
Fund investors usually make investment decisions based on recent past performance. Most of the time the new mutual funds and ETFs that are the most saleable are not the ones that are set to post big gains in the near future but those that are in the hottest categories. So what if study after study shows that funds that are top performers rarely remain so? As long a performance chasing investors are buying, the fund companies will be selling.
Interesting ETF Facts
Five of MSN Money's 10 surprising Exchange Traded Fund facts are interesting, the other five, not so much. Here are the good ones:
- 163 versus 134. The raw number of ETFs launched in the past six months versus the number of ETFs launched in first 10 years (1993 to 2003) of the ETF business' existence.
- 23 of 93. Of the 93 international ETFs on the market, only 23 are diversified funds that invest across a range of countries, regions and sectors. The rest are country- or region-specific or international-sector funds.
- 0.67%. The average expense ratio of ETFs launched in the past six months, many of which were leveraged index funds; sector, industry or niche funds (ophthalmology, for instance); or offerings tracking specialized or custom-made benchmarks.
- 0.45%. The average expense ratio of all the ETFs launched before December 2006.
- $284 billion versus $196 billion. Barclays' share of the ETF industry versus everybody else's.
For Most, Index Funds Beat ETFs
We’ve said for years that plain vanilla index funds are better than exchange traded funds (ETFs) for most fund investors, and a recent Wall Street Journal article confirms this view.
"Newly crunched data show it is a close race -- but ultra-low-cost conventional index funds outperform ETFs a lot more often than not."
As the table below shows, ETFs often slightly underperform regular index funds.
The article notes the comparison doesn’t even take commissions into consideration – an important cost you avoid buying a plain vanilla index fund directly from the fund.
The article also doesn’t note another cost of choosing ETFs: the spread. Somebody makes money when you buy and sell a stock or ETF (in addition to ordinary commissions). Buy an ETF and sell it a few seconds later, and you will lose money beyond the commissions most of the time.
The article debunks another much-ballyhooed benefit of ETFs: tax efficiency. ETFs are not more tax efficient than low fee index funds.
The financial press is fond of comparing ETFs to ordinary actively managed mutual funds, making them look in the comparison – Suze Orman is particularly guilty of this one. Actively managed mutual funds are higher fee and more tax inefficient – and they compare just as poorly to ordinary index funds as they do to ETFs.
Bottom line, ETFs can be the right choice if you trade frequently, prefer the convenience of owning all your investments in a brokerage account, or when there is no comparable traditional index mutual fund (as is increasingly the case with the newfangled ETFs that aim for more specific strategies).
LINK (Registration required.)
Bond ETF War Heats Up – First Junk Bond ETF Starts Trading
Mere days after Vanguard’s new bond ETFs (exchange traded funds) started trading, ETF giant iShares sixteenth bond-focused ETF began trading on the American Stock Exchange.
The iShares iBoxx $ High Yield Corporate Bond Fund (ticker: HYG) is the first junk bond ETF to hit the market, with a record-setting 0.50% expense ratio – more than double iShares most expensive bond ETF and near five times as expensive as Vanguard's new offerings.
There are currently only two players in the bond ETF area: iShares and Vanguard. While bond ETFs by number are a fraction of the increasingly more eclectic ETF area, as Lee Kranefuss, CEO of Barclays Global Investors’ Intermediary and Exchange Traded Funds Business notes "…financial advisors are looking to generate income for their 'Baby Boomer' clients."
Baby boomer retirement - the wave has only just begun and we're already seeing the financial services industrial complex gearing up for the greatest battle for assets in the history of investing. Can't wait. We're already sick of advertisements with classic rock soundtracks or Dennis Hopper waxing poetic about hip retirements afforded by those who choose the right broker.
More info on the new iShares ETF
New Vanguard Bond ETFs Bad Now, Better Later
ETFs are popping up all over, but until now not many have invested in bonds. While some famous rich person once said, "gentlemen prefer bonds", ETF investors clearly do not. While Vanguard was a little late to the exchange traded fund game, in recent years they have put the pedal to the metal in ETF launches. Now Vanguard is launching four new bond ETFs:
- Vanguard Total Bond Market ETF (BND) - Benchmark: Lehman Brothers Aggregate Bond Index
- Vanguard Short-Term Bond ETF (BSV) - Benchmark: Lehman Brothers 1–5 Year Government/Credit Index
- Vanguard Intermediate-Term Bond ETF (BIV) - Benchmark: Lehman Brothers 5–10 Year Government/Credit Index
- Vanguard Long-Term Bond ETF (BLV) - Benchmark: Lehman Brothers Long Government/Credit Index
The benefit of the four new Vanguard ETFs is lower fees – 0.11% compared to the 0.15% - 0.20% cost of the few other bond ETFs. Expenses in bond investing are a big deal as bond yields are low today – the less taken out of your coupon payments, the better. Until trading volumes pick up, investors who don't buy and hold may get a better total price with iShares as thinly traded ETFs tend to cost more to buy and sell.
Vanguard claims, “By operating as share classes of existing funds (rather than as stand-alone funds or unit investment trusts), Vanguard bond ETFs will be able to provide lower expense ratios and broader diversification among issues and issuers than competing products can, resulting in greater credit replication and the potential for tighter benchmark tracking.” In practice, early investors are getting a raw deal.
As of a little after 1PM on April 11th, 2007, the market price for the iShares Lehman Aggregate Fund (AGG) is up 0.19%. The new Vanguard fund based on the same benchmark, Vanguard Total Bond Market ETF (BND), is DOWN 0.15%. AGG has traded 243,000 shares compared to BND’s 14,000.
Why the performance gap? Lack of liquidity means trouble arbitraging the fund with the underlying fund holdings - the mechanism that keeps ETF’s market price close to the NAV. Those who bought BND near the market close yesterday paid a roughly 0.50% premium to NAV, while buyers of AGG paid a 0.20% premium. That’s three years worth of "savings" in fund expenses down the tubes.
Until this problem works itself out, stay away. Or consider Vanguard Total Bond Index (VBMFX). Sure its 0.20% a year, but you buy and sell at NAV commission free (at Vanguard).
Other bond ETFs:
iShares iBoxx $ Investment Grade Co (LQD)
iShares Lehman 7-10Yr Treasury Bond (IEF)
iShares Lehman Aggregate Fund (AGG)
iShares Lehman Credit Bond Fund (CFT)
iShares Lehman Intermediate Credit Bond Fund (CIU)
iShares Lehman 1-3 Year Credit Bond Fund (CSJ)
iShares Lehman Government/Credit Bond Fund (GBF)
iShares Lehman Intermediate Government/Credit Bond Fund (GVI)
iShares Lehman 3-7 Year Treasury Bond Fund (IEI)
iShares Lehman MBS Fixed-Rate Bond Fund (MBB)
iShares Lehman Short Treasury Bond Fund (SHV)
iShares Lehman 10-20 Year Treasury Bond Fund (TLH)
MAX on Fox News
MAXfunds co-founder Jonas Ferris chats with Neil Cavuto about the recent market turmoil. Not seen in this video is the off-camera high jinks where said co-founder debates who invented the ETF with a representative of the American Stock Exchange. Maybe somebody caught the scuffle on their cell phone camera and it will show up on YouTube. Ok probably not..
Actively Managed ETFs
The ETF craze may kick into overdrive now that the SEC is seriously considering allowing actively managed exchange traded funds - to heck with the front running issues.
While ETFs bring in a good chunk of all the new money going into funds these days, ETFs have been based on an index or basket of underlying. Most ordinary mutual funds are actively managed, meaning that fund managers decide which stocks to buy rather than simply investing in whatever is in, say, the S&P500 Index. That could soon change.
Many industry observers have predicted 2007 would be the year the ETF marketplace sees its first truly actively managed products. The earliest ETFs tracked recognizable, plain-vanilla indexes such as the S&P 500.
However, more firms entering the ETF business are launching products on increasingly complex indexes that, arguably, already incorporate elements of active portfolio management. "
One thing is for sure, we'll see ETFs with higher fees once "expert" management comes into play.
MAX on Yahoo! Finance
MAXfunds co-founder Jonas Ferris explains why a boom in ETFs may be a bust for fund investors in this Yahoo! Finance/Fox News video (you'll have to sit through a short ad first).
Acute observers will note he's wearing the same tie as he did in last week's video.
EZ way to size up an ETF
Fund experts weigh in on the dangers and opportunities offered by new fangled ETFs (exchange traded funds) in a recent AP story:
Market watchers said, however, that the diversification ETFs can bring doesn't excuse investors from knowing where their money is going.
'Investors should be cautious in these areas unless they have great expertise,' said Tom Roseen, an analyst at fund-tracker Lipper Inc. 'Some of the slicing - for the average retail investors - has become much too narrow.'"
One way to determine if an ETF is the sort that can get you into trouble (or offer you a speculative thrill ride...) is to check out the expense ratio. More broadly focused ETFs tend to have lower fees (sub 0.30%). With ETFs, their is almost a direct relationship between fees and risk.
There you have it. Now you don't have to waste any time looking over gobs of data and analysis at fund oriented web sites. Hey wait a minute. Scratch that last part.
LINK