ETF Prime Archive

Asset Concentration Risk and Strategy Discipline

ETFs are lower cost and more tax efficient than mutual funds.  That is a given.  You shouldn’t invest in something because it’s inexpensive, though.  Beyond costs, a crucial element of any investment strategy should be the management of (1) asset concentration risk and (2) strategy discipline.  ETFs are ideal for both, and here’s why.

Transparency … If ignorance is not bliss then holdings transparency is a big deal. Have you ever attempted to find out what your mutual fund currently holds? You can’t. Why? Because mutual funds are required to report holdings only once per quarter and, at that, one quarter in arrears. That means that any mutual fund holdings report that you would have represents the fund’s holdings at from least three and as much as six months ago.  ETFs are required to report holdings on a daily basis.  You always know what you’re holding in an ETF. 

Active mutual fund prospectuses generally grant managers license to roam widely on the securities landscape in pursuit of return, and that they generally do. Accordingly, it’s not uncommon, especially during turbulent times, for portfolio holdings to vary significantly from month-to-month or quarter to quarter.  And, yet, as shareholder of actively managed mutual funds, you’ll never know with certainty what you hold at any given time.

Breadth and depth of coverage, precision and purity of exposure – ETFs do it as well or better across the board, in every asset class.  ETFs cover U.S. and non-U.S. equities of all capitalizations, style and sector/industry flavors as well as emerging markets.  On the ETF menu are government, TIPS, municipal, agency, corporate investment grade and high yield, and international fixed income offerings.  In the “alternatives” arena there are commodities, currencies and REITs. 

Precision and purity in exposure … ETF holdings are designed to replicate or approximate the holdings of an index.  Holdings within indexes, such as the S&P 500, are established according to a set of rules specific to a given index.  Understand the mechanics of the index and you understand not just what your ETF holds but how it arrives at those holdings and you also know, unlike with actively-managed mutual funds, that it’ll have the same sort of holdings in the future. 

Favorable performance histories relative to active fund managers … Find an active fund manager who has managed to beat his generic index benchmark in a given year and, behold, you’ll have a manager residing squarely in the minority.  Well under one-half of active mutual fund managers beat their generic index benchmark in a given year; less than ten percent pull it off three years in a row. Investors have increasingly learned that they’ve got far better off buying the active fund manager’s benchmark index, which can be done through an exchange traded fund, than by placing their bets with the active mutual fund manager.

Fund Fee Update

I came across some updated mutual fund and ETF fee information from Morgan Stanley, so I thought I would update those here.  To complete the picture, I’ve included fixed income data from Barclays.

As you can see, for every major asset class, average internal fund management fees for ETFs are significantly lower than is the case for actively managed mutual funds.  Actively managed U.S. equity mutual funds, for example, carry fees five times higher than U.S. equity ETFs, on average.

If CEO’s Don’t Know, How Can We?

None of us has ever seen a time when so many companies are going out of business, needing to be consolidated, or teetering on the brink of bankruptcy.   The management of these companies never seem to see it coming.  It’s like some fantastic surprise that the economic or business outlook changed and they didn’t think about preparing for it. 

So you are wondering how this affects us as investors. Trust me, it affects everyone. For the investors who are stock pickers, it’s like walking through a land mine. Straight from the CEO’s mouth, Bear Stearns is fine and you believe them. For the mutual fund manager it’s a huge challenge because they have hundreds of companies to track and can’t get intimate enough with the management to get a feel for who they can trust and who is competent.  

That might be another reason why almost all mutual funds underperform their benchmarks over the long haul and why indexing with low cost ETF’s make makes more sense.   

Let’s go back in time and I will show you a few examples of some very supposedly competent CEOs who have said things that make you wonder.  

Robert Toll, CEO of Toll Brothers, was named one of Barron’s Top 30 CEOs worldwide in 2005.  On December 6, 2006, Toll announced he’s seen the bottom of the housing slump. 

As we know, over two years later and we still haven’t found bottom yet.

Hank Greenberg, former AIG Chairman and head for four decades. On September 18, 2008, Greenberg said AIG didn’t need a bailout.

In September 2008 AIG took in $85 billion from the federal government.  In October 2008 an additional $38 billion.  In November 2008 another $27 billion.  Today AIG now needs more – lots more.

Rick Wagoner, CEO of General Motors.  July 15, 2008 Wagoner said GM was a taking a series of actions that would add $15 billion of liquidity to GM’s already strong cash position.

November 2008, three months later, General Motors asked the government for aid and this February GM sought a total of up to $30 billion in U.S. government aid, more than double its original request in November.  GM is certain to need billions more in order to survive.

I could go on, but you ge the point….often times CEO’s – even the best ones – can’t effectively project where their companies are headed.  If they can’t, how can an individual investor?  And how can an actively managed mutual fund manager who is supposed to be following hundreds, or even thousands, of companies?

Industry at a ‘Tipping Point’

I mentioned last week that the entry of Schwab into the ETF business marked a pretty important day for the industry.  Today Marketwatch.com posted a story on their site about the same topic, but made a bold statement.  According to Marketwatch, Schwab’s entry, along with Pimco’s announcement last year that it was getting into the business, could mark a ‘Tipping Point’ that forces all the other major mutual fund houses to follow suit. 

Most of the important indexes already have good ETF alternatives.  It will be interesting to see if Schwab and Pimco simply copy ETFs that are already available, or use their formidable resources to drive additional innovation in the industry.  Let’s hope it is the later.

Wall Street Journal: Diversify with ETFs

In Monday’s Wall Street Journal, there is a great article about how investors can use ETFs outside of their 401k plans to improve their portfolio.  Most 401k plans are full of mutual funds that give exposure to stocks and bonds, but few give you access to alternative assets.  These assets, such as gold and other commodities, real estate, and foreign currencies, can lower the risk and potentially increase the returns of a portfolio compared to one made up strictly of stocks and bonds.

 ETFs can get you direct exposure to alternative assets.  Since most 401ks don’t give you this access, every investor should use some of their non-401k investments (and IRA , for example) to invest in this asset class with ETFs.  Longer-term, the demand for ETFs will ensure they make their way into everyone’s 401k plan (regardless of whether the mutual fund industry embraces the idea), but for now at least average investors have the tools available through ETFs to compensate for existing 401k plan limitations.