ETF Prime Archive

Ignore TV, Watch M2

The media is full of noise from talking heads debating the merits of TARP, bank bailouts, gov’t debt buybacks, foreclosure prevention, stimulus checks, Wall Street bonus babies, etc.  It’s impossible to turn on the television and not find someone who is an expert on what the Treasury and Fed should be doing.

I don’t think anyone knows how things are going to play out, and even Bernanke is making this up as he goes.

So I take what most people say with a grain of salt.  But I do like to listen to statistics.  And there is one statistic that tells us a lot about how a portfolio should be constructed over the next few years.  That statistic is the M2 money supply.

M2 is generally regarded as the best measure of the total amount of money in our economy.  And there has historically been a relationship between long-term money supply growth and price inflation.

The Fed publishes the weekly money supply at its website.  As of last week, the seasonally adjusted level of M2 was growing at annualized rates in excess of 15% over the previous 3 and 6 month periods.  15% is a big number and should tell an informed investor that they should include some inflation hedges in their portfolio.

So don’t get too caught up in the daily debates on TV, including whether or not we are going into a deflationary spiral or headed for inflation.  Keep an eye on M2.  Don’t be surprised if it starts to acclerate.

TIPS: An Important Inflation Hedge

With massive stimulus programs currently getting geared up, along with related record-ripping government borrowing, does an average inflation rate of just one percent over the next ten years sound plausible? Maybe not, but that’s precisely what the current yield spread between ten-year Treasuries (2.93%) and ten-year Treasury Inflation Protected Securities (TIPS) (1.87%) would imply.

While nobody can pick market price or interest rate tops and bottoms, there are a few things that we can “know” with relative certainty: Over the next several years borrowing by the U.S. government will be of historic proportions and will exert upward pressure on interest rates. Meanwhile, the gaining of traction by tsunami-sized economic stimulus programs will translate into a significant source of demand for commodities and raw materials, as well as for goods and services overall.

Exposure to commodities as demand recovers can help cushion the effects of a potentially forceful inflationary wave rippling through the economy. But there’s an additional important tool that can be deployed to help further protect against the ravages of inflation: Treasury Inflation Protected Securities.

TIPS are designed to protect principal while ensuring a return above the rate of inflation, using the Consumer Price Index (CPI) as the measure of inflation. 

The two primary elements of TIPS are a) periodic payments of a fixed rate of interest against a principal amount that is b) adjusted according to change in the CPI. As inflation goes up, for example, so does the principal value against which interest payments are calculated. At maturity, the holder gets the higher of the CPI-adjusted principal level and the original issue principal or “par” value. Being indexed against a relatively broad measure of inflation, TIPS can serve as an important inflation-cushioning complement to commodity holdings. Unlike commodities, though, TIPS also generate current income.

In the near term, the risk of deflation (or falling prices) is still a real risk to the economy and to the performance of TIPS. Each passing day, though, brings us closer to implementation of demand and inflation-driving stimulus programs and related interest rate pressures from exploding government borrowing programs.

Fortunately, there are currently two ETFs that provide investors with low-cost, diversified exposure to TIPS. iShares TIP provides exposure to U.S. TIPS with a yield currently slightly above 2% and an average maturity of just under nine years (Barclays TIPS Bond Fund).  StateStreet’s WIP, with a yield of slightly less than 2.5%, provides exposure to international TIPS (SPDR DB International Government Inflation-Protected Bond ETF). StateStreet also has a global TIPS ETF currently in registration, awaiting SEC approval.

In general, and certainly against the current economic backdrop, TIPS (in combination with commodities) can play an important diversification role in investment portfolios.

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?