Spiders and Diamonds and Qubes, Oh My…

Come on, admit it. We’ve all opened a quarterly financial report sometime in our investment lives, winced at the numbers, and asked one simple, elegant question -why can’t I just put my money into something that will match the market?

Exchange traded funds, or ETFs in market shorthand, are a relatively new group of financial instruments created to answer that question. 

The concept is simple. Buy a bunch of stocks that match the ones in the Dow Jones 30 Industrials, Standard & Poor’s 500 or whichever market index you want to match, then let the money ride until you want to cash out. The same idea works for bonds, commodities and presumably just about anything else bought and sold in a formally organized public marketplace.

Many ETFS have colorful names, often based on pun on the fund’s name or trading symbol. SPDRS, the Standard & Poor’s Depository Receipts fund tracking the S&P 500 and the first ETF traded in the U.S., are known as Spiders. The Diamond, listed on the ticker as DIA track the Dow Jones Industrial Averages. Qubes, named for its symbol QQQQ tracks the Nasdaq 100 index. And the list goes on.

Industry watchers at the Investment Company Institute  and Morningstar Research count more than 840 different funds traded on U.S. securities and commodities exchanges, with combined assets of more than $608 billion. Trading volume climbed from a dead start zero before U.S. trading began in 1993 to more than 1 billion shares a day in 2006, according to market mavens at Northern Trust.

So, how do they work?

As with mutual funds, ETFs are built around diversified baskets of securities, which for most funds are chosen to duplicate a market index you want to track. But where mutual fund builders ask for cash when they begin building those baskets, ETF sponsors ask their institutional investors to deposit the actual securities in the fund. In return, the sponsor refashions this megamillion collection of securities into so-called creation units that securities firms can divide into more manageable chunks for retail investors to buy.

What the retail investors get is an ETF that looks like a mutual fund but acts very differently. To over simplify, mutual funds buy and sell securities to hit their chosen performance targets while ETFs stick with the securities they start with and see where the targets take them.

This creates many practical differences for retail investors too. Investors can trade ETFs throughout the day like stocks and, if they choose, buy on margin or sell short. Mutual funds trade once a day, based on closing market prices.

Smart Money?

SmartMoney magazine recently released its list of the 100 “best time-tested” mutual funds.  But as an article from the Motley Fool illustrates, this list looks anything but smart and could cost you money.  43% of the mutual funds recommended on this list have front-end sales loads averaging a lofty 5.4% of assets.  In other words, for nearly 1 out of every 2 mutual funds you might select off this list, you would need the fund to increase in value by 5.7% just to get to breakeven. 

This doesn’t sound like a smart investment strategy in any environment and seems particularly shaky in light of the average domestic equity fund losing 37.6% in 2008. 

But wait, there’s more.  Although, mutual funds love to boast about their past performance records and SmartMoney’s list claims to represent the funds with the highest total returns since 1987, the Motley Fool points out that the average management tenure for this list of funds is only 12.5 years and thus, “this means that the vast majority (85%) of the uber-impressive track records the funds on the list boast are in no way attributable to the current manager”.  Put another way, assuming you actually think a fund manager can outperform the market (which is a topic for another day considering that ishares found 75% of active fund managers underperform on an annual basis), 85% of the current managers of the funds on this list didn’t have anything to do with the returns provided on the list. 

Smart money to me is an investment vehicle that doesn’t have front-end loads and where returns aren’t tied to transient fund managers trying to outperform the market.  ETFs anyone?

Wall Street Journal: Use of Bond ETFs Growing

Most people who are familiar with ETFs see them as a better way to create well diversified equity portfolios and give them access to alternative assets like commodities or real estate.  They typically don’t consider fixed income ETFs as essential building blocks of a portfolio.  That perception is changing, though.  As the Wall Street Journal reports, investors are increasingly using ETFs to replace existing holdings in their bond portfolios.

Fixed income ETFs have all the same benefits as equity ETFs – transparency to exactly what you hold, low costs, and tax efficiency.  Being able to know what types of bonds you hold each day is especially important right now due to the volatile environment we’re in, and the unusual spreads and pricing relationships we have in some sectors of the fixed income world(municipals yielding more than government bonds!).

The number of fixed income ETFs right now can’t match the sheet number (and redundancies) of bond mutual funds.  That’s actually a good thing – – it’s easy to find the ETF that can target the section of the bond market you or your financial advisor are interested in.

Why Mutual Fund Companies are Stuck

The whole of the mutual fund distribution space is “stuck,”  if for no other reason than none of its primary practitioners can bring themselves to categorically call a spade a spade.

What and where’s the spade?

Actively managed mutual funds are the spade.

The mutual fund food chain- from fund sponsors to wire house brokerages to discount brokerages and to insurance and annuity companies – has far too many current and historical earnings and cash flows tied to actively managed mutual funds to be out on the streets hammering away with some plain and simple truths on matters that divide the exchange-traded fund (ETF) and actively managed mutual funds –  transparency of holdings, breadth of coverage, consistency of coverage, cost, tax advantages, trading flexibility for managing risk,  and the persistent failure of active managers to beat generic passive index benchmarks.

For those businesses with a significant portion of their earnings and cash flow streams tied to actively managed mutual funds, the truth hurts. Facing, acknowledging and communicating the truth comes with risk of alienating clients and advisors who have been trained or conditioned over the past twenty years to believe the hollow, active mutual fund manager storyline of  chest-beating and hard-selling, of  managers who’ve realized a two or three year streak against their peers or an index, and their misplaced confidence and hints that more of the same certainly must follow despite requisite disclaimers and the sheer weight of historical evidence to the contrary.

Given the above realities, ETFs represent superior alternatives in nearly every corner of the investment universe.  Conflicted, inconsistent and flawed advice has come to typify active mutual fund manager-based so-called solutions and emerged against both a backdrop of reinforcing secular trends (interest rates, inflation, dollar softening) and a series of benign and thus  psychologically reinforcing,  economic shocks over the past twenty years.  Both the mutual fund message and its messengers now clearly represent second class solutions for managing risk and returns.  And that’s why mutual fund companies are stuck.