ETF Prime Archive

Separating the Cart (instrument) from the Horse (strategy): The Real Beauty of ETFs

The educational starting point for all investors new to ETFs, be they novice or experienced professional, ought to be Investment Cart & Horse 101.

 ETFs enable investors to clearly and objectively distinguish, both in investment thinking and in investment practice, between the proverbial “cart” and “horse“, i.e., the investment instrument and investment strategy.

The gross mismatch between an active fund manager’s stated investment objective(s), and the broad (prospectus-imparted) license to roam widely and at will across much of the investment landscape, renders separation of investment instrument from investment strategy absolutely and utterly impossible to discern within the actively-managed mutual fund.

 For investors and advisors, unfortunately, any attempt to use actively-managed mutual funds to construct a disciplined and coherent strategy – one which demands control and predictability regarding the composition of portfolio holdings – is inescapably and entirely rendered an exercise in futility. “Asset allocation” strategies, at best, devolve to an extremely crude approximation game as individual fund managers exercise broad discretion in modifying, at times quite dramatically, security and asset class composition within their funds. Gone, usurped by active mutual fund managers, is investor or advisor control over the composition and modification of their strategy.

 In contrast, index-based ETF instruments provide a systematic, rules-based recipe for gaining exposure to a broad market or segment of a market. And while mutual fund reported holdings data ranges from three to five months stale, daily reporting of ETF holdings enables the investor or advisor to see precisely how index rules are reflected in a related ETF’s holdings. For the investor or advisor familiar with the index and the ETF, there are no surprises regarding the composition of an ETF. The manner of asset class coverage and security selection are “programmed” into the index and corresponding ETF.

Utilization of index-based ETFs enables the investor and advisor to shed active-manager decision-making risks – a step that is supported by a mountain of academic research and decades of market experience. With index-based ETFs, investor and advisor attention can be focused where it should be: entirely on strategy, understanding that the instruments will deliver intended exposures predictably and reliably. Actively-managed mutual funds rob investors of this capability by undermining the strategy, through manager drift, and weakening investor confidence and resolve to stick with a game plan. Active fund mangers, after all, have no definitive requirement or proclivity to do so themselves.

 In using ETFs, investors and advisors are better equipped to construct and deploy strategies as well as to consider the performance of instruments and strategies independently, largely as a result of their ability to “separate the cart from the horse.” These risk management and control perspectives can never be shared or enjoyed by investors and advisors using actively-managed mutual funds.

Missing the Target

Over the past several years, target-date (or life-cycle) mutual funds have gained popularity as fund companies tout them as an easy way for investors to obtain an appropriate asset mix in their portfolio for a particular age or investment timeframe. 

Theoretically, these funds are designed to allow an investor to select a date that approximately corresponds to their retirement – say 2020 or 2030, and the fund manager will attempt to provide an allocation of stocks, bonds, and cash that becomes more conservative the closer the individual gets to retirement. 

The idea is that the investor can rest comfortably knowing that their investments are properly aligned with their risk tolerance and time horizon. 

However, as an article in Fortune magazine recently pointed out, investors hoping that target-date funds would be a simple way to ensure they were properly managing risk have been shocked by the overly-aggressive nature of these funds.

The article points out that, “According to Israelsen, the average 2010 fund marketed to investors who were aiming to retire next year – was more than 45% invested in stocks in December.  As of March 2008, the mammoth Fidelity Freedom 2010 Fund (FFFCX) housed 50% of its assets in equities, and AllianceBernstein’s 2010 portfolio (LTDAX) was 57% in stocks in February of last year.  The funds lost 25% and 33%, respectively, last year, barely beating the S&P 500.” 

Investors hoping to retire next year surely were not expecting a portfolio allocation that could expose them to 25% or 33% losses.

Industry professionals attribute the miserable performance of these funds to poor execution by fund managers, who in an attempt to chase extra returns that could help market the funds, added unnecessary risk to their portfolios by overexposing to equities.  The performance has been so alarmingly bad that Wisconsin Senator Herb Kohl has asked the SEC and Department of Labor to investigate target-date funds, particularly since many employers offer these funds in 401(k) plans and brokerages aggressively market these funds to investors for individual retirement accounts.

The bottom line is that investors should be wary when considering these funds for their retirement accounts.  In addition to the performance and asset allocation issues described above, expense ratios on these funds can be heavy and funds can include loads or commissions.  Furthermore, the asset mix in these funds is generally limited to stocks and bonds, excluding other important asset classes such as commodities and real estate that can help balance out a portfolio.

SmartMoney: ETFs “pushing mutual funds out of the picture”

There is a great article posted today at smartmoney.com about the gains ETFs are making against mutual funds.  The article describes the rapid growth of ETFs, the fact that some fund companies such as Vanguard are issuing their own ETFs in order to survive, and the benefits to an investor of owning ETFs instead of mutual funds – especially for the bond portion of a portfolio.

The article says there might be a place for actively managed funds in a portfolio (though most people know by now that most actively managed funds underperform their benchmarks over time) but it concludes that “trying to make a case for a mutual fund can be difficult.”

Mutual Fund Company Magic

When a broker tries to sell you a mutual fund, or your advisor touts the performance of a fund he or she wants to put your money into, it is modus operandi to show how wonderful the fund has performed against its benchmark, or relative to its peers.  

Before you jump into the fund, consider the impact of survivorship bias on those published performance numbers.  As the PSY-FI blog explains, survivorship bias is the result of the all-too-often habit of mutual fund companies to merge the assets of underperforming funds into the successful ones. 

Your fund might have a terrible year – perhaps miss its benchmark by 50% or more – but if you blink you just might miss that your fund was closed and your assets have moved into a succesful fund with a great track record….voila, in an instant your fund is gone and your investment is in a fund that has the best 10 year track record of any fund in its category!!!  Your bad investment has magically disappeared. Congratulations!

PSY-FI explains a number of other creative ways fund companies improve perceived returns, including ‘easy history’ bias or ‘easy data’ bias, but the main lesson for investors is simply caveat emptor!

Mutual Funds Walking, Not Running, Toward ETFs

Yes, with great anticipation and fanfare both Pimco and Schwab have proclaimed their intention to enter the ETF space. And both will likely bring with them actively managed strategies. But, given the staggering capital flows out of traditional, actively managed mutual funds and correspondingly massive flows to index-based ETFs, where’s the stampede of active mutual fund managers to the ETF structure?

We can still count on one hand the number of actively managed ETFs, comprising all of $21.5 million in assets and 0.0048% of total market ETF assets (4/14, consisting of five Powershares active ETFs of which two are formulaic and represent one-half of the assets; total ETF market assets as of Feb 09, source ICI). Hardly a relevant feature on the ETF landscape at present.

Why the slow rollout pace for actively managed ETFs? One need look no further than the “what’s in it for me?” question.

What changes for the active manager that “goes ETF”?

The most important operational change is that fund holdings must be reported daily, rather than quarterly, sixty days in arrears. In the active manager’s “what’s in it for me?” ledger this is a definitive negative. While the ETF format doesn’t hang the active manager’s strategy in public view, it does – on a daily basis – display the fund’s holdings. Daily reporting of ETF holdings also removes any opportunity to hide aggressive active manager behavior that might otherwise forever remain out of public view in a traditional mutual fund format. The long reporting cycle for the traditional mutual fund enables position “clean-up” activities or “window dressing” to the detriment of shareholders.

What changes for the investor drinking the active-manager kool-aid via an ETF wrapper?

Holdings transparency – going from holdings data that is three-to-five months stale to daily visibility. This is important for any risk manager – enabling a “trust but verify” doctrine.

Improved tax efficiency – ETF creation / redemption activity is generally classified as non-taxable, in-kind exchanges – generally significantly stripping funds of the internally-generated capital gains commonly experienced in traditional mutual funds.

What doesn’t necessarily change: An active mutual fund manager doesn’t necessarily shed a cent of overhead when adopting an ETF structure. And it’s not in any active manager’s m.o. to surrender fees simply to compete with passively-managed index-based ETFs – charging, on average, one-fifth as much as actively managed mutual funds (average for US equity ETFs, Morgan Stanley, “ETF Overview and Strategies”, 11/19/08, p16).

What else doesn’t change: Active managers consistently under-perform their self-selected index benchmarks. Active managers outperforming their index benchmark in any given year reside squarely in the minority, with those managing the feat two or three years running fewer yet.  And when both fees and the element of luck are stripped away, less than one percent of active mutual fund managers outperform their index benchmark in any given year. Taking fees to zero, improves the active manager’s chances of outperforming the fund’s index benchmark to nearly ten percent when the element of statistically random luck is removed (Wermers, et al, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas”, 5/08; also in related NY Times article, “The Prescient are Few”, Mark Hulbert, 7/13/08)

While index-based ETFs have achieved critical mass and clearly have gone mainstream, actively-managed ETFs have not yet “arrived” and, at least in the near term, active managers will continue to struggle with the “what’s in it for me” question as indexed-based ETFs continue their forward march.