Welcome to the ETF Prime Podcast

Have ETFs Killed the Mutual Fund “Rock Star” Managers?

CNBC.com published an interesting article this week on Legg Mason’s Bill Miller, who announced he was stepping down as the manager of Legg Mason’s flagship Value Fund.  Miller was one of the last of a dying breed of high profile, “rock star” mutual fund managers trying to beat their benchmark indexes each year.  Unfortunately, Miller’s unlikely run of outperformance came to an end in 2006 and Miller has struggled mightily since that time.  A recent article from Reuters titled “Miller’s Fall Shows Luck at Play in Investing” had some interesting comments from the President of Fund Research at Morningstar, Don Phillips, who said that Miller himself “always acknowledged what a difficult competitor the S&P 500 is” and that “even when he was getting all the praise, he (Miller) was very skeptical”.

California Institute of Technology professor Bradford Cornell continued with “most of the annual variation in performance is due to luck, not skill.  Annual rankings of fund performance provide almost no information regarding management skill”.

It makes sense, then, that investors are continuing to gravitate in huge numbers towards passively managed ETFs, where investors can capture the benchmark returns at a fraction of the cost charged by overpriced actively managed mutual funds.  Investors are realizing that it’s more important to pick the right asset classes than trying to pick the right individual stocks or bonds.  And what better way to pick the right asset classes than with ETFs?

As Phil Pearlman, executive editor of StockTwits, commented in the CNBC.com article, “Mutual funds remind me of AOL dial-up:  a dwindling collection of old people who don’t know better, contributing monthly to a comically inferior product and Miller was the symbol figurehead of this beta minus fees charade”.

It looks like the charade is up and Miller is smart enough to recognize that.  ETFs are quietly killing the actively managed mutual fund industry and “rock star” mutual fund managers are becoming a relic of the past.

ETF Store Show Recap – 11/12/11

Listen to The ETF Store Show every Saturday at 4pm on KCMO Talk Radio 710AM as we cover everything you need to know about Exchange Traded Funds and the world of investing.

Does your financial advisor only have you invested in stocks and bonds or maybe some equity and fixed income mutual funds?  On our most recent radio show, we explained why you might be missing an important piece of a well-diversified portfolio – alternative assets.  Many people hear “alternative assets” and immediately think of some far-fetched or strange investments.  That shouldn’t be the case.  Investments like gold, real estate, and agricultural commodities can help lower the overall risk of your portfolio without sacrificing the returns.  Many alternative asset classes have a lower correlation with traditional investments like stocks and bonds.  So when stocks zig, maybe gold zags.  This has the effect of lowering the volatility of your portfolio and potentially, enhancing the returns.

It’s critical to have uncorrelated assets in your portfolio so when the markets take a nosedive (think 2008 for example), you have investments that can counteract some of the decline.  Even as recently as ten years ago, it could be extremely difficult for the average investor to access alternative asset classes.  Many alternative assets were unavailable to all but the wealthiest and most sophisticated investors.  That all changed in 2004 with the introduction of the first commodity-based ETF, the SPDR Gold Trust, ticker GLD, which invests directly in gold bullion.  Since the introduction of GLD, a number of ETFs have been launched that invest in a whole range of other commodities – things like silver, platinum, palladium, oil, natural gas and agricultural crops.  ETFs have become the everyday investor’s gateway to alternative investments.

So next time your advisor says, “alright, we’re placing you in a portfolio of 60% stocks and 40% bonds – now your diversified”, you may want to ask them where your alternative assets are.

Listen to the full show here.

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Beware of Mutual Fund Capital Gain Distributions

As the end of 2011 quickly approaches, it’s time to start considering the tax consequences of investments you hold in taxable accounts.  One of the biggest benefits ETFs provide investors is they can cut your tax bill.  Because of their legal structure and minimal trading, ETFs typically distribute very little, if any, capital gains to investors.  In contrast, many mutual funds distribute capital gains – sometimes even if the mutual fund is down for the year!

So, why is this case?  Take the following example:  Let’s say there’s a mutual fund shareholder that wants to sell their mutual fund shares because they need cash to buy a house.  The mutual fund manager may need to sell shares of stocks held by the fund to raise cash to meet this shareholder redemption request.  When the mutual fund manager sells shares of stocks owned by the fund for a gain, the mutual fund is required to distribute those gains to all mutual fund shareholders.  So to recap, if you’re a shareholder of the mutual fund and another shareholder redeems their mutual fund shares, you may be penalized with a taxable capital gain distribution even though you didn’t do anything.  That hardly seems fair.  And what’s worse, these capital gain distributions are “phantom gains” in that the share price of a mutual fund is reduced by the amount of the capital gain distribution.  So net-net, shareholders haven’t gained anything other than a tax bill.

Contrast that with ETFs where a shareholder wanting to raise cash can simply sell their shares on the stock exchange with no impact to you.  There are instances where ETFs may reconstitute or rebalance holdings, thus generating a capital gain distribution, but those instances are rare.  For example, iShares – the largest ETF provider, recently announced that 99% of their ETFs (231 of 233) are not expected to pay capital gain distributions to shareholders this year.  In fact, over the last 10 years, 99% of the time iShares funds have not paid capital gains.

So, what can you do to protect yourself?  If you must buy a mutual fund, wait until after the fund pays out its capital gains before you buy.  You can generally check with the mutual fund provider website to find that date.

If you already own a fund and it hasn’t yet paid its capital gains distribution, you can avoid the distribution and still retain much of the performance of the fund by selling the fund and buying a highly correlated ETF that tracks the same or a similar benchmark.  You can use ETF Database’s mutual fund to ETF converter tool here to help you in that process.