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Jane Bryant Quinn: ETFs “Going In For the Kill”

Since actively managed mutual funds keep cash on hand to be able to meet daily customer redemptions, conventional wisdom holds that mutual funds should outperform index funds and ETFs in down markets because the cash acts as a cushion when there is a falling market.

That didn’t happen last year.  As Jane Bryant Quinn of Bloomberg explains – in fact, 58% of all actively managed funds lost more in value than the benchmark against which they measure themselves.  (Remember that the fund companies themselves get to choose the benchmark they want to be measured by).  Small-cap managers did much worse – 72% of them missed their self selected benchmark.

According to Quinn, the benefits of ETFs – lower costs, lower taxes – combined with their outperformance in a down market, have them “going in for the kill” against actively managed mutual funds.

Understanding Indexes

Nearly all ETFs track an index (the exceptions are a small number of actively managed ETFs). Where they differ, however, is what indexes they track and how they go about their tracking.  Understanding these differences is important to make sure you choose the right ETFs for your portfolio.  This is especially true as the number of ETFs proliferate.

Before investing in an ETF, there are a number of characteristics about its underlying index you should investigate and understand.  I’ve summarized the main ones below.

How are the components of the index selected?

Most indexes can be categorized as market indexes or custom indexes.
Market indexes are the most widely known kind and some of the largest ETFs track those indexes. A market index attempts to track the performance of a broad group of securities or sectors.  These indexes include the S&P 500 , Dow Industrials, and Nasdaq Composite index.  SPY is the largest ETF which tracks the S&P 500.
A custom index is simply any index constructed using specific rules to create a group of securities that doesn’t follow more widely known passive indexes. Many of them screen out certain companies based on qualitative or quantitative features using proprietary methodologies.  ETFs that track socially responsible or clean energy, for example, are based on indexes developed by companies using their own qualitative criteria of what those themes represent.  Similarly, quantitative indexes are ones using proprietary formulas to identify attractive companies in certain sectors of the market.  Powershares is by far the biggest player in ETFs that track quantitatively determined indexes.

How are components of the index weighted?

Are they market-cap weighted, equal weighted, or fundamentally weighted?  Once the components of an index are determined, the relative proportion of each component of an index must be determined.  Most of the large, passive indexes (think S&P, Wilshire, Russell and MSCI indexes) are market-cap weighted, which means the relative weight of a company in the index is based on the total value of its shares.  iShares, StateStreet, and Vanguard ETFs tend to be market-cap weighted indexes.  Some indexes are equal-weighted, meaning the size of each company doesn’t matter – each company has the same relative weight.  Rydex is probably best known as a sponsor of ETFs using equal weighting methodologies.  Finally, some indexes base the relative weights of a company in an index on fundamental factors, such as relative earnings or dividends.  WisdomTree is best known for its fundamentally calculated indexes.

How often is the index rebalanced and reconstituted?

When an index is rebalanced, the holdings of the index are bought or sold until they reach their intended weightings.  The more often an index is rebalanced, the chance of receiving a capital gain distribution is increased.  Also, the fund costs are likely to be higher.  The most widely followed indexes are generally rebalanced either annually or semiannually.  Many of the quantitative ones, however, are rebalanced quarterly and a few even are rebalanced monthly. When an index is reconstituted, the holdings of the index are actually changed.  For example, when a company is added to the S&P 500 index, an ETF tracking that index must purchase the new company and sell the company being removed from the index.  Similar to rebalancing, an index that is frequently reconstituted might increase the chance of capital gains in the ETF.

Once again, this isn’t an exhaustive list of items to consider.  There are other questions to ask (e.g., is the index intended to outperform a benchmark or match it? what company developed the index?), but understanding these three main aspects of ETF indexes should give you a framework for determining whether an ETF belongs in your portfolio.

Mutual Fund Company Gone Bad

Another relevant illustration:

Financial Advisor Gone Bad

Going through the summary of mutual fund fees reminded me of this cartoon I found a few months ago:

A Glossary of Mutual Fund Expenses and Fees

It is difficult for average mutual fund investors to understand what they are paying for their investments – especially if they use a broker and the broker is paid through commissions. There are so many share classes, front-end fees, back-end fees, redemption fees, etc. that it is no wonder people are confused.  It’s amazing how many people I know have no idea what they are paying.

So, I went on the web to try and find a good place for people to go to get educated, and to my surprise, the best site I could find was no other than the Securities and Exchange Commission.  The information below is taken directly from their site and is a comprehensive overview of mutual fund fees.  It may not tell you exactly what you are paying, but it should give you a good place to start – and help you know what questions to ask your advisor.

The first list of expenses below are called Shareholder Fees. These represent the fees incurred in some funds that choose to cover the costs associated with an individual investor’s transactions and account by imposing fees and charges directly on the investor at the time of the transactions (or periodically with respect to account fees). These fees and charges are identified in a fee table, located near the front of a fund’s Prospectus, under the heading “Shareholder Fees”.

• Sales loads – Funds that use brokers to sell their shares typically compensate the brokers. Funds may do this by imposing a fee on investors, known as a “sales load” (or “sales charge (load)”), which is paid to the selling brokers. In this respect, a sales load is like a commission investors pay when they purchase any type of security from a broker. Although sales loads most frequently are used to compensate outside brokers that distribute fund shares, some funds that do not use outside brokers still charge sales loads. The SEC does not limit the size of sales load a fund may charge, but FINRA does not permit mutual fund sales loads to exceed 8.5%. The percentage is lower if a fund imposes other types of charges. Most funds do not charge the maximum. There are two general types of sales loads-a front-end sales load investors pay when they purchase fund shares and a back-end or deferred sales load investors pay when they redeem their shares.
• Redemption Fee – A redemption fee is another type of fee that some funds charge their shareholders when the shareholders redeem their shares. Although a redemption fee is deducted from redemption proceeds just like a deferred sales load, it is not considered to be a sales load. Unlike a sales load, which is used to pay brokers, a redemption fee is typically used to defray fund costs associated with a shareholder’s redemption and is paid directly to the fund, not to a broker. The SEC limits redemption fees to 2%. The SEC has adopted a rule addressing the imposition of redemption fees by mutual funds in Rule 22c-2 of the Investment Company Act of 1940.
• Exchange Fee – An exchange fee is a fee that some funds impose on shareholders if they exchange (transfer) to another fund within the same fund group.
• Account Fee – An account fee is a fee that some funds separately impose on investors in connection with the maintenance of their accounts. For example, some funds impose an account maintenance fee on accounts whose value is less than a certain dollar amount.
• Purchase Fee – A purchase fee is another type of fee that some funds charge their shareholders when the shareholders purchase their shares. A purchase fee differs from, and is not considered to be, a front-end sales load because a purchase fee is paid to the fund (not to a broker) and is typically imposed to defray some of the fund’s costs associated with the purchase.

The list of costs below are referred to as Fund Operating Fees. Funds typically pay their regular and recurring, fund-wide operating expenses out of fund assets, rather than by imposing separate fees and charges on investors. These expenses are typically called Fund Operating Expenses.  In the fee table in the mutual fund prospectus, under the heading of “Annual Fund Operating Expenses,” you will find:

• Management Fees – Management fees are fees that are paid out of fund assets to the fund’s investment adviser (or its affiliates) for managing the fund’s investment portfolio , and administrative fees payable to the investment adviser that are not included in the “Other Expenses” category (discussed below).
• Distribution or Service Fees (Often known as 12b-1 Fees – This category identifies so-called “12b-1 fees,” which are fees paid by the fund out of fund assets to cover distribution expenses and sometimes shareholder service expenses.”12b-1 fees” get their name from the SEC rule that authorizes a fund to pay them. The rule permits a fund to pay distribution fees out of fund assets only if the fund has adopted a plan (12b-1 plan) authorizing their payment. “Distribution fees” include fees paid for marketing and selling fund shares, such as compensating brokers and others who sell fund shares, and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. The SEC does not limit the size of 12b-1 fees that funds may pay. But under FINRA rules, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75 percent of a fund’s average net assets per year. Some 12b-1 plans also authorize and include “shareholder service fees,” which are fees paid to persons to respond to investor inquiries and provide investors with information about their investments. A fund may pay shareholder service fees without adopting a 12b-1 plan. If shareholder service fees are part of a fund’s 12b-1 plan, these fees will be included in this category of the fee table. If shareholder service fees are paid outside a 12b-1 plan, then they will be included in the “Other expenses” category, discussed below. FINRA imposes an annual .25% cap on shareholder service fees (regardless of whether these fees are authorized as part of a 12b-1 plan).
• Other Expenses – Included in this category are expenses not included in the categories “Management Fees” or “Distribution [and/or Service] (12b-1) Fees.” Examples include: shareholder service expenses that are not included in the “Distribution [and/or Service] (12b-1) Fees” category; custodial expenses; legal expenses; accounting expenses; transfer agent expenses; and other administrative expenses.

So there it is, a complete inventory of mutual fund expenses.  Keep in mind that, according to the SEC website, the SEC typically does not impose a limit on what a fund can charge, so buyer beware!!