ETFs: Cutting-edge Technology Benefits Individual Investors

Exchange traded funds, or ETFs, are the most recent innovation in the evolution of investment management.  Like the previous developments in mutual funds and discount brokerage services, ETFs result from the application of the latest advancements in information technology and processing capability to the enormous benefit of the individual investor.  Not surprisingly, ETFs were one of the fastest growing investment vehicles in 2004.   Assets under management in United States-based ETFs grew in excess of 70% to $269 billion as of December 31, 2004.  The phenomenal growth wave continues in 2005 and will likely continue for the foreseeable future. 

What are ETFs?  And why are these investment products so enormously beneficial to individual investors?  In order to fully appreciate the beauty of the ETF structure, it is important to first review the basic elements of a sound investment strategy – asset allocation and security selection (or indexing versus active management).

Asset allocation

Achieving long-term, risk-adjusted returns starts with a sound asset allocation policy.  Asset allocation is the process of distributing an investment portfolio among various asset classes, including domestic and international equities, bonds, real estate and cash.  The risk and return potential of these different asset classes vary and are often uncorrelated.  The asset allocation process seeks to maximize return for a given level of risk through the construction of broadly diversified portfolios. 

Not surprisingly, several studies indicate that approximately 90 percent of the variability of investment returns stems from asset allocation, leaving only 10 percent of the variability of returns due to security selection or market timing. 

Security Selection

Security selection is the process of constructing portfolios for each of the individual asset classes.  The process begins with the choice between indexing (or passive management) and active management. Indexing involves the replication of a particular market by holding all or substantially all of the underlying securities of that market, such as the S & P 500, Russell 2000, MSCI EAFE (Morgan Stanley Capital International, Inc. Europe, Australian and Far Eastern markets) and the Lehman Treasury Indexes.  These indexes typically represent the baseline or benchmark against which active managers are measured. 

Active management is the process of making security selections, or bets, that vary from the relevant market index.  Simply stated, active managers seek to beat the index by overweighting attractive securities and underweighting less attractive offerings.  The value of the active management process can be easily measured by comparing an active manager’s return against the return of an appropriate benchmark index to determine if the manager is adding or detracting from investment results.

When it comes to performance, most actively managed mutual funds have underperformed the relevant market index.  For example, according to Standard and Poors, 72% of US large capitalization mutual funds underperformed their index for the three years ended December 31, 2004.  Similar results were posted by their small and mid capitalization mutual fund brethren.

What are exchange traded funds (ETFs)?

ETFs are index funds or trusts that are listed on an exchange and can be traded intraday like a single stock. Each ETF is a basket of securities that is designed to generally track an index – broad stock or bond market, stock industry sector or international stock market. ETFs add the flexibility, ease, and liquidity of stock trading to the benefits of traditional index fund investing.

What are the advantages of investing with ETFs?

ETFs provide a great combination of diversification, lower cost and performance. 

Diversification

Because each ETF is comprised of a basket of securities, it inherently provides diversification across an entire index, such as the S & P 500 and the Lehman Treasury Indexes. Furthermore, the expanding universe of ETFs provides investors with exposure to a diverse collection of markets, including:
•    broad-based equity indexes (such as total market, large-cap growth, and small-cap value)
•    broad-based international and country-specific equity indexes (such as Europe, EAFE, and Japan)
•    industry sector-specific equity indexes (such as healthcare, energy, and real estate)
•    U.S. bond indexes (such as long-term Treasury bonds and corporate bonds)
By utilizing ETFs for portfolio construction, an investor achieves broad diversification at both the asset class and security selection levels.

Lower cost – annual expenses

Expenses can have a significant impact on returns for investors. ETFs, in general, have significantly lower annual expense ratios than other investment products. ETFs also generally have lower costs than traditional mutual funds. As a frame of reference, according to Morningstar, the expense ratio of the average domestic equity ETF is about 0.36% compared to 0.99% for the average equity index fund and 1.52% for the average actively managed equity mutual fund.

Lower cost - tax efficiency

ETFs, like index mutual funds in general, tend to offer greater tax benefits because they generate fewer capital gains due to low turnover of the securities that comprise the portfolio. Generally, an ETF only sells securities to reflect changes in its underlying index. Exchange trading of ETFs further enhances their tax efficiency. Investors who want to liquidate shares in an ETF simply sell them to other investors through exchange trading. Because of this unique structure, ETFs are not required to sell securities to meet investor cash redemptions as can often be the case in a traditional mutual fund, potentially generating capital gains tax liability for remaining investors.
Performance

ETFs address the problem of benchmark underperformance by active managers.  Numerous studies have shown that the majority of active managers have underperformed their benchmark indexes. The high rate of underperformance relative to indexes principally results from the expenses associated with active management. Furthermore, there are very few active managers who consistently outperform their benchmark indexes. So while it is possible to identify outperforming managers in hindsight, the difficulty lies in identifying such managers that will consistently outperform in the future.

Conclusion

With this background, it becomes very apparent that the growing popularity of ETFs by both institutional and retail investors stems from their innovation and their ability to fill a technology gap in existing investment products and services.  In the 1990 book "Unlimited Wealth:  The Theory and Practice of Economic Alchemy", Paul Z. Pilzer defined a technology gap as the difference between the best practices possible with current knowledge and the practices in current use.  Each day we are exposed to new technologies that meet these objectives and the pace of change is accelerating. 

For example, the rapid deployment of MP3 players and iPods represent a technological advancement in the distribution of music compared to compact discs, and their grandfather before them vinyl records.  More recently, we have seen the introduction of video iPods to challenge the traditional methods of distribution of video programming through television and other video media.  To achieve dominance in the consumer marketplace, iPods and MP3 players have to be more than just new, they have to be better than existing technologies.  MP3 players are generally viewed as better because they are cost effective, easier to use (efficient download and storage; mobile) and provide reliable performance (digital quality; no more skips or scratches). 

Like iPods, ETFs share the winning attributes of lower cost and greater efficiency and reliability as compared to existing products. As so aptly pointed out by David F. Swensen in his book "Unconventional Success: A Fundamental Approach to Personal Investment", ETFs offer retail investors the efficiency and performance reliability of distributed institutional investment management at very competitive prices.  Like other dominant technologies, ETFs will be a very disruptive influence on the retail investment advisory industry.  ETFs will not only be a competitive challenge to the traditional mutual fund industry, but will also improve how investment services are delivered to individual investors.  Informed retail investors will be increasingly resistant to current industry practices in which an investor essentially pays an adviser to sell them investment products and services.  There will be limited room for high sales loads or commissions for ETFs because part of the technology gap these products address is the efficiency of current investment product distribution and sales practices. 

Accordingly, the investment advisory industry is in the nascent phases of a dramatic, secular change toward advice driven, consumer focused investment advisory services and away from traditional sales driven business models.  The return reducing costs of sales and marketing activities together with the potential for benchmark underperformance from active investment management will increasingly give way to an information driven cost/benefit focus by individual investors. Look for more discussion on this paradigm shift in future articles.

As many of us have witnessed, truly, innovative technologies like iPods sell themselves at increasing adoption rates among consumers until cresting near full adoption.  It is probably no coincidence that the most popular family of ETFs from Barclays Global Investors is marketed under the iShares name. Today, assets under management of ETFs represent just a small fraction of the $8 trillion traditional mutual fund industry.  The adoption rate of ETFs is still in its infancy, but growing rapidly.  Like other big ideas, it is an opportune time to consider core portfolio construction using ETFs.  Who knows, maybe someday there will be podcasts about iShare investment products that you can listen to on your iPod.