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.
