Vanguard's New Indexes

Investment News carried an story on Vanguard's announcement that they are changing equity index providers from MSCI to CRSP (domestic and balanced) and FTSE (international).  The change in providers will reduce the licensing costs of using the indexes a bit, though I doubt that is the reason for the change (the recent reduction in fees by BlackRock and Schwab notwithstanding).  CRSP has the most comprehensive stock price data, and thus a more robust universe from which to construct its domestic indexes.  FTSE's indexes are expansive, though I am not sure how they compare to MSCI's.  ( The article does mention that FTSE assigns the Korean market to the emerging markets index, while MSCI relegates it to the developed markets index.)

Having worked with Vanguard for over fifteen years, I am certain that this change was studied to death before being adopted.  Some ten years ago, when Vanguard moved for the S&P and Russell indexes to MSCI's, issues of coverage and allocation were modeled for effect on risk and performance.  I expect that any differences in expected performance will be compensated with the reduced fees and reflective of any change in the risk profile.  Overall, I do not expect fund performance under the new indexes to diverge more than a few basis points per quarter from the performance of the old indexes, as adjusted for the an appropriate expense ratio.

An ETF Shakeout

So it's a shakeout of two minor players.  Investment News has the story that Scottrade and Russell will be exiting the exchange traded fund business. 

Scottrade's exit comes with a change in management.  Its $100 million in FocusShares will cease trading on August 17 and liquidate.  The funds had been introduced as a low cost provider, with expense ratios 1-2 basis points lower than Vanguard.  However, the funds never gained enough investor interest to create critical mass and justify their existence, either as a loss leader or asset management product.

The Russell funds were designed to replicate active strategies through passive replication.  The lineup included 26 funds which seemed to represent legitimate investment strategies.  Only one of the funds is m ore than 15 months old, so it is difficult to tell how well the funds have been representing their strategies.  Technically, Russell is conducting a strategic review, but IN is reporting that 30 related jobs have been cut.  Perhaps another fund family will pick up the funds, one that already licenses Russell indexes, such as iShares or ProShares.

Exchange Traded Product Ripe For a Premium?

JPMorgan's Alerian MLP Index ETN (AMJ) has issued its maximum shares, according to a story in Investment News.  As noted in the story, this turns the notes into a closed-end fund.  Now, advisors can expect the note to trade at a premium to NAV, reflecting a very generous yield.  However, that premium could just as easily and quickly disappear when oil and gas related properties fall out of favor.  Or, JPMorgan could just register additional units which would eliminate the premium in one fell swoop, as happened with Credit Suisse VelocityShares Daily 2X VIX Short-Term ETN (TVIX).  An opportunistic advisor would be looking for an alternative to AMJ and establishing a reasonable premium for exit.

ETF Trading 301

Financial Advisor magazine, via fa-mag.com, published a column by Stoyan Bojinov, a contributor to ETF database and etfdb.com.  In it he details three trading tips that ought to allow any advisor (or investor, for that matter) to improve trading results and lower trading costs.

1. When trading international funds, trade when the market for the underlying assets is open.  This increases the accuracy of the NAV quote, and improves the quality of the ETF quote in relation to the NAV.
2. Use limit orders to trade inside the spread.  the advice on ETFs has long been to trade only with limit orders.  This is suggested to avoid suffering severe haircuts that occur when electronic order systems encounter those moments when market makers are absent. Well, exchange traded funds also tend to have wider spreads than other securities with similar volume.  Placing a limit order inside the spread may entice a market maker to fill your order, and the with the cost being the potential for a few minutes delay and a few cents adverse movement in the price.
3. Inquire into upcoming distributions.  As Mr. Bokinov notes., ETFs are by their nature tax efficient.  However, some funds, notably leveraged and inverse ETFs, conduct a lot of trading in order to maintain the expected exposures.  This trading can lead to significant distributions.  As with traditional open-ended funds, it may make sense to defer a purchase or accelerate a sale in the face of an imminent dividend.

These tips are valuable reminders that a little bit of planning can create value for a client in even the most mundane task in the investment process.

A Quick Primer on Leveraged ETFs

Seeking Alpha had a short article on the mathematics of leveraged ETFs.  It has a demonstration of the classic upside/downside dichotomy (i.e. it takes 100% gain to overcome a 50% decline).  It also mentions, without going into detail, the effect of constant rebalancing to maintain the advertised leverage position.

What is not is that these two mechanisms conspire to frustrate the use of leveraged ETFs as a long term position.  the daily re leveraging of the portfolio exacerbates the tyranny of the upside/downside dichotomy. 
The portfolio sheds leverage after a decline in order to maintain its ratio, just when that leverage would work in the investor's favor in any reversion to the mean.  On the other side, while the portfolio naturally de-levers on an upside move, daily rebalancing adds leverage, to the portfolio's detriment when the markets mean-revert.  Thus, the observation that over a long term holding period, a leveraged ETF will tend to underperform the the underlying asset simply multiplied.

Supercharged ETFs

As I was catching up on my Forbes reading, I came across this article about leveraged ETFs.  Now I have shied away from any of the leveraged funds because their performance has confounded naive expectations.  For example, when a particular index would be up 20% one year, one would expect the 2x fund based on that index to be up 40%.  Experience showed us, though, that the fund might be up any where from 0% to 50%.  when the index registered a single digit gain, the fund may actually have lost money.  The key to the disconnect is in the mechanics of managing that leveraged exposure.  The fund rebalances to its leverage target every day.  That is the leverage on the initial NAV changes each day based on the cumulative gains realized since the inception of the investment.  Thus if the index experiences a 50% increase, the fund will take on 50% additional leverage, but the performance will still be calculated on the original investment.

Inn strongly trending markets this can actually work in the investor's favor, delivering performance that is greater than the advertised leverage.  In a directionless market with some volatility, the leveraged fund will tend to decline.  This result can be traced back to the mathematics of loss and gain that we all learned early on:  if an investment loses 50% of its value, it will take a 100% gain to break even.

The article acknowledges all of this and essentially says use them anyway.  I would recommend against using any of the leveraged funds, suggesting instead to use a brokerage account and buying your index tracking fund on margin.  The investor can maintain his leverage relative to his original investment, according to his own comfort.  Also, you can probably find a cheaper fund in which to invest.

Most Researched ETFs

Investment News published a list of the ten most researched ETFs, as compiled by Morningstar.  They were4 able to compile the list by tracking the number of times a fund's profile was accessed through Morningstar Advisor Workstation.  The top ten are:

1. iShares Barclays TIPS Bondsw (TIP)
2. iShares MSCI Emerging Markets (EEM)
3. SPDR Gold (GLD)
4. iShares MSCI EAFE (EFA)
5. Vanguard Emerging Market Stock (VWO)
6. iShares Barclays Aggregate Bond (AGG)
7. SPDR S&P 500 (SPX)
8. PowerShares DB Commodity Index Tracking (DBC)
9. iShares iBoxx $ Investment Grade Corp Bond (LQD)
10. iShares S&P U.S. Preferred Stock Index (PFF)

Only a couple of surprises here.   PFF is a pleasant surprise.  Preferred shares provide an attractive yield and are eligible for the 15% qualified dividend tax rate.  And its 7.40% yield dominates the 4.79% of LQD.  That there are three funds representing an inflation hedge theme (TIP, GLD, and DBC), with significantly different strategies and sponsored by three different management companies, is a testament to the sophistication of advisors today.

What this list indicates to me is that advisors are looking to ETFs to fulfill two roles in client portfolios:

1. Instant diversified exposure to a broad market or asst class; and
2. Easy liquid exposure to for highly specific portfolio enhancement (e.g. yield enhancement, inflation hedge).

These were the original objectives driving the development of ETFs at the turn of the century. As with open-end mutual funds, product extensions representing more narrow or arcane investment strategies are interesting, but will not be the main focus of the advisor community.

ETF Fees and Expenses

The Mad Hedge Fund Trader has posted a short commentary on hedgetracker.com.  His premise is that new entrants into the ETF space will break the monopoly of BlackRock, State Street and Vanguard.  He cites new offerings by PIMCO, Van Eck, and ProShares as competition that will drive costs down and improve profit margins for traders.

In general, competition will tend to put downward pressure on pricing of similar products.  That said, Vanguard and State Street are two of the lowest cost producers in the industry, and Barclays was one as well.  Since BlackRock picked up the indexing business of Barclays (including the iShares franchise), it seems that BlackRock will continue that business model.  On the other hand, PIMCO, Van Eck, and ProShares are not considered among the pricing innovators.  Don't expect them to lead a revolution in ETF pricing any time soon.