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Making Sense of the Explosion in Exchange Traded Funds
By Nancy Zambell, Contributing Editor
Rarely has the stock market encountered a phenomenon like exchange traded funds (ETFs). The first one – the SPDRs ETF, which tracks the S&P 500 – was introduced by the American Stock Exchange in 1993 and now holds assets of more than $79 billion.
But the real story is how much the market has soared in the last couple of years. According to State Street Global Advisors, at the end of 2007, there were 629 ETFs with total assets of $608 billion – a 45% increase just in 2007!
In their beginnings, ETFs were essentially index funds whose aim was to mirror the performance of an existing index. But because of their unique features, they caught on like wildfire with investors, and have since expanded to a mega-universe of ETFs that include sector, commodity, and coming soon – actively-managed vehicles.
ETFs hold tremendous advantages over the average mutual fund:
• Expenses are significantly less than most mutual funds. According to Morningstar, the least expensive ETF is Vanguard’s Total Stock Market (VTI), with a mere .07% expense ratio. When was the last time you saw a mutual fund with such low expenses? Although you should know that sector ETFs do incur higher expenses than the broad market index ETFs. And trading in ETFs do require a broker, albeit, a commission. However, the total expenses (unless you are an active trader – and if that’s the case – you shouldn’t be in ETFs), are, on average, much lower than the expenses of mutual funds investing in similar asset categories.
• Liquidity and transparency. ETFs can be traded all day long, instead of just once daily for mutual funds. With funds, you buy your shares at the end of the trading day, at the published net asset value (NAV). ETFs are continuously priced throughout the day. You buy and sell them just like stocks. That means you can get in and out of the ETF market at your convenience – not the fund’s. And unlike mutual funds, with ETFs, you can use limit orders; you can sell them short; and you can trade options.
• Less capital gains distributions. Investment turnover in ETFs is not as frequent as in mutual funds, lending themselves to lower capital gain distributions; hence, a smaller tax bite for most investors. Additionally, many mutual funds are forced to sell shares when they incur huge demand for redemptions (as the fund holders are selling their shares back to the mutual fund company), triggering tax consequences. With ETFs, there is a buyer for every seller, so the ETF itself is, most likely, not going to rack up huge tax bills that may come back to haunt you at the end of the year.
• No minimum investment for ETFs. Most mutual funds (unless in a retirement plan) will require a significant investment to start.
With these unique advantages, it’s no surprise that the industry has experienced tremendous growth. And while that gives investors many more choices for growing their funds, it can also be a double-edged sword – offering too many choices. After all, with more than 600 options, how does an investor pick the right ETF?
Additionally, one more adverse consequence is that so many ETFs are in the marketplace that some of them cannot attract enough investors to remain viable. Just this month, Claymore Securities announced that it is withdrawing 11 of its smaller ETFs from the market and Wall Street analysts expect more consolidation in the near future.
And unlike mutual funds that close their doors to new investors, while keeping existing customers, when ETFs shutter their doors, investors are liquidated. They get cash, which may be a loss or a gain, and that may trigger a taxable event. And of course, they then have to find an alternative investment for their funds.
So, what’s an investor to do? The answer is really fairly simple. Just as with any other investment – stocks, commodities, bonds or real estate – you need to do your homework.
To give you a head start, we’re going to tackle a few of the more popular ETF families, to give you an idea of the type of ETFs each has to offer.
Most investors know the Vanguard name, the venerable fund family that pioneered index mutual funds. Long known as a low-cost leader in mutual funds, Vanguard has earned the same reputation with its ETFs.
As you can see by the following chart, Vanguard easily beats its competition – on average – on its expense ratios. And you might also be interested to know that the company just further slashed expenses on a number of funds from 10-33%
Vanguard offers 37 select Vanguard ETFs, including the three new mega cap vehicles the company just introduced.
Its offerings include a wide range of ETFs:
1. Selected capitalization ETFs (small-, mid- and large-cap), including growth and value options for each cap level
2. Growth
3. Value
4. Extended market for small- and mid-cap stocks
5. Total stock market
6. Dividend appreciation
7. High dividend yield
For additional information on Vanguard ETFs, see their website at:
http://www.vanguard.com/jumppage/vipers/
Wisdom Tree joined the ETF industry in 2006, with 20 new products. Today, the company has some 40 ETFs.
Unlike most of the ETF industry, Wisdom Tree does not target market cap-weighted indexes. Instead, the company focuses on fundamentally-weighted indexes.
Here’s the difference. Market cap is simply the number of shares outstanding multiplied by the current stock price. When the index is market cap-weighted, it tends to overweight companies that are richly valued and underweight those with low valuations.
In contrast, fundamentally-weighted indexes are based on fundamental parameters such as revenue, dividend rates, earnings or book value. Wisdom Tree determines the weighting of their indexes by either the amount of cash dividends that companies in each index pay as well as earnings.
The company’s philosophy focuses on cash dividends because it believes that weighting by dividends can raise a portfolio’s dividend yield and also offer potential bear market protection as investors flock to companies that pay dividends during trying markets. Additionally, Wisdom Tree screens for profitable companies. It then weights the portfolios by earnings to lower their combined price-earnings ratio, which the company believes will result in above-market returns.
Wisdom Tree offers domestic, as well as international ETFs, classified by small-, mid- and large-cap companies, high yielding equities and dividend funds.
The company just launched the first India ETF, Wisdom Tree India (NYSEArca: EPI) that gives pure exposure to local Indian securities, and it is planning to shortly launch four new currency ETFs.
For more information on Wisdom Tree, please see their website:
http://www.wisdomtree.com/home.asp
PowerShares offers more than 100 ETFs that include a wide range of styles, industries, commodities, currencies, specialty access and broad market funds. The company is known for the tax-efficiency of its almost-actively-managed ETFs.
Its PowerShares QQQ (Nasdaq: QQQQ), which tracks the Nasdaq-100 Index, is one of the most traded securities in the world, with more than 165 million shares changing hands daily.
Additionally, PowerShares now sponsors the BLDRS (Baskets of List Depositary Receipts) family of ETFs, which offer exposure to international equities with low expense ratios. There are currently four BLDRS, representing widely-held ADRs (American Depository Receipts) including two market index funds and two regional index funds.
The company just announced the new PowerShares’ BuyWrite ETF portfolios, which will offer continuous access to a buy-write, or covered call, investment strategy on three of the most widely recognized U.S. market indexes. The ETFs are:
PowerShares DJIA BuyWrite Portfolio - NYSEArca: PGB
PowerShares S&P 500 BuyWrite Portfolio - NYSEArca: PBP
PowerShares NASDAQ-100 BuyWrite Portfolio – Nasdaq: PQBW
The company states that the portfolios are based on Chicago Board of Options Exchange (CBOE) BuyWrite indexes which, over the past decade have had at least 25% less volatility than related stock indexes.
And lastly, PowerShares also intends to shortly launch a new India ETF, the PowerShares India Portfolio, which will trade under the symbol PIN.
For more information on PowerShares, please see its website:
http://www.powershares.com/
iShares are owned by international financial behemoth, Barclays and hold more than 50% of the assets in the total ETF market. The company’s ETFs take an index or ‘passive’ approach to investing. The 40 sector and industry-group iShares attempt to mirror the returns of their target index less any fees and expenses. 22 of the industry iShares ETFs track Dow Jones indexes and 11 track S&P Global indexes.
The commodity-related iShares track price movements of the underlying commodity, such as gold or silver, and also include a broad-based commodity index.
The company’s ETFs include domestic and international indexes that focus on sectors, subsectors, regions, individual countries, market caps, value, growth and fixed income.
iShares just launched five new international ETFs that trade on the Nasdaq:
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iShares FTSE Developed Small Cap ex-North America Index Fund (IFSM)
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iShares FTSE EPRA/NAREIT Global Real Estate ex-U.S. Index Fund (IFGL)
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iShares FTSE EPRA/NAREIT Asia Index Fund (IFAS)
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iShares FTSE EPRA/NAREIT North America Index Fund (IFNA)
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iShares FTSE EPRA/NAREIT Europe Index Fund (IFEU)
For more information on iShares, please go to their website:
http://www.ishares.com/splash.htm
As with any investment, doing a little research prior to jumping in is imperative. I’ve found that Morningstar has become my favorite website for screening ETFs. On the site, you can screen for styles, expense ratios, performance numbers, etc.
www.morningstar.com
Additionally, Morningstar just added a Fair Value rating to their ETFs which I believe will be extremely useful as the industry ages and ETFs accumulate significant track records.
With ETFs, your two primary concerns – after determining the style factors – will be the expense ratios, and of course, performance. You will want to compare both metrics with similar ETFs before making your investment decision.
Fortunately, there are some excellent resources on the Internet to do just that. Two that I recently found are:
http://www.etftrends.com/files/02-29-08ETFReport.pdf
http://www.marketwatch.com/tools/etfs/html-top5.asp?siteid=mktw
Morningstar also offers you pre-built screens which track the best performing ETFs.
As always, take your time, decide what type of ETFs you want to own, then do a little research to make sure you are buying the best performing vehicles, at the lowest cost.
This concludes this week's issue of Financially Fit. We encourage you to visit our website to review past issues of Financially Fit:
http://www.brokeradviser.com/newsletter.cfm
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