Ten New Year’s Resolutions for ETF Buyers
01/03/2011 10:33 am EST
With 2011 just around the corner, ‘tis the season for pledges to better everything from health to wealth to happiness in the coming year. Below, we offer up ten New Years’ resolutions for ETF investors looking to cut expenses, round out their portfolios, and maximize returns in 2011.
10. Slim Down Your Expense Ratios
If you’ve already made the jump away from pricey active mutual funds to more cost-efficient ETFs, our Mutual Fund to ETF Converter might not be of much use. But just because you’ve embraced ETFs in an effort to become a more cost-conscious investor doesn’t mean that you’ve done all you can to trim your expense ratio. Some of the gaps between expense ratios of similar or even identical ETFs are wide enough to drive a truck through, meaning that there may be opportunities to slash expenses by a few basis points (or put another way, a zero-risk way to improve bottom-line returns). Consider the following all-ETF model portfolio, which works out to a weighted average expense ratio of 32 basis points:
This portfolio might seem like a model of cost efficiency, charging an effective expense ratio that is only a fraction of the fees a similar portfolio comprised of actively managed mutual funds would rack up. But don’t pat yourself of the back just yet. Using ETFs linked to nearly identical indexes, it’s possible to slash expenses by more than 50%:
9. Stay Up-to-Date on New ETFs
The last year has been a period of record expansion for the ETF industry; more than 200 new ETFs, ETNs, and other exchange traded products have launched during the last 12 months, bringing the total lineup to nearly 1,100 funds. Among the new ETFs to debut this year are products that may be appealing to all types of investors. Many of the new ETFs now launching offer hyper-targeted exposure or access to advanced investment strategies.
For example, the UBS Long/Short VIX ETN (XVIX) or various leveraged products might not have much use for buy and holders, but can be extremely powerful tools for short-term traders. On the other hand, the cost-efficient Vanguard ETFs linked to the S&P 500 and other popular domestic and international equity benchmarks could be a big deal to those with a longer-term focus. But with an average of nearly one new ETF every trading day in 2010, keeping track of all the options can be a bit tricky.
In addition to the launch of more than 200 ETFs in 2010, the product pipeline has continued to fill with innovative and intriguing ideas for new funds. That means that 2011 should be another active year on the product development front, and that keeping up on all the various ETF options isn’t going to get any easier. Fortunately, there are a few easy (and cheap) options for staying up-to-date on all that the ETF industry has to offer. Our free ETF newsletter covers all new product launches, as well as many of the filings made for proposed funds. The monthly roundup posted on the first of each month gives a quick rundown of the new additions to the space over the previous 30 days, while the ETF Edge newsletter offers a more in-depth look at the investment thesis behind all of the new ETFs on a monthly basis.
NEXT: Drop this Screening Habit in the New Year|pagebreak|
8. Drop the Bad Habit of Liquidity Screening
When seeking to identify the exchange traded products consistent with an idea or strategy, the first step taken by many investors is to narrow down the universe of potential securities based on assets under management or screening volume. While different investors have different thresholds, the most common rules of thumb seem to imply that an ETF offers sufficient liquidity if it trades at least 100,000 shares daily or has at least $100 million in assets under management (AUM). A common fear among investors relates to getting stuck in an illiquid security and having to pay a premium to exit the position.
For certain securities, such as individual bonds or small cap stocks, implementing liquidity screens makes a lot of sense. But there are several misconceptions about the liquidity of ETFs and the usefulness of filtering out low-volume funds. Because shares of an ETF can be created or redeemed by certain market participants, these securities are capable of what is often called “spontaneous liquidity,” meaning that historical trading volumes aren’t necessarily indicative of the true liquidity of an ETF. In reality, the liquidity of exchange traded products is derived from the liquidity of the underlying assets, a relationship that is clearly lost on many investors.
Implementing liquidity screens isn’t necessarily hazardous to your portfolio’s health, but it may result in the exclusion of products that would otherwise be effective and efficient tools for accomplishing a given investment objective. Paul Weisbruch of Street One Financial sums up the flawed logic behind liquidity screens quite nicely:
“In essence, these ‘rules’ address ETFs and ETNs as if they were individual small cap stocks from a feasibility of trading standpoint and largely this practice of installing such screens is akin to investing with ‘blinders’ on. And in a world of increasing ETF usage, limiting your strategies due to embedded misconceptions regarding ‘trading volume and liquidity’ simply handcuffs your overall performance and competitive ability because in order to keep pace with peers, one must often venture into new strategies as they become available or at least have the capacity to be nimble where necessary.”
7. Fill in Those Portfolio Holes
The rise of the ETF industry has simplified the asset allocation process for many investors, making it possible to construct a balanced portfolio with only a handful of individual securities. But while establishing comprehensive exposure to stocks, bonds, and even commodities seems straightforward, many investors overlook some potentially valuable asset classes when constructing a portfolio. Consider the following all-ETF portfolio:
At first glance, this allocation might look pretty good, covering all the major asset classes in a relatively cost-efficient manner. But upon further review, there are some major omissions from this portfolio:
Of course, filling these “portfolio holes” is relatively easy with ETFs, as there are multiple options to choose from for many of these categories.
NEXT: Learn to Take Advantage of Free ETF Trading|pagebreak|
6. Take Advantage of Free ETF Trading
When discussing the advantages of ETFs, there is a pretty good chance that the issue of expenses is going to come up. And when it does, the discussion will likely focus on expense ratios, the annual management fees charged by the fund manager. But in reality, expense ratios are only one component of the total cost equation, and cost-conscious investors can do a lot more to enhance their bottom line than simply minimizing management fees.
For high-turnover investors, trading commissions incurred when buying and selling can add up quickly and can end up making a significant contribution to total expenses. Fortunately for ETF investors, online brokers are desperate to attract ETF investors and have begun offering competitive commission-free trading programs to entice them. Schwab and Vanguard both offer commission-free trading on their ETFs, while iShares has partnered with Fidelity on a platform that includes free trades on 25 of the largest iShares funds.
In our opinion, the commission-free ETF platform offered by TD Ameritrade is by far the most robust. More than 100 exchange traded products from multiple issuers were selected by the ETF team at Morningstar, giving investors access to a wide variety of asset classes and investment strategies (though we wish a physical gold ETF such as IAU would have been included). But for investors who are paying up to $10 for each ETF trade they execute, embracing any of these commission-free programs is an easy way to reduce expenses and enhance returns in the new year.
5. Rethink Your Commodity Exposure
After huge inflows in 2009, this year has seen interest in commodity products wane a bit–a somewhat surprising development given the huge gains delivered by these products. Part of the issue may be frustration with the performance of futures-based products relative to a hypothetical “spot return.” Returns to futures-based products depend not only on the change in spot prices, but on the slope of the futures curve as well. When futures curves are sloping upward, investors in commodity ETFs are essentially running into the wind, with a “contango drag” eating into returns.
For investors who embraced commodities as an asset class capable of smoothing overall portfolio volatility, coming up with a “contango-free” option is the Holy Grail. And thanks to ongoing innovation in the space, there are now some creative products that may offer considerable advantages over the “first generation” of commodity ETFs.
One is the United States Commodity Index Fund (USCI), a product linked to an index that utilizes price and momentum factors to construct a balanced basket of futures contracts. USCI is based on a ton of academic research, but the investment thesis behind the product is relatively simple. The theory is that the slope of the futures curve can provide some insights into the inventory levels of various commodities; when inventories are low, users of the commodity may be willing to pay a premium for owning spot relative to long-dated futures, creating a “convenience yield” that leads to a backwardated curve.
USCI is a relatively new fund—it launched in August—so the performance data is somewhat limited. But during its brief history, USCI has outpaced other broad-based commodity products by a wide margin. USCI was recently up about 27% since inception; the PowerShares DB Commodity Fund (DBC), which has some $5 billion in assets, was up about 17% during that same period. Again, it’s important to keep in mind that those figures reflect less than six months of actual results, but the early returns to USCI have been pretty good. If you’re in the market for commodity exposure or looking to make a switch from a different product, USCI might be worth a closer look.
NEXT: Balance Your Emerging Market Exposure|pagebreak|
4. Balance Your Emerging Market Exposure
Emerging markets have been one of the compelling stories of the last few years as the world’s developing economies have expanded at a tremendous clip while many “advanced” countries struggle to overcome rising unemployment and ballooning debt burdens. Many investors have increased allocations to emerging markets, a reaction to a widening growth gap between developed and developing markets (coinciding with an apparent narrowing of the risk gap).
Not surprisingly, many investors have embraced ETFs as a preferred tool for accessing emerging market equities. By far, the two most popular products are the iShares MSCI Emerging Markets Index Fund (EEM) and the Vanguard Emerging Markets ETF (VWO), which have combined assets of about $90 billion and are both linked to the MSCI Emerging Markets Index. EEM and VWO are excellent products. They offer exposure to a broad basket of stocks in a number of different markets, including some of the most profitable and fastest-growing companies in the world. But they shouldn’t be a one-stop shop for emerging markets exposure; there are a handful of other ETFs that can be used to complement these ultra-popular options:
3. Consider a New Weighting Methodology
If you achieve equity exposure through an ETF, chances are at least one of the funds you own is linked to a market-capitalization-weighted index. Most equity ETFs are, simply because many of the best-known equity benchmarks are cap-weighted, meaning that weightings to individual securities are determined based on the value of components’ equity (market capitalization is equal to shares outstanding multiplied by price per share). But some investors have expressed concerns over the methodology used to construct and maintain cap-weighted indexes. Because there is a direct link between stock price and the allocation an individual security receives, there is a tendency to overweight overvalued stocks and underweight undervalued stocks.
There are a number of equity ETFs linked to indexes constructed using various other weighting methodologies, including equal-weighted and dividend-weighted funds. Generally, there will be considerable overlap between these funds, with the weighting strategy being the primary difference. And while this may sound like a relatively minor twist, the impact on bottom line returns can be material.
Through December 21, a review of the various large cap domestic equity funds showed the ultra-popular SPY—linked to the cap-weighted S&P 500—to be the laggard. And the considerable gaps between alternative products—the equal-weighted RSP had beaten SPY by about 500 basis points—clearly shows that the weighting methodology can have a big impact on bottom-line returns:
Some investors likely stick to cap-weighted indexes because they are familiar and easy to grasp. And it’s important to keep in mind that the performances in the table above reflect a relatively limited period of time. But clearly, the impact made by the weighting methodology can be significant and is perhaps worth closer consideration when making asset allocation decisions.
NEXT: Time to Rethink Exchange Traded Notes (ETNs) |pagebreak|
2. Rethink Exchange Traded Notes (ETNs)
When many of the world’s largest financial institutions were pushed to the brink of collapse during the recent recession, the effects were felt throughout the investing world. Bailouts to Wall Street banks were a subject of intense debate and tremendous controversy, and new related businesses felt the pinch of increased regulatory scrutiny and investor anxiety. And interest in exchange traded notes, a cousin of the ETF, suddenly (and understandably) declined.
ETNs are debt instruments issued by financial institutions, such as Barclays, UBS, and Credit Suisse. But instead of making interest payments based on a fixed or floating rate, payments to investors are linked to the return on an underlying index. As a result, ETNs generally don’t exhibit tracking error that can plague ETFs, since the return to investors is simply calculated based on the change in the specified index. The downside, however, is that ETNs expose investors to credit risk. Whereas an ETF represents a fractional ownership interest in a basket of securities, an ETN is a debt instrument backed by the credit of the issuing institution. If the bank that issued the debt goes belly up, ETN investors get in line with the rest of the creditors (ETNs are generally senior unsecured debt securities).
There may be additional advantages to exchange traded notes as well. These securities can be more tax-efficient means of accessing commodities and can offer advantages for master limited partnership (MLP) exposure as well. There are even ETNs that may make trend following more efficient from a tax perspective, perhaps offsetting any credit risk for certain investors.
The credit risk inherent in ETNs should never be written off (Lehman Brothers was once an ETN issuer), but the improved financial footing of big banks has no doubt lessened the risk of utilizing these securities. For some investors, ETNs might not make much sense. But for others, they may be a quick and relatively easy way to improve tax efficiency, reduce tracking error, or establish exposure to asset classes and strategies not readily available through other securities.
1. Take Advantage of Free ETF Tools
Navigating the ETF world continues to become a more challenging task with each new product launch and wave of innovation. Fortunately, there are a number of free tools designed to help ETF investors find the funds that are consistent with their investment objectives:
By Michael Johnston of ETFdb.com