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While not quite in the same league as "how many angels can dance on the head of a pin?", the question of whether to use index exchange traded funds or mutual funds to implement our model portfolios' asset allocations is getting close. Let's look at the arguments on both sides of this issue:
Exchange Traded Funds' supporters point to a number of this product's advantages:
(1) Unlike mutual funds, ETFs are continuously priced throughout the trading day, whereas mutual fund sales take place at the end of the day price.
(2) In theory, ETFs should be able to more closely track an index than a mutual fund. Both index ETFs and index mutual funds face the need to reinvest dividends and interest they receive on the securities they own. They both also need to adjust their holdings in response to changes in the companies included in the underlying index they track. However, because they are "open ended" mutual funds, index fund managers are also confronted with the need to provide liquidity to buyers and sellers of their fund's shares, which requires them to hold a percentage of their assets in cash. ETF managers don't have to do this, because purchases and sales of their funds' shares only take place in the secondary market (ETFs are closed end funds). Because they don't have to hold cash to provide liquidity, they should be able to track an index more closely than an index mutual fund.
(3) Because ETFs trade like a stock, an investor can employ a wider range of trading techniques with them, such as stop loss and limit orders, and short sales. Increasingly, futures and options are becoming available on the more liquid ETFs (e.g., as has happened with QQQs, which track the NASDAQ index), which creates more potential trading strategies.
(4) The operating expenses on many ETFs tend to be lower than on index mutual funds which track the same index, because ETFs don't provide the same level of service to their owners that mutual fund owners receive (e.g., telephone service centers, free fund transfers, check writing privileges, etc.). Consider three index investment vehicles which track the S&P 500: the first two are ETFs: SPY's expense loading is .12% (that is, 12/100 of 1%), while IVV's is .09%. The biggest mutual fund which tracks this index is Vanguard's (VFINX), which has expenses of .18%.
(5) Finally, supporters claim ETFs are more tax efficient. A mutual fund is an open ended investment company. When you sell shares in an index mutual fund, you sell them back to the mutual fund company. If offsetting buyers aren't available, the number of outstanding mutual fund shares is reduced, and some underlying shares in the companies that make up the index being tracked will have to be sold by the fund to finance the outflow of cash caused by the net redemptions. This sale of the underlying company shares triggers capital gains distributions for all the owners of the index mutual fund. In comparison, an ETF trades on a stock exchange; when you dispose of your ETF shares, you are selling them to other buyers, not back to a mutual fund company. As a result, a sale of the ETF shares does not have the potential to trigger a sale of the underlying shares in the companies that make up the index being tracked. In this manner, the potential for unwanted capital gains arriving on your tax return is minimized. This is not to say that ETFs never make distributions. When the composition of the index they track changes (as recently happened with the S&P 500), the ETF trust has to sell and buy shares, and this can trigger capital gains distributions. ETFs also receive dividends on some of the shares they own, which they may also distribute.
Supporters of index mutual funds often respond to these arguments with ones of their own:
(A) Operating expenses are only part of the story. When you buy an ETF, you also pay a brokerage commission, which you usually avoid when you buy an index mutual fund (which rarely carry front end sales loads).
(B) For people who dollar cost average -- investing an amount of money each month into the index fund or funds they own, the ability to avoid trading commissions makes mutual funds a much better deal over time (that is, the avoided sales commissions on ETF purchases more than offset the slightly higher operating expenses charged by the index mutual fund).
(C) If you are a long term, buy and hold investor (as many index fund investors tend to be), the ability to trade ETFs throughout the day, and to employ a wide range of trading strategies really isn't very useful.
(D) Mutual fund companies provide a range of services (e.g., a knowledgeable person on the other end of an 800 number to answer your questions) that many discount brokerages do not (this assumes that, in order to minimize sales commissions, people buy ETFs through discount rather than full service stockbrokers).
(E) In practice, many ETFs have had larger tracking errors versus the index than comparable mutual funds.
As you can see, there are good arguments on both sides of this issue. On balance we are agnostic -- we have concluded that the right index vehicle to use really depends on an investor's individual circumstances, and not on one or two arguments that apply equally to everyone.
Consider the case of an investor who is considering a single investment in either an ETF or a mutual fund that tracks the same index. Which one makes the most economic sense?
As you would expect, there are a number of variables at work. First, the size of the investment matters. Second, the difference in expenses between the index mutual fund and ETF matters. Third, the expected holding period matters. Any difference in tracking errors (assuming both funds track the same index) also matters. Finally, differences in taxes can be important if the investment is held in a taxable account. As we said, theoretically, tax treatment should favor the ETF. And with lower turnover in its holdings, the ETF should generate less investor-level taxes.
Because of the profusion of deep discount commission structures, we've approached this issue as a breakeven problem. Assuming no difference in tracking errors (which, as noted above, may not be a good assumption to make), and leaving the tax treatment aside (because in theory it favors the ETF), we calculate the present value of the expense savings, based on different holding periods. Since these savings are quite certain (i.e., the initial investment is known, as is the difference in expenses), we discount them at 3%, our estimate of the long term real risk free rate of return (we use real rates because we aren't including any inflation in our estimate of future expenses). If the present value of the future expense savings is less than the commission you would have to pay to purchase the ETF, you would be better off buying a no-load mutual fund that tracks the same index.
Here are three examples. First, let's assume a $1,000 initial investment, a 5 basis point (0.05%) difference in the expense ratios (in favor of the ETF), and a flat $10.99 commission at Ameritrade. Over all holding periods up to 20 years, you would be better off with the mutual fund (even at 20 years, the present value of the expense savings is only about $7). However, if the expense savings rises to 25 basis points, then you'd be better off with the ETF if you expected to hold it for six years or more. If the expense savings rise to 50 basis points per year, the ETF is a better deal if you expect to hold it for 3 years or more.
Next, let's increase the investment to $10,000. At 5 basis points expense ratio difference, you would prefer the ETF if you expected to hold it for three years or more. When the expense ratio rises to 15bp/year or more, you would prefer the ETF under all circumstances.
For a $100,000 investment, you always prefer the ETF. However, there are two other important points to keep in mind. First, we emphasize that this analysis is for a one-time investment. If you are making regular investments over time (and incurring commissions on each purchase), you may well be better off with the index mutual fund. Second, if the tracking errors were greater for the ETF than the mutual fund, this would reduce the relative attractiveness of the ETF, as it would effectively reduce, or even reverse, the difference in expense ratios.
Rising rates most likely means a bear market for fixed income ETFs. Although all fixed income ETFs have already suffered from the Fed tightening., if the Fed continues on its apparent course, tightening at every FOMC meeting, these funds face further downside risk in the weeks and months ahead. However, because of their fat coupons -- the high yields these ETFs provide -- as well as the continued domestic and foreign demand for bonds, especially treasuries, fixed income ETFs can be notoriously difficult (and expensive) to short. One alternative for an investor who believes that these ETFs are vulnerable to rate increases is to develop a hedged or short-long position in these funds.
Especially vulnerable to rising rates are ETF portfolios with longer durations such as the iShares Lehman 20 Year Treasury Bond Fund (AMEX:TLT) and the iShares Lehman 7-10 Year Treasury Bond Fund (AMEX:IEF). When rates rise, portfolios of bonds with shorter dated maturities such as the iShares 1-3 Year Treasury Bond Fund (AMEX:SHY) will likely suffer, but they should hold up better than ETF portfolios with longer dated maturities such as TLT and IEF. The reason for this is that an investor who owns longer dated issues has effectively locked in a given yield for a longer period of time. As rates rise, that yield looks less attractive. The chart below shows the performance of TLT, IEF, and SHY after a rate hike.
The chart above provides an example of how these three ETFs might react in an environment of rising rates -- ETF portfolios holding bonds with shorter duration outperforming those with longer duration. According to iShares, the effective duration of TLT is 12.87; the average maturity is 22.62 years. For IEF, effective duration is 6.44; average maturity is 7.75 years. For SHY, the effective duration is 1.62; average maturity is 1.7 years.
One way to take advantage of this phenomenon would be to short ETFs with longer duration and longer maturity such as TLT, and buy the ETF with shorter maturity like SHY.
Another possibility would be to develop a hedge position that combines government securities, like those held in TLT, IEF, or SHY, with an ETF that holds corporate debt like the iShares Goldman Sachs InvestTop Corporate Bond (AMEX:LQD).
One important reason to consider combining ETFs holding corporate and government debt is that they should behave differently in a rising interest rate environment. Yields on lower-rated debt, such as corporate debt, have historically risen more slowly on a percentage basis than yields on government debt. The simple reason for this is that corporate yields are higher than treasury yields. Typically, when the Fed raises rates and the yield curve shifts upward, the twenty-five basis point move is more important for a security with a 4.5% yield than a 9% yield. In fact, on a percentage basis, it might be expected that the shift in yield would be about half as important. An investor can expect that ETFs holding bonds with higher yield will have less interest rate related volatility than those with lower yields.
Investors attempting a hedge position using an off-set in corporate bonds need to be aware of credit spreads, the number of basis points that corporate debt trades above treasuries. Credit spreads have been decreasing for years and are historically tight. A significant risk with any position that involves a long position in corporate debt is the potential for widening credit spreads.
Although rising rates most likely mean a bear market for bonds, this does not mean there is no money to be made in trading bond portfolios. One idea is to sell short fixed income ETFs (which are portfolios of bonds), with the idea of profiting from their fall. However, because of the continuing domestic and foreign demand for safe investments as well as the high yields fixed income ETFs provide (and a short seller is expected to pay), selling fixed income ETFs short can be both difficult and dangerous. One alternative is to develop a hedged or short-long position in these funds that is neutral in respect to interest rate changes, but makes a bet on credit spreads.
A credit spread is measured in the number of basis points that corporate or non-treasury debt trades above treasury debt. US treasury debt is considered the safest investment in the world. As a result, an investor holding a treasury bond is paid a lower interest rate for holding that bond compared to bonds the market deems more risky, such as bonds issued by corporations. In times of fear, investors seek out the safest investments, and demand for treasuries increases. Investors are willing to pay a premium for owning treasury bonds and demand a higher percentage return for corporate bonds. When this happens, credit spreads widen. On the other hand, when investors become more confident that corporations will repay debt, credit spreads typically narrow.
Many credit spreads have not been so tight since before LTCM (Long Term Capital Management), the hedge-fund run by ex-Salomon Brothers bond trader John Meriwether, nearly brought down the world financial system in 1998 through betting, primarily, that credit spreads would narrow and market liquidity would increase. As the chart below shows, credit spreads have been decreasing since 2000 and are historically tight.
The above chart is the historical credit spread of B-rated industrial debt above treasuries. It has March of every year on the horizontal axis and the number of basis points this debt trades above treasuries on the vertical axis. The chart shows the sharp move upward in the fall of 1998 that ruined LTCM, reflecting the "flight to quality" during the Russian debt crisis. Two years later, in 2000, the even sharper spike reflects investors' move into treasuries as the equity markets collapsed and corporate scandals emerged. Since late 2002 credit spreads have narrowed considerably. B-rated industrial debt now trades about 300 basis points (3%) above treasuries.
How might an ETF investor make a bet on the direction of credit spreads? He could develop a combination of a long and a short bond position. If an investor expected credit spreads to widen he would want to own treasury debt and sell or short corporate debt. If he expected credit spreads to continue to narrow, he would want to make the reverse trade: long corporate debt and short treasuries. The iShares Lehman 20 Year Treasury Bond Fund (AMEX:TLT), iShares Lehman 7-10 Year Treasury Bond Fund (AMEX:IEF) and the iShares 1-3 Year Treasury Bond Fund (AMEX:SHY) are all ETFs with portfolios of treasury bonds. The iShares Goldman Sachs InvestTop Corporate Bond (AMEX:LQD) holds corporate bonds exclusively.
In order to make a bet purely on the credit spread, an investor would want to match bond maturity and duration as closely as possible. According to iShares, bonds held in LQD have an average maturity of 10.11 years, and average effective duration of 6.62. Among fixed income ETFs holding treasury bonds the duration and yield profile of IEF, which has an effective duration of 6.44 and average maturity of 7.75 years, is closest to LQD.
The historical credit spread chart above compares the ten-year treasury with high yielding B-industrials. The bonds held in the LQD portfolio, however, are mostly high grade debt, with, on average, A quality. The chart below, though similar to the above chart, shows the credit spread of of the higher grade A quality debt, compared to the benchmark 10-Year treasury.
Like the first chart above, this chart has time on the horizontal axis and basis points that highly rated corporate debt trades above treasuries on the vertical axis. This chart also reflects the "flight to quality" during the Russian debt crisis in 1998. The move up in 2001 reflects investors' move into quality after September 11th. Since September 11th, credit spreads have narrowed considerably. A-rated industrial debt now trades about 60 basis points (0.6%) above treasuries.
One note of caution for any investor who sees an opportunity to be long on treasuries and short on corporate debt: historically, credit spreads have narrowed in environments of rising interest rates. There may be less risk of this now due to the already historically tight credit spreads shown in the charts above.
Using ETFs to make a bet on the direction of credit spreads is somewhat difficult, because the only fixed income ETF focused on corporate debt has a portfolio of high-grade corporate bonds. Making a bet on the direction of credit spreads will become easier with the introduction of an ETF focused on the typically more volatile high-yield bonds. Since eventually there will likely be ETFs offered for every major financial product, it is only a matter of time before using ETFs to make bets on the direction of credit spreads becomes a common strategy.
Small cap ETF enthusiasts can target growth or value companies within the small cap universe. The iShares S&P 600 SmallCap/Barra Growth (AMEX:IJT) and iShares S&P 600 SmallCap/Barra Value (AMEX:IJS) are two funds which provide such precision with a unique methodology.
These funds divide the small cap world purely by the ratio of their stock price to book value. The half of the sector with high P/B is growth, whereas low P/B is value. Proponents say it is the best means of separating stable, lower growth stocks well from riskier but potentially more lucrative ones. This system is not based on earnings (such as in the Price/Earnings ratio), and it turns out that the funds have similar average P/E ratios. Their Price/Book value, however, differs significantly:
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Fund |
Price/Book Value |
Price/Earnings |
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IJT (Growth) |
5.34 |
17.68 |
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IJS (Value) |
1.72 |
16.69 |
The two funds nonetheless correlate substantially. In the last year, both have climbed over 50% (as of March 2004) in a rebound after a prior sharp fall:
The above graph provides two lessons. First, these two funds are sufficiently alike that an investor can choose one for exposure to small stocks without concern of lack of diversification. Second, they are both risky, high reward funds. This is no surprise, as small stocks have historically outperformed large ones but with greater swings. Clearly the best time in recent history to jump into either fund was in early spring of 2003. The time of easy money has passed.
At first glance, book value seems like an odd choice for dividing the market. Book value is the net asset value of a company, calculated by subtracting liabilities and intangible assets such as goodwill from total assets. It's essentially the liquidation value of a company. Why is a balance sheet accounting figure of a company's breakup value being used for investment analysis where there is no intent to break a company up? After all, earnings (an income statement item) are the primary long-term attraction for investors.
The reason book value is popular is that it helps explain variability in average stock returns extremely well. Eminent economists such as Eugene Fama and Kenneth French tout it as the most revealing measure. It is harder to fudge than earnings and tends to be quite stable, leading to an index with low turnover. This is critical for funds that follow it because it lowers transaction costs.
A lively debate surrounds the merits of value vs. growth. Research in the late 1980s and 1990s found that value companies give higher returns at a given level of risk, but more recent research suggest that capitalizing on this is nearly impossible because value companies have more tightly held stock.
Barra, Inc., an institutional investment advisor and index provider, helps manages the index with Standard & Poor's. Price/Earnings ratios will likely remain the more common method of separating value and growth, but book value is perfectly valid.
Putting together a diversified portfolio that makes sense is the true challenge for any investor. As a starting point, we present four model portfolio families for various investor philosophies and personalities. Some individuals like to keep things simple, others like fine-tuning.
Within the model portfolios, the degree of expected risk may be modified by modifying the equities vs. bonds split. Typically, investors shift their portfolios into lower-risk securites such as bonds as they grow older or near their retirement goals.
It doesn't get much simpler than this - one total domestic market stocks and one total market bonds component. It's the perfect approach for the investor who wants to buy, hold, and forget about their account. Note there no emphasis on growth or value, and none on large vs. small cap, but all securities are US.
Remember these are one of several portfolio families we profile and should be assessed for fit with the investor. Allocations based on age are typical and assume an intermediate risk profile.
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Investor age |
Wilshire 5000 or Russell 3000 allocation |
Bond index allocation |
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<25 |
< 80%> |
< 20%> |
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25-35 |
70% |
30% |
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35-45 |
60% |
40% |
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45-55 |
50% |
50% |
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55-65 |
40% |
60% |
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65-75 |
30% |
70% |
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75+ |
20% |
80% |
This portfolio is similar to the basic domestic stock/bond split, but this time we add a broad international index fund for further diversification.
Remember these are one of several portfolio families we profile and should be assessed for fit with the investor. Allocations based on age are typical and assume an intermediate risk profile.
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Investor age |
Wilshire 5000 or Russell 3000 allocation |
MSCI EAFE allocation |
Bond index allocation |
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Young |
50% |
30% |
20% |
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Middle age |
40% |
20% |
40% |
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Retired |
30% |
10% |
60% |
The idea here is to lay down a core total market stock component (every public company in the US weighted by its capitalization) and explore by overweighting certain asset classes that appear undervalued. Core and More portfolios can take on many shapes and sizes depending on which asset classes are overweighted. Below we present a portfolio that overweights a hypothetical portion of the market based on company size and an industrial sector.
All portfolios should be assessed for fit with the investor and are intended as a conceptual framework. Allocations based on age are typical and assume an intermediate risk profile.
|
Investor age |
Wilshire 5000 (Total Stock Mkt) |
Russell X000 Index |
S&P XX Sector |
Total Bond Market |
|
<25 |
40% |
20% |
20% |
20% |
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25-35 |
35% |
17.5% |
17.5% |
30% |
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35-45 |
30% |
15% |
15% |
40% |
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45-55 |
25% |
12.5% |
12.5% |
50% |
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55-65 |
20% |
10% |
10% |
60% |
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65-75 |
15% |
7.5% |
7.5% |
70% |
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75+ |
10% |
5% |
5% |
80% |
This portfolio is a very simple interpretation of slice and dice, with large caps coupled with small value. "Slice and dice" refers to the practice of ignoring large portions of the market and by default overweighting elsewhere. This portfolio deviates from the total stock market approach by concentrating exclusively on value stocks, a popular approach among the passive indexing crowd. They argue that value company stocks offer slightly higher long-term returns at much lower volatility. They also question the benefit of holding medium-sized companies, since many historicial studies show similar returns to large companies (such as in the S&P 500) with higher volatility. Small growth companies in particular are questioned for their indifferent performance and high volatility.
All portfolios should be assessed for fit with the investor. Allocations based on age are typical and assume an intermediate risk profile.
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Investor age |
S&P 500 Value |
Small Value |
Bond index |
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Young |
60% |
20% |
20% |
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Middle age |
45% |
15% |
40% |
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Retired |
30% |
10% |
60% |
The suite of indicators MarketVolume™ provides was designed to satisfy the needs of every type of investor. They have indicators for specific sectors and indexes that satisfy trading styles from day trading and swing trading to long-term investing
MarketVolume's Exchange Volume indicators are excellent tools for investors to know where the whole market is going. Their signals are accurate portrayals of the market
The Exchange Volume indicators are the result of technical analysis based on the combined volume of all stocks in particular exchanges. To give you signals of market change as easy understandable charts, they analyze—in real time—over 11,000 stocks on the NYSE, NASDAQ, and AMEX exchanges
The New York Stock Exchange (NYSE), the largest equities marketplace in the world, is home to about 3,000 companies worth more than $17 trillion in global market capitalization. MarketVolume's New York Stock Exchange Indicator combines the volume for all NYSE traded securities on a minute-by-minute basis and then apply volume technical analyses to our JavaVolume™ Charts. This becomes the NYSE Volume Indicator, an ideal indicator for predicting future index trends.
When interpreting the chart above, you need to remember that the most important factor is the relationship between Index Price and the Volume Moving Average (VMA). These two signals are excellent longer-term indicators of where the market is heading. In the first example we see that the index has been trending down for over a week, and that the VMA during that period has been steadily increasing. This steadily increasing VMA signals that there is a lot of buying pressure and that the market will change direction. The peak of the VMA signals that the market will take this new direction. On the second signal we can see that the market did change direction substantially and that the only reason for an increasing VMA here is profit-taking. This profit-taking will cause the index to change direction again until there is renewed buying pressure in the future.
Below is an example of how one of our exclusive institutional investors used this signal for the index to maximize profits by trading some of the derivatives of the NYSE index:
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Security |
Return |
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Listed below are some of the derivatives which you can trade using this indicator:
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Securities |
Issuer |
Type |
Symbol / Root |
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CBOE |
Options |
NYA |
By trading index securities using our volume indicators instead of stocks, you gain stability and predictability that stocks do not have. An index is a far more logical in it's actions than the individual stocks it's based upon.
When interpreting the chart above, you need to remember that the most important factor is the relationship between Index Price and the Volume Moving Average (VMA). This charts is an excellent example of a signal that confirms the bottom in the index. As the index was trending down from 13:30 , we see a very large increase in the VMA; this is a signal that the index should change direction after the peak and begin to go up. In this case, after the peak the index did not go up, but it continued to go down. This new downward trend is still accompanied with an elevated VMA (as the VMA never returned to normal levels), and that signals that this market bottom is going to be a long-term resistance level and that it is safe to play up.
Below is an example of how one of their exclusive institutional investors used this signal for the index to maximize profits by trading some of the derivatives of the NASDAQ Composite index:
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Security |
Return |
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When interpreting the chart above, you need to remember that the most important factor is the relationship between Index Price and the Volume Moving Average (VMA). Here we see that the index has been trading down for almost 2 days, and at the end of those two days the VMA begins to increase substantially. This sharp increase signals that a bottom has been reached and that professional investors are buying. Once the VMA has peaked, that signals the safest point in which to make a trading decision, as it is here that the index has confirmed a new upwards trend.
Below is an example of how one of our exclusive institutional investors used this signal for the index to maximize profits by trading some of the derivatives of the AMEX index:
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