Publications

ETF's Have Expanded Investors' Indexing Options

Dayton Business Journal - March 2006
Expert Advice Column by Kathleen A. Carlson

Indexing has either gotten a whole lot easier or a whole lot harder, depending on your viewpoint, with the introduction of hundreds of exchange traded funds - ETF's for short. In case you've been lost in space for the last 24 months and missed the invasion, ETF's are mutual funds that are traded on an exchange just like a stock. Typically, a fund is composed of a basket of stocks designed to mirror the performance of some segment of the market like healthcare stocks, large value stocks or Australian stocks.

There are a couple of basic portfolio principles index funds were created to address. Investors will include index funds in their portfolios as a hedge against underperforming a market segment. Statistics have supported the concept that, over the long-term, the return of a market index will exceed the average return produced by active management. A review of some performance measures would bear this out.

The Vanguard Group's offering that mirrors the S&P 500 index is one of the oldest and most widely used index funds. The Vanguard 500 fund was up 4.8% in 2005, which ranked in the 61st percentile for funds in Morningstar's Large Blend classification - blend of large cap value and large cap growth stocks. This means that 60% of the large blend funds provided higher returns than the Vanguard 500 Index and 39% provided lower returns. During this one-year period, the Vanguard fund underperformed the average for the market segment. If we lengthen the measurement period, the drag of higher fees, trading costs and missteps by managers start to weigh on the actively-managed average. The Vanguard 500 Fund ranked in the 41st percentile over the last 3 years, and with its slightly positive return of 0.4%, it ranked in the 44th percentile over the last 5 years.

The results aren't confined to just the large cap segment. Barclay's, a U.K. - based financial services conglomerate, sponsors a number of ETF's designed to track the performance of several Russell indices. The Russell 2000 Value ETF mirrors the performance of an index composed of 2000 small cap, low-priced stocks. It was up 4.5% in 2006. The return ranked in the 71st percentile of Morningstar's small value fund category. Over the last five years, the Russell small value ETF had a 22.9% annualized return, which put it in the 38th percentile.

Barclay's has ETF's for all nine size/value segments made popular by Morningstar. They are listed under the "iShares" brand name. Only the ETF designed to match the performance of the Russell large growth segment provided a return that ranked below the 50th percentile for the last three years. The mid cap blend ETF was the best, posting a three-year annualized return of 23.6% and a 13th percentile ranking. With these kinds of results, we can see why investors have so eagerly embraced them. If there's a broad market segment you're interested in tapping, including international markets, there's a good chance there's an ETF available to access it.

On the other hand, a problem sometimes occurs when trying to use ETF's to invest in the more narrow industry sectors. Studies have indicated that as much as 85% of a stock's return can be explained by the return of its industry. For example, National City Bank's stock price will rise or fall around the same magnitude as the average change in the price of a domestic bank stock. A small part of National City's volatility will be explained by factors unique to its business. Investors, accepting this second portfolio principle, who want to trade industries as a means of implementing their big-picture strategies may use industry-specific ETF's.

Investors buying the Oil Service Holders, sponsored by State Street Global Advisers (SSGA), because they believe oil prices will rise to $75 per barrel are looking for the entire industry to benefit from the trend. They want to capture the industry return. If they chose to invest in only one oil service stock, the company-specific risk could lead to above average or below average results. An ETF full of oil service stocks is a lower risk way of investing in the trend.

In example above example, I created a scenario for a fairly narrow industry sector that was created by SSGA. Oftentimes, we are not so lucky. Recognizing the aging of the baby-boom population, investors may want to invest in the healthcare sector. SSGA has a Healthcare Holder, but traditional pharmaceutical companies like Merck and Pfizer make up 30% of the fund. While the pharmaceutical industry will benefit from more demand from the aging boomers, investors are questioning how much of the demand will increase the companies' bottom lines because of their nearer-term problems like drugs coming off patent or pricing pressures.

Investors interested in buying industry-specific ETF's need to look at the holdings of the fund to be sure they are getting the kind of exposure they desire. Medical diagnostic or equipment makers may be a purer way to benefit from the trend. Anything with the word 'noninvasive' should perform great! However, the ETF industry hasn't yet evolved to create such a specialized fund. It's only a matter of time.