Conducting Effective Etf Researchconducting Effective Etf Research

In a post last week we began the conversation about Exchange Traded Funds (ETFs)

and described some of their general characteristics and differentiating features from mutual funds. ETFs can be an important part of your investment portfolio. Since they trade like common stocks they are as easy to buy and sell as any other stock through your broker or online trading system or however you manage your investments. They dont come with multiple share classes or layers of fees and expenses like mutual funds and because they are passively managed vehicles the management fee component tends to be lower than that of mutual funds. Finally, because ETFs offer you direct access to numerous investment styles, industry sectors, asset classes and geographic locations, they are very useful as an asset allocation tool in constructing risk-efficient, diversified portfolios. We will be talking more about asset allocation in forthcoming blog posts. The purpose of this discussion is to set a foundation for conducting effective ETF research and understanding the risks, returns and trade-offs from alternative ETF strategies.

In a sense ETFs are like mutual funds in that they are pooled vehicles containing multiple assets; in another sense they are like common stocks because they trade continually in the intraday market on securities exchanges. In another sense they are manifestly different from both mutual funds and stocks, and these differences matter from a research standpoint.

Not an actively managed mutual fund

With the exception of the index fund variety, most mutual funds tout the investment skills of the fund management team as one of the key selling points, and the point of having a team of ace professionals is to beat the market. Actively-managed funds will advertise how decisively they outperformed the S&P 500, or the Barclays Corporate/Government Bond Index, or the Nikkei 225 Japan Index. So clearly a big part of the research one conducts on such a mutual fund is on the fund managers themselves what qualities and strategic mindset make it likely that they can consistently beat the market?

That is not a central feature of ETF research. Lets consider for arguments sake two contrasting vehicles: the iShares Russell 1000 Value Index (IWD) and the BlackRock Large Cap Value Fund (MDLVX). The Black Rock Large Cap Value Fund is an active fund managed by Robert Doll, a seasoned investor with a long track record of active fund management. If you invest in MDLVX you are in no small part investing in the skills of Doll and his team of portfolio managers and analysts. This team is fishing in the pool of large cap value stocks (i.e. the Russell 1000 Value Index) and taking positions in a relatively small number of those stocks deemed to be attractive by the metrics of their investment strategy. According to the investor factsheet for MDLVX the fund currently holds 107 stocks. For this expertise you are paying a management fee of 1.40%.

By contrast, the entire purpose of the exchange traded fund IWD is to replicate the Russell 1000 Value, not to beat it. When you look at the performance of IWD what you care about is how closely the performance of the ETF mirrors that of the benchmark. For example as of 6/30/10 the 1 year return of the Russell 1000 Value Index was 16.92%, and for IWD the return was 16.75% (and bear in mind that returns for ETFs, as for mutual funds, are generally presented net of fees). The 5 year return was likewise: -1.64% for the index and -1.73% for the fund. For this convenience in obtaining a proxy for a market benchmark you are paying 0.20% in management fees.

Interestingly iShares, one of the leading ETF firms and the operator of IWD among many others, was recently acquired by BlackRock from Barclays and now coexists alongside Bob Doll and his colleagues.

The benchmark is what matters

Since with an ETF you are effectively buying the underlying benchmark, what matters is how well you understand the benchmark, and this really is where the research focuses attention. Benchmarks can be as broad or as narrow as you wish for example the whole US stock market (something like the Russell 3000 Index is a good proxy) or the engines of global growth (there is an ETF that tracks the MSCI BRIC Index of Brazil, Russia, India and China). As you get into the exercise of researching and understanding the performance of different benchmarks you will start to think about how they relate to your own investment objectives how much return you are seeking over defined time periods and what kind of risk you feel comfortable assuming along the way. This is the beginning of understanding the art and science of asset allocation. As I noted earlier in this post, ETFs can be an efficient and effective tool for asset allocation, and this will be a topic for one of our posts in the very near future. For more information please Visit : www.jemstep.com

by: Jem Step

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