Michael Krause, President of AltaVista Independent Research, has an excellent exchange traded fund (ETF) service. Recently he came out with some opinions regarding the evaluation of ETFs. He raises some good questions and makes some points including:
- ETFs are evaluated like Mutual Funds, but that is a problem
- Need to use forward-looking measurements, like fundamentals
- ETF fees are irrelevant
ETFs: A Fundamentally Different Approach
Why the Warmed-Over Mutual Fund Approach is the Wrong Approach
by Michael Krause
President, AltaVista Independent Research
January 22, 2007.
When the world’s first exchange traded fund, the S&P 500 SPDR, was listed over a decade ago, things were simpler. People were broadly familiar with the S&P 500 index, and assuming an investor had already decided to try to track the index, explaining the advantages and disadvantages of the ETF structure versus that of a comparable index mutual fund was sufficient as far as ETF analysis was concerned.
Since then, however, the number of ETFs available to investors has exploded. The array of over 400 choices and the flexibility it brings is positive, but it also complicates the selection process. How do I know which ETF make the most sense for my portfolio?
Perhaps because ETFs started out being compared to mutual funds, as they grew in number most analysts started evaluating them as mutual funds. Morningstar™, for example, the large mutual fund rating outfit, says in materials on its website, “The Morningstar Rating for exchange-traded funds uses the same methodology as the Morningstar Rating for [mutual]funds.”
Therein lies the problem. Mutual funds are typically evaluated based on past performance and fees.
That’s appropriate for most mutual funds, which are actively managed, because what you are really doing is hiring a manager to invest on your behalf. Therefore it makes sense to ask how well the manager has done this in the past, and how much the fund charges for his or her services.
But with ETFs it’s different. There is no active manager deciding when to buy or sell certain stocks; no one, for example, deciding when to lighten up on a certain sector or when to increase exposure to a certain market cap segment. There is nothing inherently good or bad about a particular index that an ETF tracks. Rather, the investment merit of an ETF is determined by two factors: market conditions, and the fundamentals of the underlying stocks which comprise the fund. These, of course, change all the time.
This difference is like night and day; it is one being backwards-looking versus forward-looking. Who is not aware that, over the past five years, Technology stocks in general were a bad investment? What moderately-informed investor doesn’t already know that over the same time period small cap stocks outpaced large cap stocks? If a mutual fund manager failed to foresee changes in the economy and in the market, and stayed overexposed to large cap Tech stocks, you’d have a valid complaint that he was probably not earning his keep. But an ETF tracking an index of Tech stocks, or an index of large cap stocks, didn’t change its portfolio because it isn’t supposed to—it is just supposed to track the index.
However, concluding that, based on past performance a Technology ETF is therefore a bad investment going forward, or that a small-cap ETF is therefore a good investment, is absurd. Tech stocks were a bad investment, and small caps were a good investment, but that tells you next to nothing about how they are likely to perform in the future. And besides, unlike a mutual fund you can short an ETF, so even a bad investment, correctly identified, can be turned into a good thing.
So, how do we intend to divine any forward-looking measurements of an ETFs investment merit? Fortunately, we have a set of existing tools that can help. One of the least-recognized but important advantages of an ETF is that they are transparent. Unlike a mutual fund, the holdings of an ETF, and their weight in the index, can be known at any point in time, As a result, it is possible to marry the list of constituents with all the fundamental data available about those constituents to create a very informative picture of the basket as a whole. One can find the answer to important questions such as:
• Which ETFs offer the best earnings growth? The best dividend yields?
• Which are seeing estimates raised, and where are they getting slashed?
• Which show trouble brewing on the balance sheet?
• How is it valued, relative to expectations and relative to other ETFs?
Knowing such information is extremely helpful because it is forward looking. You can use this information either to compare ETFs across categories or within categories. Financial advisors often develop an asset allocation plan based on the goals, risks tolerances, and time horizons of their clients, and then try to select an investment to represent each asset class. But when using ETFs to accomplish this, too often they have to make a leap of faith as to which ETF is the best bet within the asset class, based on little or no information.
For example, two options for tracking small cap stocks are the iShares S&P Small Cap 600 index fund (IJR) and the iShares Russell 2000 index fund (IWM). Both are from ETF-giant Barclays, both have an expense ratio of 20bp, and both have three-star ratings from Morningstar™.
So now what? If I told you that one of those indexes was trading at 17.0x estimated earnings per share (EPS) this year, and the other was trading at 21.3x, wouldn’t that knowledge perhaps make a difference? If you were concerned about a slowing economy and wanted to position your portfolio for the next downturn and I could tell you that during the last recession profit margins for both indices declined but that for one of them profit margins declined much worse—and in fact turned negative—wouldn’t that information affect your investment planning?
To be sure, there is no guarantee that current expectations about fundamentals will prove to be accurate—or even if they are that the market will care in the near term. But over the long term, most investors believe that fundamentals such as earnings and valuations are what drive the stock market. That is why most people, before buying stock in, say, General Electric—which after all is really a collection of business not entirely different from an ETF—would make an effort to compare GE’s fundamentals to that of other industrial companies, and to the market in general.
This brings me to another point, which many would consider so heretical that if I said it at a fund industry conference I’d be laughed out of the room. But humor me for a moment if you would. Mutual fund investors have been indoctrinated with the belief that fees only rob you of performance, and should be avoided or minimized to the extent possible. For mutual funds that’s probably true since few active managers are able to consistently outperform their benchmarks anyway. But for ETFs fees are largely irrelevant.
Now before you stop reading, all else being equal fees do matter. But rarely if ever is all else equal. Fees for ETFs have already been reduced to such an extent that the difference of a few basis points between funds is likely to be overwhelmed by the difference in performance, making fees a secondary and far less important consideration.
Consider, for example, that among several large cap domestic stock ETFs last year, the S&P 500 SPDR (SPY), with an annual fee of 10 basis points, returned 15.8%, while the Dow Industrials DIAMONDS (DIA), with an annual fee of 18 basis points, returned 18.9%. The large-cap iShares Russell 1000 (IWB), at 15 basis points, was up 15.4% and the NASDAQ-100 Tracking stock (QQQQ), at 20 basis points, gained only 7.1%.
Between all those large-cap domestic stock funds there is a spread of no more than 10 basis points in fees, yet a difference in performance of 11.8 percentage points. And don’t assume that the difference will even out in the long term: over the past five years, the spread in cumulative performance is 23.4 percentage points! Who really believes that, five years from now, the performance of each of these funds will be within 0.5 percentage points of each other? That’s the difference that 10 basis points in fees compounded over five years would make.
You’d find similar divergence in returns if you examine small caps ETFs, ETFs within a certain geographic category, or even ETFs from the same fund company both targeting Growth stocks! For ETFs, fees often amount to a rounding error.
Rather, each of the funds mentioned above, despite targeting the same category, have notably different profiles in terms of sector balance, expected earnings growth, historical profitability of constituent firms, and valuation measures such as the price-to-earnings ratio. It is these differences, not fees or past performance, that are likely to determine by and large how the funds will fare in the future.
That is why AltaVista employs a fundamentally different approach to ETFs. Our ETF Research Center provides fundamental analysis of ETFs so that investors can make more informed decisions about which funds are right for them. This approach is intuitive, forward-looking, and, we think, a lot more relevant than past performance and fees.
To be certain, some of the lessons about investing in mutual funds also apply to ETFs. You need to consider your portfolio as a whole, making sure that the funds you select aren’t just highly rated but also suitably diversified and reasonably uncorrelated. For that task, portfolio construction tools are widely available. But whatever the similarities between mutual funds and ETFs as investment vehicles within a portfolio, when it comes to evaluating an individual ETF, the warmed over mutual fund approach just doesn’t cut it.