SEC guidelines for target date funds and disclosure miss the critical problem with these very popular products. They don't do what consumers THINK they do. Target date funds make investing easy for long term investors in 401k and other DC pension schemes by promising to make systematic asset allocation changes that reduce the equity exposure of the portfolio as retirement, or the target date approaches. As a result, 80% of all new and redirected assets into U.S.-based DC plans are flowing into these funds. 77% of assets in these products are controlled by three manufacturers, Fidelity, Vanguard, and T. Rowe Price who must bear much of the responsibility for the misdirection.
By suggesting that equity exposure is being reduced over the life of the investment, investors think RISK is being reduced. If this were true, there would be no problem. But equity exposure does not equal risk exposure and risk changes over time. Think in terms of two relatively recent example. The RISK of the S&P 500 pre-Tech Bubble with less that 10% technology exposure and in 2000 with technology representing over 30% the risk in the market, as represented by a 252 day moving average of S&P 500 SD, spiked to over 15% during the period. The recent financial crisis saw an even more dramatic shift in the risk of stocks and bonds as corporate spreads over treasuries ballooned in late 2008 early 2009 and the SD of the S&P 500 spiked to a mind blowing 60%! So for target date funds to imply that they are systematically reducing RISK exposure is misleading at best.
The remedy is Target Date Funds 3.0, an approach that maintains a consistent approach towards portfolio RISK. It is a systems solution as much as an investment solution but most importantly in the debate about full disclosure to clients, it provides an honest relationship between what investors understand they are getting and the marketing hype of the industry. For more information www.purinvesting.com
Thursday, December 9, 2010
Tuesday, October 19, 2010
Risk is a Ten Letter Word
Investors over the recent past not only know about volatility, they likely have the scars to prove it!
Exchange-traded funds (ETFs) are well known for their low cost, tax efficiency and diversified exposure to markets, asset classes, sectors, commodities and industries. Less well known is that ETFs provide neat packets of stable risk that can not only be used to construct tailored portfolios but also to control risk easily and more effectively than ever before.
Case for more volatility
Capital market volatility threatens the adequacy of RRSPs, the solvency of defined benefit pension plans, the patience of clients and the sanity of advisors. Systemic risk from deregulation, interconnected global financial and banking structures exacerbated by an explosion in derivatives use, high frequency trading, and advances in information technology suggests that “returns are likely to remain highly heteroskedastic, showing periods of consistently high and low volatility,” says Ioulia Tretiakova, Manager of Quantitative Strategies, PŮR Investing Inc.. Nothing in currently proposed banking reform legislation suggests otherwise. The problem is that capital markets dislike uncertainty most of all.
Even if you believe that the credit crisis was a “once-in-a-lifetime” aberration, advisors have a duty to clients to protect them from it.
Managing volatility
Diversification theory suggests selecting assets that don’t move in the same direction at the same time (uncorrelated). This is smart because if one asset class is zigging (i.e. Canadian equities) while another is zagging (i.e. gold) the volatility of the combined portfolio will be dampened. But very much like a balance sheet, these relationships are more like a snapshot than the dynamic of an income or cash flow statement that show changes between periods. Two important things to remember:
• correlation between asset classes can and does change over time;
• market volatility can over-ride correlations.
I mention these caveats because they are too often ignored or forgotten by investment professionals and retail investors alike. The table below shows the correlations between several asset classes represented by ETFs. Because they are already individually diversified, ETFs provide reliable risk that can be assembled into effective portfolios. Low and negative correlations are the best combinations for diversification.
Diversification failed to protect portfolios during the market meltdown. There is little protection against crises of confidence and lack of liquidity.
This chart illustrates the development of the U.S. credit crisis as represented by the interest rate spread between U.S. Treasury bonds and corporate bonds. As confidence deteriorates, lenders demand higher yields to hold any debt instrument other than Treasuries, so the spread opens up. The shaded area shows the volatility of the S&P 500 – 126 day moving average. Volatility remained stable until mid-2007 before spiking in 2008-2009.
Market volatility is a big challenge for investors and their advisors. Let’s assume a 60% stock 40% bond portfolio is considered appropriate for an investor in 2005. As the stock market rose in 2006 and 2007, the portfolio sells stocks and buys bonds to rebalance to the 60:40 fixed asset mix. This seems reasonable because we’re supposed to “sell high” and “buy low”, right? But is the “risk” of the portfolio the same in 2008-2009 as it was in 2005? Clearly it is not.
A better solution would be to maintain the “risk” represented by the 60:40 asset mix consistently through periods of market volatility. The risk of a portfolio should represent the risk tolerance of the investor that doesn’t change in good or bad markets. If “12” represents the risk of a 60:40 mix in 2005, the “risk” of the portfolio would have spiked to over 30 in 2008-2009! To keep this portfolio at 12, equities would be 20% and bonds 80% in mid 2008. An alternative less disruptive to the mix would have been to buy the iPath S&P 500 VIX Short Term Futures ETN (VXX). Either approach would have saved serious money for investors.
Sophisticated
The idea of managing to a consistent risk is a sophisticated institutional approach on two levels. Firstly, the idea of budgeting risk is a concept used only by the largest pension funds and institutional pools of capital. No mutual fund in Canada uses this strategy as far as I know. Secondly, managing volatility is a cutting edge idea. The availability of volatility ETFs like VXX and VXZ (the mid-term version of VXX) makes these tactics available to individual investors. Hedging long positions with short or inverse ETFs is also a tactical option, but that is a subject for another time.
Summary
ETFs offer the potential to bend and shape risk in ways previously available only to institutional portfolio managers with hundreds of millions under management. This capability comes with the responsibility for advisors to “up” their game, but the payoff will benefit their clients and their practices.
Exchange-traded funds (ETFs) are well known for their low cost, tax efficiency and diversified exposure to markets, asset classes, sectors, commodities and industries. Less well known is that ETFs provide neat packets of stable risk that can not only be used to construct tailored portfolios but also to control risk easily and more effectively than ever before.
Case for more volatility
Capital market volatility threatens the adequacy of RRSPs, the solvency of defined benefit pension plans, the patience of clients and the sanity of advisors. Systemic risk from deregulation, interconnected global financial and banking structures exacerbated by an explosion in derivatives use, high frequency trading, and advances in information technology suggests that “returns are likely to remain highly heteroskedastic, showing periods of consistently high and low volatility,” says Ioulia Tretiakova, Manager of Quantitative Strategies, PŮR Investing Inc.. Nothing in currently proposed banking reform legislation suggests otherwise. The problem is that capital markets dislike uncertainty most of all.
Even if you believe that the credit crisis was a “once-in-a-lifetime” aberration, advisors have a duty to clients to protect them from it.
Managing volatility
Diversification theory suggests selecting assets that don’t move in the same direction at the same time (uncorrelated). This is smart because if one asset class is zigging (i.e. Canadian equities) while another is zagging (i.e. gold) the volatility of the combined portfolio will be dampened. But very much like a balance sheet, these relationships are more like a snapshot than the dynamic of an income or cash flow statement that show changes between periods. Two important things to remember:
• correlation between asset classes can and does change over time;
• market volatility can over-ride correlations.
I mention these caveats because they are too often ignored or forgotten by investment professionals and retail investors alike. The table below shows the correlations between several asset classes represented by ETFs. Because they are already individually diversified, ETFs provide reliable risk that can be assembled into effective portfolios. Low and negative correlations are the best combinations for diversification.
Diversification failed to protect portfolios during the market meltdown. There is little protection against crises of confidence and lack of liquidity.
This chart illustrates the development of the U.S. credit crisis as represented by the interest rate spread between U.S. Treasury bonds and corporate bonds. As confidence deteriorates, lenders demand higher yields to hold any debt instrument other than Treasuries, so the spread opens up. The shaded area shows the volatility of the S&P 500 – 126 day moving average. Volatility remained stable until mid-2007 before spiking in 2008-2009.
Market volatility is a big challenge for investors and their advisors. Let’s assume a 60% stock 40% bond portfolio is considered appropriate for an investor in 2005. As the stock market rose in 2006 and 2007, the portfolio sells stocks and buys bonds to rebalance to the 60:40 fixed asset mix. This seems reasonable because we’re supposed to “sell high” and “buy low”, right? But is the “risk” of the portfolio the same in 2008-2009 as it was in 2005? Clearly it is not.
A better solution would be to maintain the “risk” represented by the 60:40 asset mix consistently through periods of market volatility. The risk of a portfolio should represent the risk tolerance of the investor that doesn’t change in good or bad markets. If “12” represents the risk of a 60:40 mix in 2005, the “risk” of the portfolio would have spiked to over 30 in 2008-2009! To keep this portfolio at 12, equities would be 20% and bonds 80% in mid 2008. An alternative less disruptive to the mix would have been to buy the iPath S&P 500 VIX Short Term Futures ETN (VXX). Either approach would have saved serious money for investors.
Sophisticated
The idea of managing to a consistent risk is a sophisticated institutional approach on two levels. Firstly, the idea of budgeting risk is a concept used only by the largest pension funds and institutional pools of capital. No mutual fund in Canada uses this strategy as far as I know. Secondly, managing volatility is a cutting edge idea. The availability of volatility ETFs like VXX and VXZ (the mid-term version of VXX) makes these tactics available to individual investors. Hedging long positions with short or inverse ETFs is also a tactical option, but that is a subject for another time.
Summary
ETFs offer the potential to bend and shape risk in ways previously available only to institutional portfolio managers with hundreds of millions under management. This capability comes with the responsibility for advisors to “up” their game, but the payoff will benefit their clients and their practices.
ETFs and the Egg Management Fee
I met a broker from Rochester at breakfast on the second day of an ETF conference in Albany New York. I was a speaker on the first day and a moderator on the second and was curious about the audience’s knowledge level and how the message was getting through. “Do you use ETFs in your practice?” I asked. He admitted that he had purchased some SPDRs (Standard & Poor’s Depositary Receipts, SPY) for his largest client. “I went to a meeting with her auditor and all he said was ‘I see that your broker bought an ETF for your portfolio, he must be doing a good job for you!’. I am here to find out what I bought and why they are so good!”
There is a halo effect over ETF use that transcends their undeniably beneficial use in portfolios. But we, in the industry, should not rest on our laurels. There is a directness that has accompanied the electronic revolution and social media that can bite, so making ETFs just another offering on the investment product buffet could be dangerous.
Take for example the Ally Bank ads that portray conventional bankers as insensitive to clients. Clients are portrayed as kids in the commercials. Fine print, exclusionary offers, undisclosed information, run-arounds, and the now ubiquitous “egg management fee” are offered as proof of big bank practices that “even kids know” aren’t fair. It could be argued that banks deserve this treatment. But mutual funds could be tarred with the same brush and with them, the entire investment profession. In Canada, the major banks, through branches and wholly-owned brokerage firms, account for two thirds of all mutual fund sales. And yes, mutual fund fees seem inexplicably large in relationship to what they deliver particularly when compared with ETF fees. But mutual funds still provide retail investors with professional management and diversification while sharing expenses. That their structure is out-dated is not entirely their fault: lack of transparency in an era of full disclosure, once-a-day pricing in a 24-hour-a-day global market, bundled fees when everything is being unbundled (except cell phone packages, strangely enough). The traditional mutual fund format struggles to keep up.
The same fate may await practitioners if they treat ETFs like just a bunch of mutual funds and stuff them into client portfolios like “last year’s hot performer”. ETFs should be used to provide the kinds of solutions, continuous client value and vehicles for managing risk for which they are so well suited with costs justified and construction communicated simply and effectively.
Managing an expanding ETF universe
There are lots of ETFs and more each week. While there are many ways to sort them, keeping things simple has great appeal because it is easier to explain to clients. Ioulia Tretiakova, Director of Quantitative Strategies at PŮR Investing, classifies the ETF universe into two basic categories: those that are passive and those with embedded strategies.
“Passive ETFs follow a simple index or an unleveraged commodity. They are characterized by low fees. Those with embedded strategies are everything else. ETFs with embedded strategies often have higher fees. Leveraged and inverse ETFs and those that follow a manipulated index like revenue or fundamentally weighted, are examples. Actively managed ETFs are the most obvious examples of an embedded strategy.”
Explaining to clients that a low cost core of passive ETFs is an effective way to capture beta, or exposure to market returns will help. You could build a core of actively managed mutual funds or ETFs with embedded strategies that try to outperform your benchmark, but it is difficult to identify successful ones in advance, extremely difficult to pick them consistently year after year, and you risk the inefficiency from fund overlap (see AER Sept 2010 “How Many?). You do, however, know their cost in advance. Go with what you know, it’s logical and clients understand it.
With your passive core established, consider the manageable characteristics of ETFs (or other assets) that make the most impact on portfolios, cost and diversification are the most important followed by liquidity, tax efficiency and tracking error. This column has examined each of these in the past.
What about returns? They can’t be predicted in advance, but by capturing the market return inexpensively with a core of passive products, you can select other “satellite” assets around the core that position the portfolio to perform. Diversified exposure to areas you feel will do well like small capitalization stocks, emerging markets, or commodities, can be added as individual securities, passive ETFs, mutual funds or ETFs with embedded strategies. If the satellite investments chronically underperform the core, you will know and so will your clients. But what to do about it will be clear. In coming issues we will examine the considerations for satellite assets more closely.
Keeping portfolio construction and classification of ETFs simple will help clients understand what you are doing, help dispel the mystery of the “egg management fee” and will distinguish ETFs as a signature part of the portfolio menu.
Mark Yamada is the President and CEO of PŮR Investing Inc. www.purinvesting.com
There is a halo effect over ETF use that transcends their undeniably beneficial use in portfolios. But we, in the industry, should not rest on our laurels. There is a directness that has accompanied the electronic revolution and social media that can bite, so making ETFs just another offering on the investment product buffet could be dangerous.
Take for example the Ally Bank ads that portray conventional bankers as insensitive to clients. Clients are portrayed as kids in the commercials. Fine print, exclusionary offers, undisclosed information, run-arounds, and the now ubiquitous “egg management fee” are offered as proof of big bank practices that “even kids know” aren’t fair. It could be argued that banks deserve this treatment. But mutual funds could be tarred with the same brush and with them, the entire investment profession. In Canada, the major banks, through branches and wholly-owned brokerage firms, account for two thirds of all mutual fund sales. And yes, mutual fund fees seem inexplicably large in relationship to what they deliver particularly when compared with ETF fees. But mutual funds still provide retail investors with professional management and diversification while sharing expenses. That their structure is out-dated is not entirely their fault: lack of transparency in an era of full disclosure, once-a-day pricing in a 24-hour-a-day global market, bundled fees when everything is being unbundled (except cell phone packages, strangely enough). The traditional mutual fund format struggles to keep up.
The same fate may await practitioners if they treat ETFs like just a bunch of mutual funds and stuff them into client portfolios like “last year’s hot performer”. ETFs should be used to provide the kinds of solutions, continuous client value and vehicles for managing risk for which they are so well suited with costs justified and construction communicated simply and effectively.
Managing an expanding ETF universe
There are lots of ETFs and more each week. While there are many ways to sort them, keeping things simple has great appeal because it is easier to explain to clients. Ioulia Tretiakova, Director of Quantitative Strategies at PŮR Investing, classifies the ETF universe into two basic categories: those that are passive and those with embedded strategies.
“Passive ETFs follow a simple index or an unleveraged commodity. They are characterized by low fees. Those with embedded strategies are everything else. ETFs with embedded strategies often have higher fees. Leveraged and inverse ETFs and those that follow a manipulated index like revenue or fundamentally weighted, are examples. Actively managed ETFs are the most obvious examples of an embedded strategy.”
Explaining to clients that a low cost core of passive ETFs is an effective way to capture beta, or exposure to market returns will help. You could build a core of actively managed mutual funds or ETFs with embedded strategies that try to outperform your benchmark, but it is difficult to identify successful ones in advance, extremely difficult to pick them consistently year after year, and you risk the inefficiency from fund overlap (see AER Sept 2010 “How Many?). You do, however, know their cost in advance. Go with what you know, it’s logical and clients understand it.
With your passive core established, consider the manageable characteristics of ETFs (or other assets) that make the most impact on portfolios, cost and diversification are the most important followed by liquidity, tax efficiency and tracking error. This column has examined each of these in the past.
What about returns? They can’t be predicted in advance, but by capturing the market return inexpensively with a core of passive products, you can select other “satellite” assets around the core that position the portfolio to perform. Diversified exposure to areas you feel will do well like small capitalization stocks, emerging markets, or commodities, can be added as individual securities, passive ETFs, mutual funds or ETFs with embedded strategies. If the satellite investments chronically underperform the core, you will know and so will your clients. But what to do about it will be clear. In coming issues we will examine the considerations for satellite assets more closely.
Keeping portfolio construction and classification of ETFs simple will help clients understand what you are doing, help dispel the mystery of the “egg management fee” and will distinguish ETFs as a signature part of the portfolio menu.
Mark Yamada is the President and CEO of PŮR Investing Inc. www.purinvesting.com
Monday, July 12, 2010
Target date funds 3.0
By showing declining equity exposure as a retirement date approaches, target date fund managers imply that portfolio risk is automatically being reduced. This seems like a wonderful thing to investors who do not have the time or inclination to make asset mix changes themselves. Well, 2008-2009 showed us that risk for each asset class is far more important than the static relationship that professional money managers use to establish diversification between asset classes. In other words, they buy stocks, bonds, cash, and commodities in the belief that they all won't zig at the same time.
Target date 1.0 offered a date in the future. Target date 2.0 added conservative, moderate and aggressive options to each target date but the flaw remains. Fixed equity glide paths are like staring at a balance sheet; useful in helping to describe a "point in time" but useless in a dynamic capital market with risk that changes...often by a lot!
Target date 3.0 uses a dynamic glide path and constant volatility re-balancing. This means that the RISK of the portfolio is managed to a declining glide path and the asset mix is changed to reflect what is happening in the market right now. In TDF 1.0 and 2.0, the asset mix is managed to a fixed glide path while the risk is allowed to fluctuate. It doesn't make any sense to subject an investor to inappropriate risk. Furthermore, investors working towards a capital accumulation goal should know whether they are ahead or behind their projected growth path. TDF 3.0 automatically shifts risk based on progress towards this goal. Get behind, take a little more risk, get ahead, take a little less. Common sense. How does one do this for a defined contribution pension plan with thousands of members? Mass customization. www.purinvesting.com
Target date 1.0 offered a date in the future. Target date 2.0 added conservative, moderate and aggressive options to each target date but the flaw remains. Fixed equity glide paths are like staring at a balance sheet; useful in helping to describe a "point in time" but useless in a dynamic capital market with risk that changes...often by a lot!
Target date 3.0 uses a dynamic glide path and constant volatility re-balancing. This means that the RISK of the portfolio is managed to a declining glide path and the asset mix is changed to reflect what is happening in the market right now. In TDF 1.0 and 2.0, the asset mix is managed to a fixed glide path while the risk is allowed to fluctuate. It doesn't make any sense to subject an investor to inappropriate risk. Furthermore, investors working towards a capital accumulation goal should know whether they are ahead or behind their projected growth path. TDF 3.0 automatically shifts risk based on progress towards this goal. Get behind, take a little more risk, get ahead, take a little less. Common sense. How does one do this for a defined contribution pension plan with thousands of members? Mass customization. www.purinvesting.com
Thursday, May 20, 2010
The Death of Asset Allocation as You Know It Part 2
“Experienced investors understand four wonderfully powerful truths about investing, and wise investors govern their investing by adhering to these four great truths:
1. The dominant reality is that the most important decision is your long term mix of assets; how much in stocks, real estate, bonds, or cash.
2. The mix should be determined by the real purpose and time of use of money.
3. Diversify within each asset class – and between asset classes. Bad things do happen – usually as surprises.
4. Be patient and persistent. Good things come in spurts – usually when least expected – and fidgety investors fare badly. “Plan your play and play your plan,” say the great coaches. “Stay the course” is also wise. So is setting the right course – which takes you back to great truth number 1.”
— Charles D. Ellis, 2007
Charles Ellis is a dean of institutional investing. The founder and managing partner for 30 years of respected consulting firm Greenwich Associates, he pioneered the systematic application of measurable investing activity. Supported by the 1986 research of Gary Brinson, L. Randolph Hood, and Gilbert Beebower, and follow on work by Jahnke, Ibbotson and others, the important role of asset allocation in the investment process developed.
In 2008-2009, extreme volatility, caused by the financial crisis, repealed the laws of asset allocation. Everything went down. Judicious choice of non-correlated assets was meant to invoke the protective properties of diversification. But correlations, based on historical relationship, have always wavered in the face of crisis. Yet advisors and professional investors alike embrace the tenets articulated by Ellis above.
It is not that these platitudes are wrong. There aren’t many absolutes in the investment world after all (except, perhaps, that costs detract from returns). Rather, there should be a fifth truth:
“The risk of assets selected for a portfolio should not only be consistent with the goals, time horizon, and risk tolerance of the investor or mandate, but should be kept consistent particularly when market risk rises and falls.”
Risk is like the temperature of bath water, some like it hotter than others, some cooler. If the temperature is too hot, add some cool. Conversely for a cooler bath, remove some cool and add some hot. Portfolios can be managed the same way.
If you would like to follow our ongoing research, please leave your email address and we’ll keep you apprised as we progress over the next several quarters.
1. The dominant reality is that the most important decision is your long term mix of assets; how much in stocks, real estate, bonds, or cash.
2. The mix should be determined by the real purpose and time of use of money.
3. Diversify within each asset class – and between asset classes. Bad things do happen – usually as surprises.
4. Be patient and persistent. Good things come in spurts – usually when least expected – and fidgety investors fare badly. “Plan your play and play your plan,” say the great coaches. “Stay the course” is also wise. So is setting the right course – which takes you back to great truth number 1.”
— Charles D. Ellis, 2007
Charles Ellis is a dean of institutional investing. The founder and managing partner for 30 years of respected consulting firm Greenwich Associates, he pioneered the systematic application of measurable investing activity. Supported by the 1986 research of Gary Brinson, L. Randolph Hood, and Gilbert Beebower, and follow on work by Jahnke, Ibbotson and others, the important role of asset allocation in the investment process developed.
In 2008-2009, extreme volatility, caused by the financial crisis, repealed the laws of asset allocation. Everything went down. Judicious choice of non-correlated assets was meant to invoke the protective properties of diversification. But correlations, based on historical relationship, have always wavered in the face of crisis. Yet advisors and professional investors alike embrace the tenets articulated by Ellis above.
It is not that these platitudes are wrong. There aren’t many absolutes in the investment world after all (except, perhaps, that costs detract from returns). Rather, there should be a fifth truth:
“The risk of assets selected for a portfolio should not only be consistent with the goals, time horizon, and risk tolerance of the investor or mandate, but should be kept consistent particularly when market risk rises and falls.”
Risk is like the temperature of bath water, some like it hotter than others, some cooler. If the temperature is too hot, add some cool. Conversely for a cooler bath, remove some cool and add some hot. Portfolios can be managed the same way.
If you would like to follow our ongoing research, please leave your email address and we’ll keep you apprised as we progress over the next several quarters.
Thursday, April 15, 2010
Bird-brained stock picking
Less guesswork with exchange-traded funds
Every week at home, as a keen young portfolio manager, I would pour over the charts of all the stocks traded on the New York and American Stock Exchanges that were included in a binder with 12 charts to the page, 24 in total when open.
My pet cockatiel, named Dow Jones, would fly around the room as I worked. One day, he landed on my shoulder and walked down my arm onto the chart book. He shuffled around and pecked showed his displeasure in a unique bird-like way on one of the charts. The next day that stock went down sharply! A humorous coincidence!
He did it the next week and the next. Each stock that received a “deposit” went down in price. Still a humorous coincidence, but I realized it represented a random key to how many people make investment decisions.
People are notoriously random when it comes to making investment decisions. They base them on conversations overheard in the office bathroom, or relatives who’ve seen big returns on their investments, or the sound bites of investment journalists. And then they pray. People do what they think worked for them in the past regardless of the method’s randomness. Sometimes their lottery ticket selection strategy is more systematic. No wonder so many investors end up with a portfolio of random securities with no plan or purpose.
But when it comes to exchange-traded funds, there is no guesswork. There is less guesswork with exchange-traded funds (ETFs). These securities track an broad indicies, a commodities, currencies, sectors and industries and allow investors to take leveraged long and short positions. a grouping of assets like an index fund, or a trade like a stock on an exchange. They offer diversification, and the ability to sell short, buy on margin, and purchase as little as one share and trade like a stock during regular exchange hours.
There are only three basic ways to build portfolios with them, all others are variations. Over the next three issues, I will examine each of these.
Here is a brief overview of how ETFs portfolio construction works:
Fundamental approaches
The fundamental approaches use some form of “top down” or “bottom up” analysis. Assessing views of global, regional and local economies and their impact on sectors, industries and companies, ETFs lend themselves nicely to these strategies because they make country, regional, sector and industry investing simple.
Institutional managers can use ETFs to establish broad exposure before making specific securities investments and they can hedge existing exposure by shorting the relevant ETF. Portfolios for individual investors can similarly benefit from diversified exposure to elements identified by the portfolio manager.
“Bottom up” managers, or stock pickers who screen for superior growth, value a combination of both or other factors, have style ETFs as well as large, mid-cap, and small capitalization alternatives in different regions and sectors to choose from.
Many large portfolios and pension schemes employ “core” plus “satellite” or “tactical” approaches. They create a passive core cheaply and select active alpha-seeking strategies around that core.
ETFs offer flexibility and choice at a low cost so these traditional approaches can be applied to private client portfolios effectively. The tax efficiency of separately managed accounts combines nicely with ETFs so many firms will be encouraged to transition pooled and mutual fund assets to this format. Indeed, low costs contribute to better performance, so complacent product vendors should pay attention.
Market timing
Today, there are 1,000 ETFs available worldwide, with another 500 or so in registration, a fact attractive to many. Include currency; commodity; leveraged or enhanced; long and short; so-called “fundamental” and even Chinese real estate ETFs; and the possibilities grow.
Traders feed on volatility. So it’s good news that the dampened relative volatility of groups of securities, which counters traders’ need for action, is offset by better liquidity from the ETF structure.
Leveraged ETFs that offer the holder two times the daily price movement of an index are available; inverse versions go up two times the daily fall in price of an index. This is the type of action that traders want. But leveraged ETFs are not just for traders.
Trading has done much to democratize capital markets for individual investors; specialized education in financial analysis is not required. Technical analysis, the trader’s discipline, doesn’t care about companies, products, margins or market share. All that matters is price movement.
Within the movement of prices (and sometimes trading volume) lies all the necessary information needed to make buy and sell decisions. Anybody can apply these methods to the price of anything. This is pure market timing.
SIDEBAR
Risk management
The low cost and tax efficiency of ETFs are what individual investors should exploit. However, there are many other perks to using ETF products:
1. A free lunch: Lowering risk by using levered ETFs : If achieved, investors benefit from the higher return potential from leverage without assuming additional risk.
2. Risk budgeting through sophisticated portfolio construction: Only the most sophisticated institutions use this approach that optimizes diversification by assigning weights by risk.
3. Constant volatility: Consistent risk exposure for individuals can help avoid sharp market declines.
ETFs are neat little packages of diversified risk that make effective building blocks for many kinds of portfolios. Next month: ETFs in greater detail.
Every week at home, as a keen young portfolio manager, I would pour over the charts of all the stocks traded on the New York and American Stock Exchanges that were included in a binder with 12 charts to the page, 24 in total when open.
My pet cockatiel, named Dow Jones, would fly around the room as I worked. One day, he landed on my shoulder and walked down my arm onto the chart book. He shuffled around and pecked showed his displeasure in a unique bird-like way on one of the charts. The next day that stock went down sharply! A humorous coincidence!
He did it the next week and the next. Each stock that received a “deposit” went down in price. Still a humorous coincidence, but I realized it represented a random key to how many people make investment decisions.
People are notoriously random when it comes to making investment decisions. They base them on conversations overheard in the office bathroom, or relatives who’ve seen big returns on their investments, or the sound bites of investment journalists. And then they pray. People do what they think worked for them in the past regardless of the method’s randomness. Sometimes their lottery ticket selection strategy is more systematic. No wonder so many investors end up with a portfolio of random securities with no plan or purpose.
But when it comes to exchange-traded funds, there is no guesswork. There is less guesswork with exchange-traded funds (ETFs). These securities track an broad indicies, a commodities, currencies, sectors and industries and allow investors to take leveraged long and short positions. a grouping of assets like an index fund, or a trade like a stock on an exchange. They offer diversification, and the ability to sell short, buy on margin, and purchase as little as one share and trade like a stock during regular exchange hours.
There are only three basic ways to build portfolios with them, all others are variations. Over the next three issues, I will examine each of these.
Here is a brief overview of how ETFs portfolio construction works:
Fundamental approaches
The fundamental approaches use some form of “top down” or “bottom up” analysis. Assessing views of global, regional and local economies and their impact on sectors, industries and companies, ETFs lend themselves nicely to these strategies because they make country, regional, sector and industry investing simple.
Institutional managers can use ETFs to establish broad exposure before making specific securities investments and they can hedge existing exposure by shorting the relevant ETF. Portfolios for individual investors can similarly benefit from diversified exposure to elements identified by the portfolio manager.
“Bottom up” managers, or stock pickers who screen for superior growth, value a combination of both or other factors, have style ETFs as well as large, mid-cap, and small capitalization alternatives in different regions and sectors to choose from.
Many large portfolios and pension schemes employ “core” plus “satellite” or “tactical” approaches. They create a passive core cheaply and select active alpha-seeking strategies around that core.
ETFs offer flexibility and choice at a low cost so these traditional approaches can be applied to private client portfolios effectively. The tax efficiency of separately managed accounts combines nicely with ETFs so many firms will be encouraged to transition pooled and mutual fund assets to this format. Indeed, low costs contribute to better performance, so complacent product vendors should pay attention.
Market timing
Today, there are 1,000 ETFs available worldwide, with another 500 or so in registration, a fact attractive to many. Include currency; commodity; leveraged or enhanced; long and short; so-called “fundamental” and even Chinese real estate ETFs; and the possibilities grow.
Traders feed on volatility. So it’s good news that the dampened relative volatility of groups of securities, which counters traders’ need for action, is offset by better liquidity from the ETF structure.
Leveraged ETFs that offer the holder two times the daily price movement of an index are available; inverse versions go up two times the daily fall in price of an index. This is the type of action that traders want. But leveraged ETFs are not just for traders.
Trading has done much to democratize capital markets for individual investors; specialized education in financial analysis is not required. Technical analysis, the trader’s discipline, doesn’t care about companies, products, margins or market share. All that matters is price movement.
Within the movement of prices (and sometimes trading volume) lies all the necessary information needed to make buy and sell decisions. Anybody can apply these methods to the price of anything. This is pure market timing.
SIDEBAR
Risk management
The low cost and tax efficiency of ETFs are what individual investors should exploit. However, there are many other perks to using ETF products:
1. A free lunch: Lowering risk by using levered ETFs : If achieved, investors benefit from the higher return potential from leverage without assuming additional risk.
2. Risk budgeting through sophisticated portfolio construction: Only the most sophisticated institutions use this approach that optimizes diversification by assigning weights by risk.
3. Constant volatility: Consistent risk exposure for individuals can help avoid sharp market declines.
ETFs are neat little packages of diversified risk that make effective building blocks for many kinds of portfolios. Next month: ETFs in greater detail.
Thursday, February 18, 2010
ETF Tracking Error: Where's the beef?
The 1 kg of stewing beef I bought ended up tasting like pork. When confronted, the butcher retorted “Well buddy, it’s meat isn’t it?” Most consumers would be incensed at this response, but for some reason, investors are far more tolerant. It may be that mutual funds have dulled our expectations by underperforming their benchmarks for decades.
But for exchange-traded funds (ETFs), the standards should be higher.
They should be higher because their benchmarks are transparent indices (for the most part) and the goal is replication.
Tracking error, what is it and why is it important
Mathematically, tracking error is the standard deviation of the difference between index and ETF returns. Example: 4% tracking error means that annual ETF returns will be within ±4% of index return, two times out of three.
Ioulia Tretiakova, Director of Quantitative Strategies, PŮR Investing Inc., affirms that while tracking error can be important if ETFs are used to hedge a portfolio, understanding tracking error helps individual investors employ these vehicles more effectively.
Causes of tracking error
There are three ways to replicate an index:
Stratified sampling: buy only some of the underlying securities: you order a chicken and get 1 wing, 1 breast, 1 leg, 1 thigh.
Optimization: use underlying securities and/or derivative instruments to mimic an index’s return: chicken fingers!
Full replication: buying all the components of an index is the most effective way to minimize tracking error. You order a chicken and get the whole bird.
Ordering a chicken and getting chicken fingers may not bother some investors, but understanding the possibility is important. To be fair, stratified sampling and optimization can be the only practical approaches given size and liquidity considerations. The DEX Universe Bond Index has 1,058 holdings while the popular iShares CDN Bond Index Fund (XBB) that mirrors it, holds only 301 issues.
Ms. Tretiakova observes, “Regulation has an impact. There is no maximum security weight for ETFs in Canada, but in the U.S. there is a 19.99% cap. Hence the return of Vanguard’s Information Technology ETF (VGT) lagged its benchmark MSCI U.S. Investable Market Information Technology Index, by 50% since inception (1/26/2004 to 1/3/2010) in part because the index weight of AT&T was 49% and only 19.99% for VGT.” This is like ordering three chickens and getting the two-bird maximum.
Should daily returns be used to calculate tracking error?
The index underlying the iShares MSCI EAFE Index Fund (EFA) and its “Loonie-hedged” cousin, XIN, does not have a contemporaneous closing time, so using daily closing NAVs and index values for tracking error calculations makes little sense; like roosters crowing dawn in each time zone.
On the other hand, the tracking error of leveraged ETFs (in Canada, the Horizon BetaPro series) should be calculated using periods no longer than daily. Over the longer term, daily rebalancing will cause divergence made all the greater by volatility; like ordering an egg and getting a two egg omelette.
Leveraged ETF tracking error
The multiple-of-daily-index-return objective of leveraged ETFs is not completely accurate, warns Ms. Tretiakova. What actually happens, in the case of a 2X ETF, is that “there is twice the total return minus one times the cost of capital. Currently, this is slightly better for investors than the stated objective of twice the price return because dividend yields are slightly higher than the cost of capital. However, when these two rates vary, the difference may be more significant.”
Leveraged Fund Performance Relative to Stated Objective
and its relationship to dividend yield-interest rate differential
ETFs with unusual tracking error
Some ETFs operate without a specifically stated benchmark, defining only broad asset class exposure. For example, the Claymore Broad Emerging Markets ETF (CWO, launched April 7, 2009) states that “The Manager will select an Emerging Markets Benchmark Index such as the MSCI Emerging Markets Index, the FTSE RAFI Emerging Index or another widely recognized emerging markets index in order to provide such exposure and may change the Emerging Markets Benchmark Index in its discretion without unit-holder approval.” This sounds like advertising chicken while delivering duck. The challenge is trying to determine the tracking error when the target index is changing. One comfort these unit-holders have is that the indicies for groups of emerging markets will likely have similar volatility (risk). This means that the advertised chicken is unlikely end up being pork chops!
Finding tracking error information
Most ETF sponsors offer tracking error information on their websites. Often shown in chart form, price movement of ETFs are easily compared with their underlying index. The actual tracking error of Canadian-traded ETFs and how they compare to others is available at http://purinvesting.com/demo/Screen.htm .
A cost to investors, tracking error is well worth monitoring. It’s one way of keeping ETF sponsors honest and assuring you don’t get salt pork when you expected steak.
Mark Yamada is President of PŮR Investing Inc. a registered portfolio manager specializing in risk management using exchange-traded funds.
But for exchange-traded funds (ETFs), the standards should be higher.
They should be higher because their benchmarks are transparent indices (for the most part) and the goal is replication.
Tracking error, what is it and why is it important
Mathematically, tracking error is the standard deviation of the difference between index and ETF returns. Example: 4% tracking error means that annual ETF returns will be within ±4% of index return, two times out of three.
Ioulia Tretiakova, Director of Quantitative Strategies, PŮR Investing Inc., affirms that while tracking error can be important if ETFs are used to hedge a portfolio, understanding tracking error helps individual investors employ these vehicles more effectively.
Causes of tracking error
There are three ways to replicate an index:
Stratified sampling: buy only some of the underlying securities: you order a chicken and get 1 wing, 1 breast, 1 leg, 1 thigh.
Optimization: use underlying securities and/or derivative instruments to mimic an index’s return: chicken fingers!
Full replication: buying all the components of an index is the most effective way to minimize tracking error. You order a chicken and get the whole bird.
Ordering a chicken and getting chicken fingers may not bother some investors, but understanding the possibility is important. To be fair, stratified sampling and optimization can be the only practical approaches given size and liquidity considerations. The DEX Universe Bond Index has 1,058 holdings while the popular iShares CDN Bond Index Fund (XBB) that mirrors it, holds only 301 issues.
Ms. Tretiakova observes, “Regulation has an impact. There is no maximum security weight for ETFs in Canada, but in the U.S. there is a 19.99% cap. Hence the return of Vanguard’s Information Technology ETF (VGT) lagged its benchmark MSCI U.S. Investable Market Information Technology Index, by 50% since inception (1/26/2004 to 1/3/2010) in part because the index weight of AT&T was 49% and only 19.99% for VGT.” This is like ordering three chickens and getting the two-bird maximum.
Should daily returns be used to calculate tracking error?
The index underlying the iShares MSCI EAFE Index Fund (EFA) and its “Loonie-hedged” cousin, XIN, does not have a contemporaneous closing time, so using daily closing NAVs and index values for tracking error calculations makes little sense; like roosters crowing dawn in each time zone.
On the other hand, the tracking error of leveraged ETFs (in Canada, the Horizon BetaPro series) should be calculated using periods no longer than daily. Over the longer term, daily rebalancing will cause divergence made all the greater by volatility; like ordering an egg and getting a two egg omelette.
Leveraged ETF tracking error
The multiple-of-daily-index-return objective of leveraged ETFs is not completely accurate, warns Ms. Tretiakova. What actually happens, in the case of a 2X ETF, is that “there is twice the total return minus one times the cost of capital. Currently, this is slightly better for investors than the stated objective of twice the price return because dividend yields are slightly higher than the cost of capital. However, when these two rates vary, the difference may be more significant.”
Leveraged Fund Performance Relative to Stated Objective
and its relationship to dividend yield-interest rate differential
ETFs with unusual tracking error
Some ETFs operate without a specifically stated benchmark, defining only broad asset class exposure. For example, the Claymore Broad Emerging Markets ETF (CWO, launched April 7, 2009) states that “The Manager will select an Emerging Markets Benchmark Index such as the MSCI Emerging Markets Index, the FTSE RAFI Emerging Index or another widely recognized emerging markets index in order to provide such exposure and may change the Emerging Markets Benchmark Index in its discretion without unit-holder approval.” This sounds like advertising chicken while delivering duck. The challenge is trying to determine the tracking error when the target index is changing. One comfort these unit-holders have is that the indicies for groups of emerging markets will likely have similar volatility (risk). This means that the advertised chicken is unlikely end up being pork chops!
Finding tracking error information
Most ETF sponsors offer tracking error information on their websites. Often shown in chart form, price movement of ETFs are easily compared with their underlying index. The actual tracking error of Canadian-traded ETFs and how they compare to others is available at http://purinvesting.com/demo/Screen.htm .
A cost to investors, tracking error is well worth monitoring. It’s one way of keeping ETF sponsors honest and assuring you don’t get salt pork when you expected steak.
Mark Yamada is President of PŮR Investing Inc. a registered portfolio manager specializing in risk management using exchange-traded funds.
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