Tuesday, April 19, 2011

Final Score: ETFs 1: Leafs 0

Too much success can be a bad thing.

The Toronto Maple Leafs don’t need to put a competitive team on the ice. Season ticket holders already compete for 90% of all seats, broadcasting revenues are maxed and virtually every game is sold out.

The Leafs represent a clear distortion in the marketplace. There is little incentive to win because fans act irrationally.

The popularity and institutional success of passive investing in general (replicating the performance of an index), and exchange-traded funds (ETFs) in particular, have led some to believe that distortions result because investors act rationally.

“ETFs are radically changing the markets to the point where they, and not the trading of underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future,” write Harold Bradley and Robert R. Litan in a 2010 paper for the Kauffman Foundation.

The authors are concerned about ETFs and other influences they feel discourage new issues and impede the efficiency of capital markets. They believe the popularity of ETFs has led to trading volumes that overwhelm the liquidity of underlying securities, thus distorting valuations.

Fundamental to the authors’ argument is the dominance of passive over active investing. Dominance that overrides the arbitrage of individual stocks gives their argument credibility.

The case for indexing

In an analysis for Vanguard research, “The Case for Indexing in Canada,” authors Philips, Walker and Kinniry restate in a Canadian context what others have observed elsewhere: that costs are difficult for active managers to overcome. The asset-weighted expense ratio for actively managed Canadian equities funds was 2.29% (May 31, 2010) versus 0.87% for Index funds, a difference of 1.42%. Cap-weighted Canadian equity ETFs have expense ratios between 0.07% (HXT) and 0.25% (XIC) for a difference of 2.04-2.22%.

Active management can occasionally overcome this disadvantage in the short term but has difficulty over the long term. The sidebar (see “Relative performance of Canadian actively managed funds”) from the Vanguard study shows the consistency with which actively managed funds underperform their benchmarks, and somewhat alarming median annual return shortfalls.

The (weak) case for active management

1. The most popular argument for active management is a desire to beat the market. Advisors say the only way to guarantee you won’t beat the market is to index. It is possible to pick an outperforming stock but difficult to do so consistently, and really difficult to pick a portfolio of winners. If investors selected only a few stocks, watched them closely and kept trading costs low, they would have more success because high turnover costs kill returns. Picking active, outperforming mutual funds is a low-probability activity. Nevertheless, investors try to pick winners because they think it is possible.

2. Fun. Indexing isn’t. There is no question that passive investing is the intelligent choice. Lower costs boost returns, but talking about stock picks is more fun. People do it even if they aren’t quite sure what they are doing. There is higher entertainment value to active management.

3. Special knowledge. In most professional endeavours, specialized education is a barrier to entry. With no apology to my portfolio manager colleagues, picking stocks is not neurosurgery. Anybody can do it. Results may not be consistent and the methodology may at times resemble picking horses at the track, but anybody can open an online account and get some kind of return. In bull markets they are likely to be successful. Less so in bear markets. Investing is egalitarian.

Current SEC investigations aside, material non-public information is difficult to obtain and illegal to use, so potential access to inside information is no longer an advantage for Street veterans. Twenty-four-hour business news media has given the public access to the same information as the professionals, on as timely a basis. The poor record of investment professionals—reflected in the mutual fund numbers—suggests that educated and experienced pros find outperforming difficult. Despite what should be a discouraging record, mutual funds have 20 times the assets of ETFs in Canada. This is hardly the overwhelming dominance to which the Kauffman paper alludes.

4. The superstar. Western society has a fascination with the superior individual. The U.S. Naval Academy graduate with a Harvard MBA and PhD in Quantitative Finance from Wharton must be a superior human being and should be able to build portfolios that outperform on any basis. If such a person exists, she is working at a hedge fund and couldn’t care less about your money or mine!

5. Not-so-smart people do it. Hubris is a huge motivator. The annoying neighbour, the chatty dentist, and Uncle Fred the blowhard all talk about how they picked the stock of the decade. Maybe they did, but you will also notice that only lottery winners are interviewed, not the hundreds of thousands of losers. Ask Uncle Fred about his portfolio’s total return over five years for a reality check.

There’s not much of a case for active management. In Canada, however, a $12 billion-a-year gorilla of an investment industry stands between the retail investor and the door containing common sense. Greed will always create the motivation to arbitrage the valuation of underlying securities in an index. This may not happen as instantly as the Kauffman authors would like, but if there is an opportunity to squeeze a penny from the market, it will be done.

In the face of all this illogical behaviour, investors can still efficiently participate in the long-term growth of an economy, sector or industry using ETFs at low cost and with full transparency. Unlike the long-suffering, irrational Maple Leafs fan, an ETF investor may appear to perform in mediocre fashion throughout the season but in the long run will beat 90% of the competition.

Stanley Cup? Who cares, because someone other than the owners will be laughing their way to the bank: you.

Tuesday, April 5, 2011

Evolving Revolution in ETFs

Free at last!

Once an opaque pastime for the rich, investing has been hidden behind obscure terminology, highly paid advisors, and arcane documents, like the mutual fund prospectus. The digital age is changing all that. ETFs are weapons in the movement to emancipate individual investors.

The explosive growth of exchange traded funds (ETFs) has been both exciting and bewildering. Retail investors, excited by broad access to timely, low-cost, tax efficient and diversified exposure to capital markets are also bewildered by the scope, breadth and number of products – 224 in Canada, 3,500 globally and 500 ETFs in registration with the Securities and Exchange Commission (March 2011). Sorting, selecting and constructing portfolios are new and growing challenges for investors. Nevertheless, ETFs have provided only the second significant advance for individual investors since the popularization of the mutual fund in the 1990s (the first being the introduction of the index mutual fund).

Mutual fund companies must also be excited and bewildered. Traditionally marketers and distributors of investment products, banks and fund companies are reassessing their business models. Scale has always been important but it is critical today with compliance expanding and margins contracting. Although the mutual fund continues to dominate retail investing, better-informed investors recognize that costs matter and that in an interconnected world, transparency and access to pricing more than once a day should be fundamental.

ETFs, because they are listed directly on stock exchanges without having to be “approved” by a sales entity, provide a distribution “end run” around the established axis of bank and fund company control, and give buying choice directly to individual investors. Furthermore, the hype around “star” managers and persistent marketing of past performance has worn thin. It is not exactly breaking news that past performance is no indication of future performance.

Sophisticated investors have been using ETFs for over a decade, but the broad public is catching on, albeit slowly. Early adopters of ETFs have been CEOs, senior executives, sophisticated high net worth investors, and investment professional themselves. However, innovation is still driven by professional money managers motivated by increasingly knowledgeable institutional clients. Individual investors can exploit these trends and ETFs enable them.

Democratizing diversification

The principle of diversification is not new. Natural selection and evolution itself may have been the first practical implementation of diversification as a means for the species to survive. Harry Markowitz put form around the substance of portfolio diversification in (Modern) Portfolio Theory (1952). Retail and institutional investors already knew not to put all their eggs in one basket but it wasn’t until the 1970’s that index or passive investing became pervasive among large institutional portfolios about ten years after the introduction of the Capital Asset Pricing Model (CAPM) suggested a distinction between systematic non-diversifiable or market risk, β, and unsystematic diversifiable idiosyncratic or asset specific risk, α. The idea of combining a low cost passive core portfolio using index strategies to capture broad market (β) returns and using satellite portfolios to generate excess (α) returns has been accepted institutional practice for 30 years. Importantly, passive investing, once the domain of the largest institutions and pension funds is becoming “mainstream”.

Investment professionals were the first to embrace exchange traded funds (ETFs) when the Toronto Stock Exchange introduced Toronto Index Participation Shares (TIPS) in 1990. Replicating the TSE 35 Index (predecessor of the S&P/TSX 60 Index), institutional managers found they could rapidly deploy cash in a diversified manner using TIPS. Individual investors gained their first access to instant transparent diversification through an exchange as a result.

Diversified Canadian Equity – ranked by diversification and cost



iShares S&P/TSX Capped Composite



BMO Dow Jones Canada Titans



Horizon BetaPro S&P/TSX 60



iShares S&P/TSX 60 Index



International diversification

Thirty years ago, international equities were considered “alternative” asset classes. Access to markets and diversification within them were barriers. Not so today. ETFs offer access to a growing array of international markets. The emerging markets are an area of particular interest to professional investors. As a consequence, more granular choices are available to all.

International or Global Equity – ranked by diversification and cost



iShares MSCI World Index






BMO International Equity Hedged to CAD



Claymore International Fundamental Index (hedged and non-hedged)



Emerging Markets Equity – ranked by diversification and cost

iShares MSCI Emerging Markets Equity Index



BMO International Equity Hedged to CAD



Claymore Broad Emerging Markets



Specific Emerging Markets Equity - ranked by diversification and cost

Claymore China



Claymore BRIC



BMO China Equity Hedged to CAD



iShares MSCI Brazil Index



iShares China Index Index



iShares CNX Nifty India Index



iShares MSCI Latin America 40 Index



BMO India Equity Hedged to CAD



The three factor model and the style box

Institutional managers have found CAPM a useful but imprecise tool. The Fama-French three factor model added style (value/growth) and size (small cap/large cap) to market risk finding that, for U.S. equity markets over time, value outperformed growth and small capitalization stocks outperformed large capitalization stocks. These simple ideas provided the basis for the Morningstar Style Box of money management categorization (1992) and contributed to the popularization of mutual funds over the past two decades. ETFs are available that address all three factor approaches.

Value Canadian Equity – ranked by diversification and cost



Claymore Canadian Fundamental Index



iShares Dow Jones Canada Select Value



Horizon AlphaPro North American Value



Growth Canadian Equity – ranked by diversification and cost



iShares Dow Jones Canada Select Growth



Small Cap Canadian Equity – ranked by diversification and cost



iShares S&P/TSX SmallCap



iShares S&P/TSX Completion Index



Sectors and countries

If three factors are good, more must be better. Breaking market risk into more component factors can be a comprehensive way to control components of risk. The simplest example is the aready-pervasive practice of isolating sectors and industries domestically and globally. Canadian sector ETFs are available for energy, financials, information technology, materials and REITs from iShares with choice in most offered collectively by Bank of Montreal (BMO), Claymore and Horizon BetaPro. Global sectors include agriculture, real estate, and water offered by Claymore with choice in metals and infrastructure offered by BMO.

For U.S. markets, BMO offers banks, healthcare and NASDAQ ETFs. Investors with access to U.S. markets get an even broader palette of ETFs in every sector imaginable. On the fixed income side, there is a growing list of sector, quality, and term choices with international and inflation protection included. Commodities and income choices are also pervasive.

What’s next and why

Investors who experienced the financial crisis and market meltdown in 2009 know that there were few places to hide from the twin forces of volatility and a liquidity vacuum. At one end of the spectrum, broad diversification did not save portfolios nor did stock picking at the other.

Expect more creative approaches towards diversification. Income generation is a popular one at the moment.

Income – ranked by diversification and cost



iShares Diversified Monthly Income



BMO Monthly Income



Claymore Canadian Financial Monthly Income



Claymore S&P/TSX CDN Preferred Share



iShares S&P/TSX Preferred Stock Index Hedged to CAD



Alternative approaches will also start to appear in Canada that replicate hedge fund strategies. BMO’s Covered Call Canadian Banks (ZWB 0.65%) and Horizons AlphaPro S&P/TSX 60 130/30 Index (HAH 0.95%) are examples. In the U.S. merger arbitrage and managed futures ETFs are several active global macro choices are also available.

Most intriguing are ETFs that reflect what professionals are trying to accomplish using risk and leverage. There is a clear relationship between volatility, as measured by the standard deviation of a market like the S&P 500, and market direction. Stable or falling volatility appears to accompany rising markets while increasing volatility accompanies falling markets. The reason is that volatility is persistent over the short term (autocorrelation = 0.75) and return is not (0.05). This has led to the tracking of VIX, a measure of volatility based upon option premiums. These strategies are not for the retail investor ...yet.

Volatility Indices



HBP S&P 500 VIX Short-Term Futures™



HBP S&P 500 VIX Short-Term Futures™ Bull Plus



As other professionals study the relationship between groups of securities we expect that their experience will be the same as PŮR’s. There are relationships that have always existed but have not yet been exploited. The application of various statistical techniques will lead to new ways to bend and shape risk and ETFs will be the testing ground for these new ideas. The retail investor will benefit in the end because the vehicles will be transparent and available on public exchanges.

The educated consumer is the ETF’s best customer today and the product stream of the future will affirm this. In a single digit return environment with pension plans shifting liability to individual and social welfare programmes under challenge, investors must take more responsibility for their financial futures. Advisors need to improve their skills and mutual funds will have to find a new value proposition.