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	Symbol	MER
iShares S&P/TSX Capped Composite	XIC	0.25%
BMO Dow Jones Canada Titans	ZCN	0.16%
Horizon BetaPro S&P/TSX 60	HXT	0.07%
iShares S&P/TSX 60 Index	XIU	0.17%

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	Symbol	MER
iShares MSCI World Index	XWD	0.45%
iShares MSCI EAFE	XIN	0.50%
BMO International Equity Hedged to CAD	ZDM	0.49%
Claymore International Fundamental Index (hedged and non-hedged)	CIE	0.68%
Emerging Markets Equity – ranked by diversification and cost
iShares MSCI Emerging Markets Equity Index	XEM	0.82%
BMO International Equity Hedged to CAD	ZEM	0.54%
Claymore Broad Emerging Markets	CWO	0.65%
Specific Emerging Markets Equity - ranked by diversification and cost
Claymore China	CHI	0.70%
Claymore BRIC	CBQ	0.64%
BMO China Equity Hedged to CAD	ZCH	0.71%
iShares MSCI Brazil Index	XBZ	0.75%
iShares China Index Index	XCH	0.85%
iShares CNX Nifty India Index	XID	0.98%
iShares MSCI Latin America 40 Index	XLA	0.65%
BMO India Equity Hedged to CAD	ZID	0.71%

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	Symbol	MER
Claymore Canadian Fundamental Index	CRQ	0.69%
iShares Dow Jones Canada Select Value	XIC	0.25%
Horizon AlphaPro North American Value	HAV	0.70%
Growth Canadian Equity – ranked by diversification and cost	Symbol	MER
iShares Dow Jones Canada Select Growth	XCG	0.50%

Small Cap Canadian Equity – ranked by diversification and cost	Symbol	MER
iShares S&P/TSX SmallCap	XCS	0.55%
iShares S&P/TSX Completion Index	XMD	0.55%

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	Symbol	MER
iShares Diversified Monthly Income	XMI	0.55%
BMO Monthly Income	ZMI	0.55%
Claymore Canadian Financial Monthly Income	FIE	0.65%
Claymore S&P/TSX CDN Preferred Share	CPD	0.45%
iShares S&P/TSX Preferred Stock Index Hedged to CAD	XPF	0.45%

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	Symbol	MER
HBP S&P 500 VIX Short-Term Futures™	HUV	0.85%
HBP S&P 500 VIX Short-Term Futures™ Bull Plus	HVU	1.15%

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.

Are we mismanaging RRSP and DC pension portfolios?

Joe and Sally joined the same company right out of school and enrolled in the registered group savings plan. Sally was three months older than Joe and retired September 1, 2008 with a $600,000 portfolio. Joe’s portfolio was worth only $480,000 when he received his simulated gold watch a few months later. Had they been members of a defined benefit (DB) pension plan [DASH] DB plans determine a pension usually based on a percentage of salary, with the benefit being the employer’s obligation [DASH] Joe and Sally would be drawing identical pensions, all things being equal. They made identical contributions [DASH] with identical employer matches [DASH] to buy identical funds in the identical proportion for forty years. The difference in outcomes because of something as uncontrollable as a birth date seems incredibly unfair. Something is wrong here.
DC plans and RSPs are different than DB plans
DC and RSP benefits are completely a function of contributions and the actual investment result for each employee. Employees are responsible for the outcome, not employers, and the pension amount is unknown until retirement. High costs, poor investment decision-making and lack of scale are documented problems with DC plans, which have generally experienced returns 1% lower than DB plans over time, according to a recent Towers Watson study.
Investing time horizon
DB plans need to match long duration liabilities to pay pensions of existing and future workers, so they usually invest with a very long-term view. Mutual funds, following the objectives in their prospectuses, similarly invest with a long-term view and often a perpetual duration. As a result, establishing and rebalancing portfolios to a fixed asset allocation is popular with DB plans because short-term market variability is theoretically evened out over time. Perpetually long investing horizons always have time to make back losses. In reality, Sally, Joe and every RSP and capital accumulation plan investor has an investing time horizon that is shrinking and shortening every day, whether due to retirement or death. Constructing a portfolio that does not recognize this fact is at best irresponsible, and at worst negligent. Yet most advisors, registered reps and educational sessions for DC plans promote the same basic strategies that were designed for DB plans: diversify, buy, hold and rebalance. The exception is the “target date fund” that automatically reduces equity exposure over time on a fixed glide path. Early generations of this increasingly popular approach have not escaped controversy, a subject we will examine next month.
Conclusion 1: DB plans invest to match perpetually long-dated liabilities, while DC and RSP investors have investing horizons that are shrinking every day. By building portfolios that have fixed asset mixes without regard for the individual requirements of each investor, the industry is ignoring what investors need. Trimming risk from a portfolio as retirement approaches is one effective tactic. A simple way to do this is to introduce ETFs to build in an increasing proportion of stable, low risk. Here are some low-risk choices that can be introduced at least five years before retirement, ranked by cost.
SYMBOL ETF MER
CLF Claymore 1-5 Yr Laddered Government Bond ETF 0.15
ZFS BMO Short Federal Bond Index ETF 0.20
ZFM BMO Mid Federal Bond Index ETF 0.20
ZFL BMO Long Federal Bond Index ETF 0.20
ZPS BMO Short Provincial Bond Index ETF 0.25
CMR Claymore Premium Money Market ETF 0.25
CBO Claymore 1-5 Yr Laddered Corporate Bond ETF 0.25
ZRR BMO Real Return Bond Index ETF 0.25
XSB iShares DEX Short Term Bond Index Fund 0.28
ZAG BMO Aggregate Bond Index ETF 0.28
CAB Claymore Advantaged Canadian Bond ETF 0.28
ZCS BMO Short Corporate Bond Index ETF 0.30
ZCM BMO Mid Corporate Bond Index ETF 0.30
ZLC BMO Long Corporate Bond Index ETF 0.30
XBB iShares DEX Universe Bond Index Fund 0.33
XRB iShares DEX Real Return Bond Index Fund 0.39
XLB iShares DEX Long Term Bond Index Fund 0.39
XGB iShares DEX All Government Bond Index Fund 0.39

Conclusion 2: If returns are 1% below DB plans, using passive or indexed vehicles can help make up the difference. ETFs are appropriate to use if RSP contributions are made once a year. If deposits are made more frequently, as they often are with DC plans, the commission cost of buying ETFs may be prohibitive despite their low fees. Buying index mutual funds and making a transfer at the end of each year to one or two ETFs is the most cost-effective approach. Claymore offers a commission-free way to buy their ETFs through certain brokers, an option worth exploring for some investors.

SUMMARY
Joe and Sally have been abandoned by their employers and the investment industry. They make poor investment choices because they lack the time, inclination and expertise to make better ones. The pension industry [DASH] from portfolio managers, insurance companies and mutual fund companies to registered reps and employers [DASH] guides investors to build portfolios that mimic institutional DB mandates with time horizons ill-suited to the needs of individuals. The high cost of investing has robbed investors of at least 1% annually. ETFs can provide part of the answer, but they aren’t being used in Canadian DC plans at all. Cutting risk from portfolios at the appropriate time can help preserve capital, but investors still don’t get the reliable retirement income they want. We will explore alternative pension approaches that use ETFs in the future.

Target date fund guidelines miss the problem

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

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.

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