Financial advisors tell their clients they will hunt for the best investment to help them outperform the market. Ah, yes, 'THE MARKET.' It is a term that has taken on life-like qualities and my, how fertile it has become. Reflecting its human creators, indexing has gone forth and prospered, spawning tracker funds that try to measure the market in increasingly diverse and complex ways.
From humble beginnings as a handful of indexes, there now exist thousands, and the growth rate shows no sign of slowing. Similar to human DNA being sliced and spliced to create more powerful drugs to save humanity from the scourge of disease, financial indexes and funds are being manipulated to try and capture the best traits of a vibrant global financial marketplace and deliver superior results.
But are the index makers and their tracker funds akin to snake oil salesmen, selling ever more obscure and narrowly focused segments of the market to investors chasing performance? Or do they really offer a miracle cure to give sickly portfolios a shot in the arm?
"Index creation is being overdone, and the proliferation of different kinds of indexes and the funds that track them is at an extreme," says Roy Weitz, publisher of the free online mutual fund investment forum "FundAlarm." (www.fundalarm.com)
"The problem with obscure indexes is that they don't represent the market," adds Weitz, who for the last 10 years has used "FundAlarm" to serve as a consumer watchdog for mutual fund investors.
For the purposes of this article, an "obscure" index or fund takes a more theme based approach rather than the traditional view that an index should measure a large cross-section of stocks by market capitalization, style or geography.
And as indexes are being churned out by the likes of Morgan Stanley Capital International, FTSE, the American Stock Exchange, Wilshire Associates, and many more, the Exchange Traded Fund market is ballooning.
According to data provided by State Street Global Advisors, at the end of 2005 there were 444 ETF's globally. In the United States there are 205, representing nearly $300 billion. These funds are supposed to offer diversification as passive investment vehicles and more tax efficiency.
In the fourth quarter of 2005 21 ETF's alone were created, more than half from Wheaton, Ill.-based PowerShares. When asked what fund might be construed as "obscure," responses from chat boards and financial planners cited PowerShares and its eye-catching Water Resources Portfolio (PHO) created Dec. 6 of last year.
In their defense, fund managers that use ETFs to track indexes say they give investors a way to target their investments with granularity, while also offering a cost-efficient way to diversify portfolios.
"We're talking about water here, how obscure is that?" Bond asks.
"What we are finding is investors and advisors are more and more interested in participating at a granular level than at a broader asset-class level. They want to be closer to where the performance will be," defends Bond.
This fund in particular is based upon the Palisades Water index "which seeks to identify a group of companies that focus on the provision of potable water, the treatment of water and the technology and service that are directly related to water consumption."
PowerShares' fund literature points out that concentrated industry investments involve greater risks than more diversified investments.
To critics of the ever finer slicing of the market, that is the crux of the argument. "PowerShares have made it part of their business to go after indexes no one else has gone after. The vast majority of their funds have been launched in the past year: Things like clean energy, water, nano-technology and some broader indexes with extra weightings. These funds don't belong anywhere near the core of your portfolio. I think this belongs more to vanity or mad money. I think they are gimmicks," says Daniel Culloton, senior mutual fund analyst at Morningstar in Chicago.
"I think they are trying to cash in on whatever excitement there is for nanotechnology, which leads one to believe that their fund is more about gathering assets and exploiting hot trends, rather than servicing shareholders," Culloton adds.
According to Culloton, who is Morningstar's ETF maven, investors should stay broadly diversified across market capitalization, style and region. And he cites past research that says anything upward of 10 or 12 funds in a portfolio is "pushing it," and perhaps all that are needed is three or four funds.
Bond, of PowerShares, would argue that there isn't necessarily safety in numbers and uses the S&P 500 SPDR as an example.
"Is water a catchy name or fad? It is a vital resource, how catchy is that? People asking this question have been around, and I have the greatest respect for them, but not every index or fund has to have 100 names in it," says Bruce Bond, founder, president and chief executive officer of PowerShares.
The SPDR (SPY) is the largest ETF with roughly $59 billion in assets, or 19.35 percent of the ETF market.
"Do you think it is really appropriate that an index which is created to measure the market be used to invest in?" asks Bond, who cautions that he tells potential investors looking strictly for a benchmark that PowerShares is not for them.
The majority of PowerShares funds, for instance are based upon American Stock Exchange Intellidex, which is a modified equal-dollar-weighted index composed of stocks selected quarterly based on a proprietary quantitative method.
"On the water or clean energy funds, these are exposures to indexes, but not based upon quantifiable methodologies. They are based on a company or people that are experts in these areas," said Bond.
In late January, Amvescap PLC of London said it would purchase PowerShares with an initial $60 million payment. If certain revenue targets are met over the next four years, Amvescap would pay an additional $170 million.
But for gadflies like Weitz, who also manages the portfolio of a wealthy family, the question of just what these new indexes measure is of great concern. "What are they measuring? If you have a poorly constructed index you are measuring something that is not meaningful," Weitz says.
"For financial planners, I think they need to be careful and justify their decisions to clients as to why they are following a particular index," he adds.
WHAT DO FINANCIAL PLANNERS SAY?
Not addressing the water index in particular, Greg Ehret, who runs the ETF initiatives at State Street Global Advisors, a division of Boston-based State Street Corp., says it all comes down to investor choice.
"I don't know if I would say 'obscure.' I think these indexes and funds provide access to a specific industry and give investors exposure to it. I think there should be more," he says.
There is no disputing the popularity of ETFs and the exposure they can offer investors through passive management rather than active stock picking.
"You ask, 'How many is too many?'" I would answer that with the question, "How many active management strategies are too many?" says Ehret, adding "I always think investor choice is good as long as they understand what they are buying."
By the end of January nearly $10 trillion was invested in the U.S. mutual fund industry alone, and more than $20 trillion worldwide, according to New York-based Strategic Insight Mutual Fund Research and Consulting. This includes open- and closed-end mutual funds, mutual funds underlying variable insurance products and exchange-traded open-end mutual funds.
"Accelerating diversification effort--from U.S. - centered equity funds to international funds, from value funds which dominated choices over the past four years, towards growth funds, and increasing use of fund-of-funds--all reflect investors' intensifying engagement in creating a more prudent asset allocation portfolio," says Avi Nachmany, Strategic Insight's director of research.
For financial planning veteran David Diesslin, the finer slices of the market don't prove to be as valuable a tool for investing as fundamental research of individual investments, although he claims he is agnostic when it comes to active versus passive investment management styles.
"The point is, we typically don't use these obscure ones. We find that in obscure markets, active management performs better, " says Diesslin, principal of Diesslin & Associates in Forth Worth, Tex.
"A large-cap stock market fund may be okay for passive investors, but as the marketplace becomes less efficient, I am less comfortable with a synthetic passive approach to investment," he says noting that in a declining market index funds become less attractive.
In addition, the less traveled indices or funds could have wider bid/ask spreads, making them more expensive because they are less efficient ways of investing.
But the point of index funds is that they offer investors a ready made way to diversify their holdings. As many put it, they allow a portfolio to 'tilt' toward a direction where they think there might be superior growth.
Arguing in their favor is Keith Newcomb, financial planner and wealth manager at Full Life Financial LLC in Nashville, Tenn.
"It provides advisors like me with a tool to call on at specific times and for specific reasons. I am really pleased they are being created," says Newcomb, "My client's needs are varied and this broad array of investable products allows me to meet my client's needs with precision."
Newcomb, who struck out on his own in 2002, adds:
"Why would you put a client in an oddball investment or index fund? Well, most investment advisors have a discipline that they follow. In my case, I use style, markets and geography to drive decision making. For me iShares in 2000, where they presented style-based slices of the broader market, allowed me to implement my strategy with more purity than before. There can be style drift in funds. An actively managed fund tends to have more problems with style drift," Newcomb explains.
For another financial planner, the proliferation of indices is simply indicative of the demand from savvy investors and institutions.
"I think the age of over-reliance on archaic asset allocation models is over," says William Wright, an investment advisor with 30 years experience, who runs Guidance Financial Consultants Inc. based in Wichita, Kan.
"What is obscure to one person is a staple to another's investment diet," Wright points out, adding that "90 percent of these types of funds are not for 90 percent of the people." But Wright says he is willing to invest in trends and actively manage them using ETFs and funds.
However, if an investment manager is actively managing money using the largely passive ETFs to gain diversification and exposure to the market, critics say the benefits of their low costs are diminished, and the investment manager can still pick the wrong trend.
According to Morningstar Research, annual ETF expenses for every $10,000 invested are approximately $36 versus $147 for a similar amount of actively managed U.S. equity funds. However, ETFs also bring commissions with each buy or sell, putting potential costs higher if they are traded actively. But one saving grace may be that ETFs have proven themselves, in general, more tax efficient than regular mutual funds.
"'Core and Explore' or 'Portable Alpha'--these are the latest names for essentially what amounts to active management," says Morningstar's Culloton. "Some advisors may have high confidence to jump in and out of ETFs. I am dubious because if individuals or managers have a lousy track record in picking stocks, what makes us think they are better at picking sectors?".
Justin Daniels is a freelance business writer.