How do you define a core equity exchange-traded fund? It's a simple question for a crucial subject, and it comes with increasingly nuanced (and controversial) answers.
Generally, ETFs are breeding like rabbits. For wealth managers looking to the ETF market for a core domestic-equity fund, the choices also come in an expanding array. In fact, one could argue that there are too many choices. So it goes in the 21st century financial industry. A progressive-minded inventory can total 29 ETFs by our somewhat subjective count, ranging from funds tracking broad U.S. equity benchmarks to products harboring alternative thinking on the notion of core.
For this story, domestic equity core excludes funds that overtly slice the market into value and growth components or, by design, focus on small- or mid-cap equities. All of those segments have a role, and it's no secret that some advisors prefer to target capitalization- and/or style-specific funds for building a core equity foundation. But for our present discussion, core is defined as either broad or large cap by design, along with what we label as alternative core.
Our tour starts with the familiar indices that cover the U.S. equity waterfront by holding stocks across the capitalization spectrum in cap-weighted fashion. The benchmarks in this corner--such as the Russell 3000 and the S&P 1500--"are everybody's core portfolio," says William Bernstein, principal of Efficient Frontier Advisors, an investment-advisory firm in Eastford, Conn. and author of The Intelligent Asset Allocator. "We always want to own a core holding," he notes.
For those who prefer a core that's deep and wide, there are five choices in the ETF universe (see table, page 60). Measured by net assets, the largest is the Vanguard Total Stock Market, holding more than $6 billion (all data is based on the September 2006 edition of Morningstar Principia).
The distinguishing features of the underlying indices are fairly muted for this quintet, as you might expect for a niche intent on delivering the entire U.S. equity market in one fell swoop. But the five ETFs aren't clones, either. Yes, there's only one U.S. stock market, but broad equity ETF returns can and do vary. For the trailing three years, for instance, annualized total returns differ by more than 100 basis points.
The three-year performance leader is Vanguard Total Stock Market, in part due to the fund's expense ratio of just seven basis points, the lowest of the five. The Vanguard ETF also posted the highest turnover ratio. Nonetheless, the Vanguard fund's three-year tax cost ratio was slightly more investor friendly at 0.3 percent, or nearly half the rate of the other four funds. In other words, Vanguard Total Stock Market's shareholders lost an average of 30 basis points to taxes over the past three years versus almost 60 basis points for the other funds in the niche.
Moving to large-cap ETFs doesn't change a lot when capitalization dictates weighting. Perhaps that explains why the S&P 500 and its competitors remain a popular choice for a core fund. In any case, there are six large-cap focused U.S. equity ETFs, although two are rival S&P 500 funds. The remaining four target competing large-cap benchmarks.
Meanwhile, new arrivals keep coming; the latest is streetTracks DJ Large Cap, which debuted in November 2005.
As with the broad ETFs, there's a bit of selection risk to consider in the six large-cap offerings. For the three years through this past September 30, for instance, the iShares Russell 1000 edged ahead of the two S&P 500 funds by an annualized 40-plus basis points.
The large-cap ETF portfolios harbor other differences as well. For example, the iShares Morningstar Large Core's geometric average market cap of the holdings is roughly twice as high as the level posted by the iShares Russell 1000. In addition, the Morningstar iShares was relatively concentrated compared with its direct competitors, holding about 44 percent of assets in its top 10 holdings versus under 18 percent for iShares Russell 1000. There's also some variation in turnover among the large-cap ETFs.
Such differences pale when you look at funds beyond the standard broad and large-cap ETF choices. Although many advisors are suspicious of applying the definition of core beyond cap-weighted indices, the push for innovation has only just begun. Perhaps the most intriguing newcomer is the PowerShares FTSE RAFI 1000, which features so-called fundamental weighting of the 1,000 largest publicly traded U.S. companies. The fundamental factors are book value, sales, dividends and cash flow. Using those factors for weighting the portfolio is expected to deliver higher returns over time, or so the fund's management asserts. Fundamentally weighted indices are promoted as emphasizing value-oriented stocks compared to market-cap benchmarks, which have been criticized for loading up on stocks considered overvalued at market peaks and underweighting undervalued securities during bear markets.
Critics charge that fundamentally weighted indices are really a rules-based twist on an old idea: exploiting the risk premium in smaller, value-oriented stocks. But no matter what you call it, the PowerShares FTSE RAFI 1000 has initially proven to be a worthy competitor to the S&P 500, albeit over a short time. Through the third quarter of 2006, the fundamentally weighted ETF's total return of 10.9 percent was well ahead of the Spider's 8.5 percent.
Another core alternative to the market-cap design is the Rydex S&P Equal Weight. Although it holds S&P 500 stocks, the portfolio equally weights the securities, a strategy that elevates the impact of smaller companies on risk and return. Indeed, the geometric market cap average for the Rydex S&P Equal Weight is about one-quarter of the Spider ETF's.
Launched in April 2003, the equal weight S&P 500 ETF has distinguished itself by beating the standard cap-weighted S&P 500. For the three years through this past September, the Rydex S&P Equal Weight's annualized total return is 15.8 percent versus 12.2 percent for the Spider. Then again, that's not necessarily surprising. Small-cap stocks have outperformed large caps over the past three years, a tailwind that's aided Rydex Equal Weight. But small caps don't always lead large caps, and so an equal weighting strategy won't always enjoy an edge.
For strategists looking for even bolder substitutes to the traditional core equity choices, there are other ETFs to consider in our alternative core universe. The remaining list is a mixed bag, and arguably a subjective one, too. In any case, the rest of this group ranges from concentrated large-cap funds (Rydex Russell Top 50, iShares S&P 100 and Diamonds Trust) to quasi actively managed portfolios (PowerShares Dynamic Market Portfolio) to dividend-oriented offerings (iShares DJ Select Dividend, for instance). There's also a socially conscious ETF (iShares KLD Select Social Index). Meanwhile, the IPOs keep coming, including the equity-sector-rotation fund (Claymore/Zacks Sector Rotation, Amex: XRO) that's so new it wasn't listed in the September edition of Principia, and so it's not in our table. We drew the line, however, with ETFs focused exclusively on securities on a given exchange. Funds that limit portfolios to Nasdaq- or New York Stock Exchange-listed names look more like an effort at promoting a brand of trading venue than offering an enlightened investment vehicle.
Meanwhile, it's a safe assumption that even more core ETF choices are coming. But it's not yet clear that new-fangled products will overtake the traditional market-cap choices. Innovation is a perennial favorite in the securities business, but old habits still die hard.
James Picerno (email@example.com) is senior writer at Wealth Manager.