Assessing ETP Integrity

In Chapter 5 of the book I take great pains to distinguish between desirable transparency in costs and in the general content or character of the portfolio and undesirable transparency that enables scalpers to trade ahead of the portfolio composition changes that are made in all index funds. Most users of index funds don’t realize the cost of the latter kind of transparency. The belief that any fund can be transparent in terms of its day-to-day composition changes is one of the great weaknesses of indexing. The pioneers of indexing argued that the most appropriate way to manage your money was to buy a broad sampling or even the entire market portfolio in miniature; do as little trading as possible in response to corporate changes and other developments over time; and, consequently, keep your costs low. Unfortunately, most indexing dollars are invested in the various component funds that make up in the S&P 1500 and the Russell 3000 index families. This concentration leads to enormous costs associated with transparent implementation of index composition changes. This impact is going to increase in significance in the months ahead.

After the new edition of The Exchange-Traded Funds Manual went to press, Vanguard introduced ultra-low expense ratios on new ETFs based on the popular capitalization and growth and value segments in the S&P 1500 and Russell 3000 index families. With Vanguard’s S&P 500 ETF at a 6 basis point expense ratio and some competitive response likely from State Street and BlackRock, the concentration of index investments in these S&P and Russell indexes is inevitably going to increase. Investors and their advisors continue to focus on fund expense ratios as if the expense ratio represented the only relevant cost.

I ordinarily avoid making market predictions, but I am confident that the S&P 500 will be the best performing U.S. large-cap index for the rest of 2010 and probably for 2011. This performance will come from money flowing into low expense ratio S&P 500 ETFs. After the inflow slows, the performance penalty associated with high market impact from index composition changes will reverse the S&P 500’s relative performance.

The rapid growth of ETFs has been followed by expansion in the ETN marketplace. Today, there’s around $11 billion in U.S. listed exchange-traded notes. What’s your view of ETNs and what do financial advisors need to know about them? (Also, from an asset allocation perspective, do you count ETNs as bond exposure? Or should they be counted as the asset they track?)

I have not seen an analysis of the impact of the Lehman bankruptcy on the small number of investors who did not react to widespread warnings to get out of Lehman’s ETNs, but the events of the past several years have made most investors acutely aware of the credit risk associated with ETNs. It seems clear that investors and their advisors will only be willing to hold ETNs from banks or other issuers with strong balance sheets.  If you watch the credit quality, ETNs can be useful.

As to how an investor should categorize an ETN in summing up his asset allocation, the answer seems clear to me: if there is enough concern about your credit exposure to the issuer that you even consider counting the ETN as corporate bond exposure, you have probably taken on some credit risk that you are not being paid to accept.

Comparing mutual fund performance relative to a peer group of funds is rampant in the mutual fund industry, yet you argue that it doesn’t give an accurate perspective of performance.

My argument on this specific point is, first, that selecting a relevant mutual fund peer group is difficult and, second, that there are a variety of ways to obtain exposure comparable to the portfolio of a particular mutual fund that are not included in any evaluator’s peer group. Another important weakness in this process is that mutual funds are rarely evaluated relative to ETFs and ETFs are rarely evaluated relative to mutual funds.

I feel that if you must make a performance evaluation of a single mutual fund, the most useful comparison is usually to an ETF based on an appropriate index.  The reason to use the ETF for comparison is that the ETF has expenses and an index does not. We have a long way to go to develop good fund evaluation techniques, but comparing ETFs to mutual funds will be an inevitable part of the solution.