- All other things being equal, when comparing them to traditional index mutual funds I think the advantages of ETFsthe ability to control tax implications more precisely, and to make fund changes during the trading dayeasily outweigh the disadvantages of having to pay brokerage commissions (which are small) to buy and sell ETF shares, and the existence of other trading costs in the form of the bid/ask spread (which also tends to be small except in thinly traded ETFs).
- We have seen ETFs expand from funds based on traditional indexes, to the creation of new indexes with some selective criteria upon which a new wave of ETFs are based. And most recently, there has been the development of non-index based ETFs. Theoretically, this could lead to ETFs that do all the same things that traditional mutual funds doincluding actively managed portfolios. But in the real world, I do not think this is possible. Thats because in the real world, it is arbitrageurs that are currently able to keep the bid/ask spreads small for ETFs. These institutional traders make small profits when discrepancies occur between the price of the underlying stocks in the portfolio and the ETFs share price. However, in order for them to do this successfully, they must have a clear idea of what exactly is held within the ETF portfolio at any point in time, and it is my opinion that without detailed and lasting buy/sell decision rules for the management of the ETF, there is no way for arbitrageurs to hedge the portfolios and keep the bid/ask spreads small. Non-index ETFs would become similar to closed-end funds, in which their share prices often deviate substantially from the net asset value of the underlying shares. And those ETFs that attempt to take advantage of known market inefficiencies, such as small market capitalizations and extreme value, would be the most hurt because of less liquidity and therefore greater pricing disparities.
- For those who feel that there are opportunities to outperform the market by making active investment decisions, who do not want to invest in common stocks, and who believe that it is possible to actually find actively managed mutual funds that will in fact outperform the market: Investing in a portfolio of traditional mutual funds is, in my opinion, the best approach.
- For those who feel they can predict the short-term movement of the market or different segments of the market (country, industries, cap size, etc.): ETFs are the best tool for short- or intermediate-term trading of this type.
- For those who basically want to be index investors: I believe ETFs are better than traditional index funds. I also believe that even an index investor should be in more than one other ETF, because segmenting the market helps diversity. For example: If you used only one ETF for the U.S. market and one for the foreign market, they will be cap-weighted and underweight small-cap and value stocks, which have historically had higher returns. By using multiple ETFs, as in the Model ETF Portfolio, you target different segments and gain a more even exposure to stocks of all sizes even if the individual ETFs are cap-weighted.
- For some investors, a combination of the above or a combination that includes some individual stock selection might make the most sense. An example of such a combination might be: choosing traditional mutual funds for U.S. investments, but using an ETF index approach for foreign equities or adding some micro-cap individual stocks to balance the cap weighting of most indexes.
- Style will be diversified. We will seek emphasis on value stocks when it is possible.
- We will seek a heavier weighting in the small-capitalization area than the typical portfolio.
- We will diversify across equities and real estate, but will not use foreign bonds for risk reductionat least not initially.
- We will diversify across equities, real estate, and short-term bonds. Short-term bond ETFs will be included as an option for investors who need further risk reduction. However, they will not be in the actual Model ETF Portfolio.
- Our style diversification will aim for a heavier emphasis on value than the overall market.
- The capitalization weightings will place considerably more emphasis on small-capitalization stocks than the overall market. We will seek to achieve this not only by including small-cap ETFs but by choosing larger-cap ETFs that do not weight solely on capitalization.
AAII Model ETF Portfolio Review and How to Take Advantage of ETFs
by James B. Cloonan
The sickness in the stock market continues, and even with the Congressional transfusion there does not appear to be a quick recovery in sight. The impact of the election is unpredictable, but by the time you read this, at least that uncertainty should have passed.
Our model portfolio of exchange-traded funds (ETFs) has slid with the market, but is doing better than the market year-to-date, down 14.9% as of the end of September, compared to a loss of 21.0% for the benchmark (the ETF benchmark is a composite portfolio consisting of 80% iShares Dow Jones US Total Market Index and 20% iShares MSCI EAFE Index). The overall results for the Model ETF Portfolio are shown in Table 1.
There have been no changes in the portfolio, as I continue to believe that this portfolio will outperform the benchmark over the long run because it has more exposure to value stocks and small-cap stocks (but please note my later comments about exchange-traded funds in general).
What ETFs Can Offer
We set up the experimental ETF portfolio two and a half years ago to see what contributions exchange-traded funds could make to an individuals portfolio, and to search for a combination of ETFs that would provide a portfolio that could outperform the general market. We later expanded that market to include foreign stocks.
I think we have reached the point where we can make some judgments about what can be expected from equity ETFs.
Before that, let me review some of the characteristics of ETFs that are important when considering them, particularly in comparison to traditional mutual funds:
Based on the above characteristics and on the history of ETFs to date, I have come to believe that:
The Portfolio Continues
After giving it much consideration, we have decided to continue the ETF portfolio in order to assist investors in the last two groups described above.
I believe the ETF portfolio will, over the intermediate and long term, outperform its benchmarks and provide risk-reducing diversification. It is certainly an easy portfolio to manage. But ultimately it is an index approach, and in my opinion will not provide the long-term returns of either the Shadow Stock or Mutual Fund Portfolios.
As mentioned previously you may find it useful for part of your portfolio. There are not as many or varied foreign mutual fund offerings, and an index approach may be the most efficient way to invest internationally while being more selective in the U.S.
For those who intend to use ETFs for timing the entire market or segments of itgood luck to you. ETFs are certainly efficient for that purpose, but our portfolio will not be trying to do that. Changes will be gradual and based on how well a fund achieves its objectives and fits into an overall diversified index approach.
As for the market, it is not possible to predict when it will turn around. As I write this it has slid below the month-end results in Table 1. It is difficult to take the long view but the stock market has always come back. If it didnt, it is hard to imagine what would be a good investment.
What helps me is not to think of my portfolio in terms of market dollar value but to think of it as ownership in a number of productive businesses. The businesses are real, and if you believe in them, the stream of their future profits is the real value.
The market price is just an opinion of the people who are buying and selling today. Market price is only important when you must sell.
And, hopefully, we dont have money we will need in the next three years in the stock market.
We will cover the ETF portfolio again in the May 2009 issue of the AAII Journal. In the meantime, you can follow it at AAII.com. The entire ETF market is covered in the October AAII Journal, which is also available on our Web sitelook for the Guide to ETFs in the AAII Guides area.
|Model ETF Portfolio: Selection Rationale|
The rationale used in building the Model ETF Portfolo is to achieve diversification across the equity classes listed below while maintaining a weighting that, in our assessment of historical data, will provide the maximum opportunity for long-term rates of return. We have a bias toward smaller-cap and value stocks and so does history.
Across national boundaries-U.S. versus foreign:
We begin with an 80% U.S. and 20% foreign portfolio but this could change. Foreign stock returns involve currency relationships as well as the usual equity analysis. The initial weighting takes into consideration the fact that many U.S. companies have significant foreign involvement.
In foreign investments:
In U.S. investments:
Which specific ETFs?
Although the above outlines the areas in which we will look for ETFs, it does not explain how we will choose specific ETFs when there are multiple ETFs in an area. It will be many years before we have enough history to develop a solid set of criteria as we have for the Model Mutual Fund Portfolio. Many of the sponsors of ETFs, however, have a history with other investment vehicles that can provide a guide, as can liquidity, expense ratios, and the philosophy espoused in prospectuses. Over time, we should be able to harden our criteria.
How the portfolio is managed
We will not make trades solely for the purpose of rebalancing, except under unusual conditions. When we make trades for other reasons, we will do so in a way that repositions the portfolio back toward the initial weighting.
The current recommended initial weighting is to give each domestic holding an equal weight (for a total of 80% in domestic ETFs) and each foreign issue an equal weight (for a total of 20% in foreign stock ETFs). If you choose not to hold a particular ETF, maintain the equal weightings in each of the domestic and foreign areas, and keep the balance of 80% domestic stock ETFs and 20% foreign stock ETFs.