July 9, 2012
More on Tracking Error

My latest story in the The Wall Street Journal’s “Investing in Funds” was about the intricacies of index fund tracking error. The stat, which can be hard to find and even harder to define, is a signal for how well an index fund tracks its benchmark. Some funds and indexes may have an inherent tracking error, due to the nature of the underlying index and the liquidity of the securities.

Using tracking error to compare funds is most useful in the rare situation of two funds tracking the same index and bearing the same cost. Outside of that, tracking error is useful only when viewed as a trend, if that.

The second level discussion around tracking error, however, can be helpful in understanding how index funds are managed. I touched upon some of this in “ETFs are People Too" and will reiterate here. To understand tracking error and index fund management (and why your fund may be better/worse than the next one), study these aspects of your funds management and processes:

Expense Ratio: Expense ratio is usually, but not always, the management fee charged by the fund’s adviser to run the fund. At times, the total expense ratio includes the management fee as well as fees charged by other funds or ETFs held by the ETF. (This pass through notion of “acquired fund fees” gets a little silly. After all, no mutual funds report through the net operational costs of the individual companies they hold.) Total expense ratios can also be driven down to a net expense ratio when the adviser waives or rebates back to the fund any cost above a cap.

Sampling: Also called optimization, sampling is an upfront admission by indexers that not all indexes are actually entirely investible. Bond indexes, in particular, can be hard to replicate based on the unavailability of certain bonds as well as the notion that some bonds are very hard and expensive to trade, regardless of their inclusion in a benchmark index. For stock funds, the ability to sample or optimize is largely dependent on the size of the fund and whether the manager, or market makers, can create baskets of the underlying securities effectively.

Rebalancing and Reconstitution: When an index is rebalanced, i.e. reweighted among its constituents, or reconstituted, i.e. screened for potential entrants or drop-outs, the index announces the changes in advance and then makes the changes several days (or weeks) later. Index fund and ETF managers, however, have to face the operational challenges of actually making those trades as close to real-time as the index shift. While ETF managers hope to make these changes mostly through market makers, at times they will actually have to buy and sell securities on their own.

Securities Lending: When interest rates were higher and demand (and appetite) to short stocks was greater, ETFs (and mutual funds) would enhance returns by lending out stocks and bonds. Due to the manner in which ETF shares are created or redeemed, whereby a market maker delivers a basket of securities or receives a basket of securities, securities lending by ETFs is generally more conservative than mutual funds. When securities are loaned out, they are over-collateralized, meaning that ETF issuer receives slightly more than the value of the security being lent. Net revenue from the loan, after lending agent fees, is income for the fund and can actually offset part of the expense ratio.

Dividends, Interest and Cash: Whether cash comes in through creation baskets or is paid by underlying holdings through dividends and interest, ETFs must reinvest cash in their holdings as well as set some aside to pay the fund’s expenses. For funds organized as Unit Investment Trusts, primarily SPY, QQQ or DIA, dividends are not reinvested in the fund and, therefore, create what is known as “cash drag” during upmarkets and a “cash buffer” during down markets. Regardless of structure, cash accrues daily to pay the manager and contributes to tracking error.

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For more on my view of the market for ETFs and other asset management products, read ETFolution at Forbes.com.

June 21, 2012
Market Maker, Mutual Fund Salesman Part II

The early results are in. Needs more time.

For those of us watching the proposals to enhance market making in exchange-traded products, time to consider the Nasdaq Stock Market and NYSE Arca plans has been extended.

While the Nasdaq proposal received 17 comment letters of varying degrees of support and refusal, the program proposed by NYSE Arca has thus far garnered just 2 comments. Sure, many of those who already commented on Nasdaq—filed earlier—may have said their piece, but the two commenters who came back for more on the NYSE Arca program are significant.

In one corner is the Investment Company Institute, which generally represents the interests of mutual funds. In the other corner is The Vanguard Group, the largest ICI member by mutual fund assets.

As I’ve mentioned before, NYSE Arca is home to the vast majority of exchange-traded product primary listings, but not necessarily the vast majority of ETP trading. In fact, it’s third after a reporting facility run by FINRA and then Nasdaq, according to XTF.com.

Industry comments surrounding the Nasdaq proposal were encouraging. Even Vanguard effectively abstained from a view.

As for the NYSE Arca proposal, ICI had some questions but still “strongly supports” a pilot to test the NYSE’s proposal.

Vanguard, not so much.

"We do not support the Proposal as currently structured," reads the letter from Vanguard Chief Investment Officer Gus Sauter. This is quite a rebuke from a company advising 48 exchange-traded funds listed on NYSE Arca

While it’s possible that more comment letters may come in on the Arca proposal, this disagreement alone should mean back to the drawing board.

Over the course of the next few weeks, I’ll be digging into this deeper on ETFolution at Forbes.com.

June 19, 2012
The Evolving Fund World View

Talk about burying the lede.

In a press release entitled “Morningstar Announces Fund Analyst Research Team Appointments,” the company announced investment fund nirvana.

And no one blinked.

No longer bound by the arbitrary restrictions of product structure, Morningstar is aligning its fund research team into active, passive, alternative and fund of funds.

Most investors don’t hold exchange-traded funds or active mutual funds exclusively. Instead, they invest across a spectrum of vehicles. Our new alignment of coverage into active, passive, alternative and funds of funds research reflects the evolution of how investors are evaluating and employing investments in their portfolios. — Morningstar President of Fund Research Don Phillips

Phillips has appointed Scott Burns to the position of Director of Fund Analysis, overseeing the coverage. Burns came up through Morningstar’s equity research team, then moved on to exchange-traded funds and recently helped build out closed end funds and alternatives.

Watching the rise of ETF-managed portfolios, I’ve often asked whether too many investors and advisers have put on blinders to certain products because: “I don’t DO ETFs” or “I stay away from closed-ends.” I would prefer to hear that people find the right product at the right cost, regardless of structure.

Of course, each product set has its nuances. Traditional mutual funds are opaque. Exchange-traded funds can fluctuate around net asset value. Closed-end funds can use leverage and trade at discounts.

Unifying fund analysis at Morningstar is a step toward showing the world that investment products are investments first and products second.

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For more, ETFolution at Forbes.com.

May 8, 2008
Target-Date Funds: Should You Ask One Out?

Originally posted at Cake Financial.

Nascent, but maturing, Target-Date Funds now demand more scrutiny. Both The Wall Street Journal and Barron’s gave these funds-of-funds, also called Lifecycle Funds, a once over this week without hitting on obvious faults and room for improvement.

According to ICI, assets in Target-Date Funds grew to $183 billion in 2007 from just $15 billion at the end of 2002. That’s 1133% asset growth compared to 88% asset growth for all non-money market mutual funds over the same period. Minute compared to over $12 trillion in all U.S. long-term mutual funds, a shift is clearly on into fund-of-fund products.

The industry has itself a winner, but I still cant figure out why or how. Asset allocation is all over the map for funds with similar retirement dates. The articles point out discrepancies in short-dated funds (2020) in which the Wells Fargo Advantage Dow Jones Target 2020 Fund is 58% invested in stock and the AllianceBernstein 2020 Retirement Strategy fund is 80% in equities. Then Barron’s points to SunAmerica 2020 High Water Mark C, with a 2.3% expense ratio holdings 50% CASH!

For the right people, Target-Date Funds are better than nothing. And, in fact, companies are using these funds for default 401(k) investments following the 2006 Pension Protection Act. Still, I was surprised to read in Barron’s that target funds represent 20% of 401(k) plan assets.

The pricing structures for these funds sound a bit screwy. Vanguard quotes an expense ratio that is the weighted average of the underlying funds. There are some funds, however, that charge a premium for the asset allocation decisions. Never mind that the Target-Date Funds are simply another asset funnel into a fund company’s own sometimes inferior products.

My 401(k) option includes Fidelity Freedom Funds. I would be in line for the Fidelity Freedom 2040 option. The fund is 67% U.S. stock, 18% non-U.S. stock, 5.2% investment grade bonds, 10.1% high-yield bonds and 0.1% other assets. While I may like the underlying fund selections (I don’t), youd’ think that Fidelity might make their Target-Date product essentially an asset allocation recommendation engine and then allow the user to pick funds around that.

I might dial up non-U.S. stock. Swap out a few U.S. stock funds and tone down high-yield. The 401(k) plan does not make that easy. You have to go through Fidelity’s Brokerage Link, which means you have to hold non-plan funds in an account within the 401(k), complicating some of the simplicity of the account.

For those who do like the asset mix in a Target-Date Fund, but want more of one fund or another, you can simply buy it outside the Target-Date Fund and make your own allocation. Like the asset mix in a younger fund but don’t want as much risk? Hold cash or a stable value fund to minimize the equity risk.

Education around such options is not provided, but if the industry truly wants to make these products more user friendly, perhaps it should be.