TCS Daily


Diamonds (and Other Funds) Are Forever

By James K. Glassman - April 16, 2004 12:00 AM

The mutual fund is the most successful investment vehicle the world has ever seen. But it has its drawbacks.

Mutual funds are not sold on an open market like individual shares of stock, but by fund companies themselves -- either directly to shareholders or through intermediaries such as investment advisers. Prices are set not every millisecond as shares trade, but every afternoon at 4, when the stock markets close in the United States -- a fact that offers chances for chicanery, as we've seen in recent scandals that have led, so far, to nearly $2 billion in fines and the resignation of three fund chief executives.

While choices are broad, mutual fund expenses can be hefty -- even though most fund managers don't beat the market as a whole. And funds trade so much that they can incur significant capital gains, making their shareholders liable each year for the taxes.

Plus, when you buy a mutual fund, you don't know precisely what you've purchased. Funds are required to list their holdings only four times a year and, since turnover for an equity fund averages about 100 percent annually, about 1/12 of the stocks are different each month. Some stock-fund managers try to time the market by loading up on bonds and cash; others say they run value funds but scoop up hot growth stocks when the spirit moves them; some small-cap funds have half their assets in mid-caps. You don't always get what you want.

It's no wonder, then, that some investors are gravitating to the antidote for these ills. It's the exchange-traded fund, or ETF. Invented 11 years ago, ETFs eschew human intervention in stock picking. You buy the shares of a portfolio that is based on an index that represents a sector (such as U.S. small-cap stocks) or an entire market (such as Latin America).

Because they are run by computers rather than by people, ETFs carry low expenses, usually around a quarter of a percentage point for the larger domestic funds, compared with 1.5 percent for the average stock mutual fund. ETFs are bought and sold on stock markets, so you'll have to pay a broker. Paying $29.95, for example, on a $10,000 purchase of ETFs adds 0.3 percent to your bill (or 0.6 percent round-trip, meaning buying and selling). In most cases, ETFs are considerably cheaper than human-managed mutual funds and cost about the same as index mutual funds. And, since they are buy-and-hold portfolios, ETFs' capital gains are minimal -- until you make your own choice to sell. Barclay's Global Investors, which manages a series of 83 ETFs called iShares, reported "zero year-end capital gains for [its] entire fund family" in 2003.

ETFs are rapidly gaining popularity around the world. A report Tuesday by Morgan Stanley noted that at the end of the first quarter of 2004, there were 302 ETFs, with assets of $229 billion -- compared with just 21 ETFs, with assets of $5 billion, in 1996. ETFs are managed by 35 firms and traded on 28 global exchanges. The first European ETF was launched only four years ago; there are now 109 such funds, with a total of $25 billion in assets. Japan has 17 ETFs with $29 billion in assets.

The United States remains the most active ETF market, with 132 funds and $160 billion in assets through February. Still, that's a pittance compared with the money in mutual funds. Stock funds alone have $3.9 trillion in assets.

The most popular ETF is commonly known by its symbol, QQQ. Its portfolio comprises the 100 largest companies on the Nasdaq Stock Market, weighted according to their market capitalization. Trading has accelerated. In March, an incredible 113 million shares of QQQ changed hands every day, on average.

Second is Spiders, the nickname for Standard & Poor's Depositary Receipts (SPY), a portfolio that mimics the S&P 500-stock index, roughly the 500 largest U.S. stocks.

Below these two, the size and trading volume of ETFs drops sharply, but in third place last month was the iShares MSCI Japan Index fund (EWJ), based on the Morgan Stanley Capital International index for Japan. The ETF, which has returned 70 percent over the past 12 months, provides a low-cost way to own the great public companies of the world's second-largest economy, which, at long last, is recovering. Expenses for the ETF are 84 basis points (0.84 percent) annually. Most stock mutual funds that concentrate on Japan carry expenses of well over 100 bp.

Another leading ETF is called Diamonds, composed of the 30 blue-chips of the Dow Jones industrial average (DIA), which on Thursday added Pfizer (PFE), American International Group (AIG) and Verizon Communications (VZ) while dropping AT&T (T), Eastman Kodak (EK) and International Paper (IP). A big attraction of Diamonds is its dividend yield, currently 2.1 percent, which is about the same as a three-year Treasury note.

Morgan Stanley reports that 15 new ETFs have already been launched this year, and an additional 40 are on the way. They'll focus on such sectors as gold stocks, Chinese stocks based in China, Treasury bonds, semiconductors, telecom services and many more. Vanguard (with a product called VIPERs), Fidelity (with PowerShares) and ProFunds (with ETFs that short stocks, or bet they will fall) are all becoming big players.

ETFs offer a simple way to balance your portfolio. If you need small-caps, you can buy iShares Russell 2000 (IWM), based on the Russell 2000 index, the small-cap benchmark. It has an expense ratio of just 20 bp, compared with an average of 158 bp for small-cap mutual funds. There's another iShares offering that mimics the S&P 600 Small-Cap index (IJR), and Barclays divides both the Russell and the S&P 600 into growth and value halves, which you can purchase separately.

Of course, an index fund is never going to beat the best-managed funds in its category. One of this year's hottest, Buffalo Small Cap (BUFSX), had returned 20 percent through April 5, compared with 9 percent for iShares Russell 2000. But, then again, no one can know which managed funds will be hottest in the future; the past is an imperfect guide. By the way, Buffalo Small-Cap is closed to new investors, as are nearly all the best-performing small-cap funds over the past year -- another good reason to own ETFs.

Small-cap mutual funds that have proved their excellence over longer stretches -- and are open to new investors -- include Baron Small Cap (BSCFX), which has returned an annual average of 13 percent over the past five years, and tiny Independence Small Cap (DSISX), with a 17 percent yearly return over the same period.

But to get back to index funds. . . .

They aren't perfect. William J. Bernstein writes on his excellent online journal of asset allocation, www.EfficientFrontier.com, "How do I really feel about ETFs? I don't buy them. Not for myself, my family and, in particular, not for the clients of our advisory firm. The reason? Because, in most cases, you can do better."

Bernstein looked at seven cases in which a head-to-head comparison can be made between ETFs and Vanguard index mutual funds: The mutual funds returned more over the period he surveyed (in most cases, three years). Why? Expenses and tracking error -- that is, the difference between the returns of an ETF and the index it tracks. "In some cases, it isn't even close; the Vanguard Small Cap Value Index Fund [VISVX] beats the relevant ETF by about 80 basis points both before and after expenses."

Vanguard's 500-stock index fund (VFINX), the most popular mutual fund in the world, returned an annual average of eight bp more than the S&P 500 index between 1993 and 2003, while Spiders returned eight bp less than the S&P.

What's surprising is that Bernstein's analysis shows that the tracking errors for the ETFs he surveyed (mainly the Barclay's iShares family) are almost always negative -- that is, the index itself has higher returns before expenses than the ETF -- while the tracking errors for the Vanguard index mutual funds are, in the seven cases he examines, positive.

"The conclusion here should be obvious . . . : Corporate culture counts. It's not that there's anything wrong with Barclay's; their tracking errors are pretty respectable. It's just that they're not Gus Sauter." Sauter, who joined Vanguard in 1987, is the legendary manager who oversees the company's index funds.

One other problem with ETFs is that they "encourage investors to trade index funds, while index funds are meant to buy, hold and rebalance," says Mark Hebner, president of Index Fund Advisors (www.ifa.com) in Irvine, Calif., whose firm designs portfolios of index funds.

Mutual funds actively deter trading -- that is, buying and selling in short-term bursts -- while many brokers are only too pleased to see you trade your ETFs as much as your heart desires.

While index mutual funds are often a great choice for investors, the proliferation of alternatives is a beneficial development. Let the competition intensify. For smart buy-and-hold investors, ETFs offer a healthy alternative to high-cost managed mutual funds, whose returns over term often disappoint.

Of the ETFs mentioned in this article, James K. Glassman owns Spiders and QQQ.


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