by WWM | Jan 2, 2019 | Exchange Traded Funds
We will end our look at exchange traded funds (ETFs) with a few words on fund of funds.
Fund of funds are also available with mutual funds. My comments apply equally to them.
Fund of Funds
As the name indicates, an investor purchases an ETF (or mutual fund) whose holdings consist solely of investments in other ETFs (or mutual funds).
In this sense, it is the same as life cycle ETFs. However, fund of funds maintain their stated asset allocations, they do not adjust the mix over time.
Or similar to ETF wraps. But with less flexibility regarding changing asset allocations within the overall fund.
For example, consider the iShares Morningstar Multi-Asset Income ETF. It invests in a multitude of iShare funds (10 at the time of writing this post) aiming for a target asset allocation of 60% bonds, 20% stocks, and 20% alternative assets.
Advantages
Simple
I think simplicity is the primary advantage.
You do not need to buy multiple investments in order to create a diversified portfolio. You simply purchase one that matches your desired asset allocation. Further, the fund of funds automatically adjusts its holdings to maintain the stated mix. Instead of monitoring and assessing many investments, you only need to track the one ETF.
Relative Cost Effective Diversity
Secondly, because fund of funds invest in other ETFs, the holdings are relatively cost effective and efficient investments. Relative, that is, compared to active management strategies or holding mutual funds.
Plenty of Options
Thirdly, there are a wide variety of fund of funds available. You should be able to find one that meets your specific investment objectives. Whether that be a simple split between cash, fixed income, and equities, or something more complex.
Of course, if your target asset allocation changes, and it will over time, you may need to sell the entire fund of funds. Rather than just fine tune a few of the sub-funds to meet your new needs.
Disadvantages
Management Fees
For me, a problem with fund of funds is always the incremental costs involved.
A major advantage of ETFs, in general, is their relatively low expense ratios. But as complexity increases, fees also rise.
Also, you need to watch for double dipping. The investments held by the fund of fund are also ETFs (or mutual funds), which have their own fees and expenses. Given increased competition, often these are adjusted down, but there is still the possibility of paying twice for the same service.
Be sure to compare annual fund of fund costs versus investing in the individual funds that make up the fund of funds before committing.
Potentially Not the Best Investments
It can also mean that the fund is not investing in the best available ETFs. Rather, the prime criteria for ETF selection is the issuer of the individual ETF.
In the iShares Morningstar Multi-Asset ETF I linked to above, all 10 sub-funds are iShare ETFs. Which makes sense given it is an iShare fund of funds. But are all 10 sub-funds the “best in class” that you would buy individually?
There are differences in performance and costs between different ETFs within the same category. I would rather select the best available ETF in a specific asset class, not simply choose the ETF because it is from the same company as the fund of funds.
Conclusion
In general, I tend not to use fund of funds. It is not usually difficult to set up a target asset allocation and choose “best in class” ETFs from across a variety of issuers. That way, I get the best individual investments and save some costs.
That said, there may be niche markets or areas where it does make sense to use a fund of fund. As competition for client money continually increases, ETF issuers are reducing/eliminating double dipping and trying to keep costs in line.
The key is to find strong investments that meet your personal objectives on a cost effective basis. That may be a fund of fund. But more often I think, you are better off building your portfolio from individual ETFs.
by WWM | Dec 19, 2018 | Exchange Traded Funds
Today we will look at life cycle or target date funds. These funds ebb and flow, it seems, in popularity. A few years ago, there were many. Today, less so. Maybe over the next decade we will see a resurgence.
In this post we will focus on exchange traded funds (ETFs). But there are also life cycle and target date mutual funds.
Some technical differences between the two, but the fundamental principles are the same.
What is a Life Cycle ETF?
There are two keys to life cycle ETFs.
Retirement Date
The ETF is based on an expected retirement date for investors.
That “target date” is normally part of the fund’s name. Investors choose an ETF that corresponds to their specific retirement timeline. For example, you are 30 years of age in 2020 and intend to retire at age 65. So you would select an ETF with a target date of 2055.
While primarily used for retirement planning, they can also be used for other objectives with fixed future dates. Examples might be: weddings, home purchase, children’s college fund.
Asset Allocation
These funds use asset allocation techniques that shift over the life of the fund.
We will cover asset allocation later as it is crucial for investment success. Even more important than the actual investments that you select.
When young, there is a long time horizon until retirement. As such, young investors can tolerate greater volatility (i.e., risk) in their portfolios in the pursuit of higher expected returns.
As investors approach retirement, they want to lock in their portfolio gains. Further, they wish to reduce the uncertainty over the amount of capital they will have at retirement.
With life cycle ETFs, the fund invests in higher risk assets initially. As time to the target date decreases, the fund shifts its investments into less risky assets.
If you want to refresh yourself on this, please review my previous post on the Life Cycle View of Wealth Accumulation.
I would also suggest you take a look at my posts on Investor Profiles, as well as Investor Objectives and Investor Constraints.
Why Use Life Cycle ETFs?
One Stop Investing
A major lure of life cycle ETFs is the ability to put your capital in one investment and (almost) forget about it until retirement.
You can set up automatic deductions from your chequing account and invest in this structure every month. The fund managers adjust the portfolio periodically to ensure that the time sensitive asset allocation targets are met.
Very simple for investors.
Cost Efficient
ETFs are generally less costly than comparable mutual funds. The same is the case here, subject to the usual caveats.
ETFs are also less expensive to own than paying a professional to pick individual equities, bonds, and other assets as part of one’s portfolio.
Cost Effective
It is highly questionable as to whether professional asset managers can actively outperform a passive investment strategy.
For most investors, I would recommend taking a passive approach. Therefore, utilizing ETFs and open-end index funds are the preferred course over paying a professional.
Life Cycle Approach (Generally) Works
This is the way to successfully invest over the long run.
The use of asset allocation strategies based on one’s phase of the life cycle, that is. Not necessarily the use of life cycle funds.
Why Not Use Life Cycle ETFs?
Not Costless
I also believe that cost minimization is crucial to wealth accumulation.
While ETFs are generally less costly than mutual funds and active management, there are still annual fees and expenses charged for life cycle ETFs.
You are paying for someone to purchase and adjust ETFs over time on your behalf. Something that you should be able to do for free.
Additionally, life cycle funds invest in other ETFs. These ETFs have costs of their own. So you run the risk of paying twice for operating costs.
Investors May Not Be Homogenous
Life cycle ETFs make assumptions about generic investors based on an expected retirement date.
But investors are individuals and not all cut from the same cloth.
Some investors may be more risk averse than others. Some investors may expect to live a long life after retirement and will want to continue seeking higher returns through riskier investments. Or perhaps other priorities – children, health issues, career interruptions, home purchase, etc. – come along that require individual investors to deviate from the life cycle planning of the generic investor.
Deviations in your personal life from that of the generic investor can complicate the simplicity of investing in only one product and forgetting about it until retirement.
Invest and Forget
Investment companies love this concept.
Some investors love this concept.
I would suggest smart investors be more cautious about “invest and forget” investments.
Regardless of the investment, you always need to monitor its performance. Not just in absolute terms, but against its peer group, designated benchmarks, and its expected return versus risk profile.
While I do not expect investors to study charts and data daily, you should always review your holdings at least annually. Quarterly or semi-annually is even better. Should there be issues with certain investments, you will need to take action.
“Buy and forget” is not the answer to successful results.
Conclusion
So those are the pros and cons of life cycle ETFs and, to a similar extent, life cycle mutual funds.
Another relatively new investment concept, I have not seen long-term performance data. So I cannot comment on their net or relative results.
Given the investment strategy, you should invest for the long-term. Do not plan to be actively trading these funds.
Also, the investment strategies employed encompass a wide variety of asset classes and take a holistic approach with the investor. If you have other investments outside the life cycle fund, you need to monitor the fund to ensure that you do not over-invest in any one area. Otherwise the efficiency of your total investment portfolio may suffer.
I do like the simplicity of these investments. And for many people, the easier something is, the more likely they will partake.
However, I think that the average investor can easily create a well diversified portfolio of ETFs or index mutual fund encompassing all necessary asset classes. Then, through periodic monitoring and rebalancing to reflect your unique objectives and constraints, you can replicate what these life cycle funds achieve.
And without paying a management fee.
As to how one should set up an investment strategy, we will come to that in the new year.
by WWM | Dec 12, 2018 | Exchange Traded Funds
Exchange traded fund (ETF) wraps are another product you may encounter.
Relatively small in number, ETF wraps are gaining some popularity.
Not a topic to spend much time on, but I want to expose you to this investment approach.
Also, you can add a few useful investment terms to your vocabulary.
ETF Wrap
Whenever you see the term “wrap”, think of the associated product as a mix of investments wrapped together in a package. In this case, ETFs are lumped together and sold to investors.
How the ETFs are grouped for investment purposes may be the result of decisions by either the investor or a professional asset manager.
With investing accounts, always remember the term “discretion” Discretion is the ability to choose a specific course of action.
Discretionary Account
In a discretionary investment account, the asset manager chooses the specific ETFs held in the investor’s portfolio.
With an ETF wrap, the investor selects from a range of asset allocation options (e.g., 100% Canadian equities; 100 % Global equities split 10% Canada, 40% U.S., 50% other; Balance portfolio of 60% equities, 40% fixed income). The variety offered (and fees!) may differ between asset managers, so comparison shop if you want a managed, discretionary, ETF wrap account.
Once the investor decides on the mix, the asset manager makes the day to day decisions within those parameters.
Non-Discretionary Account
In non-discretionary accounts, the investor makes all the decisions. There may be investment advisors who provide advice and recommendations, but the selections lie with the investor alone.
As with ETF wrap discretionary accounts, the investor has to initially choose an asset mix.
But then the investor must also make the decisions as to the specific ETF investments among the available options. So there is more work involved for the investor.
Advantages
The arguments for using an ETF wrap account are the same as in all ETF versus open-end mutual fund discussions: often lower total expense ratios; no-loads or sales charges; increased liquidity; possible tax efficiencies.
As we have previously seen, these advantages may be true on average, but there are significant variances between individual ETFs and mutual funds. So do your analysis and due diligence.
With ETFs generally less costly than mutual funds, you can get professional management for less cost. The lower ETF costs may offset the money paid for asset management.
Further, the asset managers are only selecting investments from the pool of available ETFs. Compare this with mutual fund managers or asset managers in discretionary equity accounts. These managers must analyze a substantially larger investment set when making decisions. This increases their workload and should increase their costs and management fees relative to a manager that only needs to select from ETFs.
As such, professional management of an ETF wrap account should be cheaper than in an actively managed mutual fund or equity account.
Disadvantages
With discretionary ETF wrap accounts, you are paying for portfolio management, operating, and administrative costs.
Yes, management fees for ETF wraps should be less than in an actively managed account, but you are still paying for a service you may not need.
Conclusion
If this is something you think makes sense for you, feel free to invest in ETF wrap accounts.
I think though, that as your investment knowledge strengthens, you will be comfortable managing your own investment portfolio (made up primarily of ETFs and no-load open-end index mutual funds), so that you do not want to pay extra costs for these accounts.
by WWM | Dec 5, 2018 | Exchange Traded Funds
We initially reviewed passively managed, index exchange traded funds (ETFs). These make up the vast majority of ETFs.
But there are other, less common, ETFs out there. We have looked at both actively managed and leveraged ETFs.
Next in the progression is inverse ETFs.
Inverse ETFs
Like normal index ETFs, inverse ETFs also track a specific benchmark index. But the objective is to move in the exact opposite direction of the index.
Through the use of derivatives and advanced trading strategies, inverse ETFs essentially create short positions on the benchmark index. These ETFs profit when the benchmark index decreases in value. If the Standard & Poor’s (S&P) 500 falls 5%, an non-leveraged inverse ETF, such as the ProShares Short S&P500 (SH), should rise approximately 5%.
The definition of inverse ETFs has some flexibility. It often includes funds that employ leverage to enhance short positions and accelerate relative returns. For example, Direxion Daily Financial Bear 3X Shares (FAZ) utilizes significant leverage to short shares in the financial sector.
Unsurprisingly, inverse ETFs are also known as “short” or “bear” ETFs.
Not a large investment category. I count only about 133 inverse ETFs in December, 2018 (others may find slightly more or less, depending on how one defines “inverse”). But given market uncertainty, there is some investor demand for these products at the moment.
Advantages of Inverse ETFs
Markets Do Not Continuously Rise
If you believe that a specific market will decline over a certain time period, inverse ETFs give you the opportunity to profit from a short position.
Some investors wish to pursue bear market trading strategies in anticipation of a negative market. Other investors want to use inverse ETFs to hedge their long positions in the market.
Professional Management
I am not an advocate of paying for professional management. However, I also do not recommend trading derivatives and shorting securities for many non-professional investors.
If you plan to engage in these activities, it may make sense to pay a professional to do it for you.
That said, many of these inverse ETFs are passively managed. There is no management other than ensuring the market is (inversely) tracked as dictated by the fund prospectus. However, there will be higher fees than a non-inverse ETF due to increased operating costs involved.
No Margin Required
If you short individual securities or indices, you require a margin account. But investing in inverse ETFs does not necessitate opening a margin account and worrying about margin calls.
Additionally, shorting securities within a margin account can be extremely risky.
In theory, shorting a single stock can result in an infinite loss to the investor. This would occur if the share price continued to rise and the investor was not able to close his position. Not a practical concern for most investors, but there is the possibility for significant losses should the share price rise sharply in a short period.
With inverse ETFs, there is no possibility of an infinite loss. At most, you will lose the money used to buy the ETF. Your loss will cap at 100%. Not good, but better than 1000% or more.
Good Variety of Inverse ETFs
Finally, there are a variety of inverse ETFs available. Should you so desire, you can short broad market indices, index subcategories, or countries and regions.
Some investors utilize inverse ETFs to target specific sectors or commodities for speculative, hedging, or commercial purposes.
Disadvantages of Inverse ETFs
Increased Complexity, Increases Cost
As with other more complicated ETFs, the greater the work involved, the greater the expenses.
When we looked at long ETFs that track the S&P 500, we saw the S&P Depositary Receipts (SPDR) S&P 500 ETF (SPY) has an annual expense ratio of 0.09%.
What about an ETF that tracks the same index but takes a short position?
As at December 1, 2018 the inverse ETF ProShares Short S&P500 (SH) has an expense ratio of 0.89%.
Once again, a significant price is paid for the more complex fund.
Tracking Error
In using derivatives to short the index, there may not be a perfectly negative correlation.
Or, over time, the ETF may experience return drift as small tracking imperfections magnify. The greater the time frame, the greater the potential deviation.
Both of these can impact the performance of the ETF and not allow it to inversely mirror the index’s returns.
Conclusion
I do not invest in inverse ETFs. But that is mainly because I do not like to pay management fees and am I able to use derivatives and margins to short positions when I wish.
For investors that cannot, or do not want to trade derivatives or personally short securities, it may be worth it to pay a management fee for this service.
When to Potentially Use Inverse ETFs
I would not advise investing in inverse ETFs as a long-term strategy. That would assume the markets will continuously decline in value. Likely not a valid assumption. But if it was, the markets can only fall so far and there would hopefully be other asset classes that would make better long-term investments.
Instead, using inverse ETFs as short-term hedges may be prudent. Locking in investment gains or seeking protection from anticipated declines in specific sectors.
Others may utilize inverse ETFs to engage in market or sector timing activities. Not necessarily a bad strategy but be aware that trying to time market movements is extremely difficult.
Analytical Keys When Selecting an Inverse ETF
In selecting an inverse ETF, analysis should focus on three areas.
One, if the fund is actively managed, what is the experience and track record of the managers? If you plan to pay for professional management, you want to hire the best you can find.
Two, how well does the fund inversely replicate the performance of its benchmark index? If you believe that an index or sector will decline, you want to make sure that the inverse ETF will rise in approximately the same proportion.
Three, what is the fund’s annual expense ratio on both an absolute basis as well as relative to the ETF’s peer group and alternative investments? There may be significant differences between expense ratios on inverse ETFs tracking the same index. Always try to get the best performance for your investment dollar.
by WWM | Nov 28, 2018 | Exchange Traded Funds
To date, we have focussed on passively managed exchange traded funds (ETFs).
But ETFs may also be actively managed.
A relatively new development versus actively managed mutual funds. And not much different in how they are run. Most of the issues, for and against, equally apply to both types of funds.
Actively Managed ETFs
The first actively managed ETFs only came into existence in 2007. You might read elsewhere 2008. That is because the initial ETF from 2007 failed.
According to the 2018 Investment Company Fact Book, at the end of 2017 there were 1832 ETFs with total assets of USD 3400 billion. Of those, only 194 were actively managed ETFs with assets of USD 45 billion.
Not many to choose from and relatively little in the way of assets.
But as they are marketed, we will spend a bit of time on this category of ETF.
Like actively managed mutual funds, these ETFs have a management team making decisions on portfolio holdings.
As with passive ETFs, there should be a benchmark index targeted by the active ETF. However, the active managers have significant leeway in which to choose specific investments. Managers may engage in market-timing activities, alter sector allocations, or even select investments that are outside the scope of the tracking benchmark.
In a passive ETF, investors have a good idea as to the ETF portfolio. In an active ETF, the actual portfolio may deviate significantly from the target benchmark.
Advantages of Actively Managed ETFs
There are a few perceived advantages of actively managed ETFs versus both actively managed open-ended mutual funds and passively managed ETFs.
Same ETF Advantages Over Mutual Funds
The potential advantages over actively managed open-ended mutual funds mirror the general perceived advantages of ETFs over funds.
The absence of loads or sales charges; the ability to buy and sell continuously during exchange trading hours; (normally) increased liquidity; generally lower total expense ratios; possible tax efficiencies depending on jurisdiction.
Please review previous posts for more detailed information on potential ETF advantages relating to trading abilities, annual expense ratios, and transaction costs.
Improved Transparency
Another major perceived advantage is increased transparency.
In investing, transparency is the level and availability of relevant information in order for investors to make informed investment decisions. It also refers to the timeliness of the information as data must be timely to have any relevance.
In most countries, mutual funds are required to disclose their holdings periodically. This may be quarterly, semi-annually, and/or annually.
What is held between reporting dates may be difficult to discern.
Exacerbating matters is that there is also usually a lag between period end and disclosure dates to shareholders. For example, there may be a requirement that the fund reports to its shareholders no later than 60 days from period end. That makes funds in many locations less than transparent as to their holdings.
Lack of transparency may cause problems for investors in creating efficient portfolios.
It also promotes activities by fund managers that are potentially detrimental to investors. These include window dressing, index hugging, and investment style departures.
With actively managed ETFs, transparency is greatly improved.
In many jurisdictions, actively managed ETFs must disclose their holdings on a daily basis or better. As a result, shareholders know what their investments contain and can better allocate their capital.
That said, you still need to watch for deviations from stated investment objectives in actively managed ETFs. If the active manager deviates from the stated style, you may find your overall portfolio is not what you expected. Perhaps too much of one investment or too little of another. As well, the actively managed ETF you purchased may shift its own risk-return profile over time.
Active Over Passive
A potential advantage of actively managed ETFs is that they are actively managed.
While the data generally indicates otherwise, there are many investors who believe that active management can create superior returns (that is, manager alpha).
If you are in this group of investors, these ETFs may be of interest.
Costs May Be Less
One reason actively managed portfolios tend to underperform passively managed ones over the long run is operating costs.
Actively managed portfolios have management fees. They also normally have higher turnover which increases transaction and administration expenses. The greater total expense ratios in managed portfolios put them at a performance disadvantage to passive portfolios.
But while an actively managed ETF will have higher costs than a passive ETF or index fund, it may have a lower cost structure than many actively managed open-end mutual funds.
Mutual fund costs include sales distribution fees, shareholder processing and communication costs, etc. that are not present in ETFs. So it is possible that an actively managed ETF may have a lower cost ratio than a similar open-end fund.
Also, with a lower cost structure, there is less of an initial performance disadvantage against passive ETFs. So the managers have less of a hurdle to match the passive ETF results.
These factors may lead to relatively higher returns in the actively managed ETF.
Lots of mights and mays.
The reason is that actively managed ETFs are such a recent phenomenon. With only a short history and so few ETFs, it is impossible to intelligently assess relative performance.
My instinct says that over time passive ETFs will prove superior in most market segments. There may be opportunities for active ETFs (like active mutual funds) in niche and/or inefficient markets. But time will tell.
Disadvantages of Actively Managed ETFs
As with any investment, there are also some potential negatives.
Passive Over Active
The obvious disadvantage is the classic active versus passive argument. Why pay management fees for something that likely will not result in a positive alpha?
As we just saw, there is no evidence that an actively managed ETF will outperform over time. Until I see conclusive evidence, it might be better to stick to a low cost passive approach.
Costs May Be Less, But…
While actively managed ETFs may have less overall expenses than active mutual funds, there may be transaction costs on ETF trades that do not exist for open-end funds. Depending on one’s trading pattern, there may not be a cost advantage for ETFs over open-end funds.
Also, there can be a substantial variance between total expense ratios of ETFs and mutual funds. And this is especially true for ETFs and funds that follow different investment styles.
Always compare cost structures between investments of the same style. Never assume an ETF will automatically be less costly than an open-end mutual fund.
Again, the useful rule of thumb is that the more work required by a fund, the greater the annual cost. And while I think that there may be potential manager alpha in niche or inefficient markets, these markets also tend to require greater work and incur higher costs.
Improved Transparency
Another potential disadvantage is the increased transparency. Yes it is a two-edged sword.
Investors like the increased portfolio transparency. ETF managers less so.
Active managers do not like disclosing their holdings. In doing so, others can determine the manager’s investment choices and strategies and replicate them.
Many investors try to mirror the investments of successful investors like Warren Buffet. By knowing an actively managed ETF’s holdings in real-time, investors can create their own identical portfolios without incurring any management fees.
Not a profitable situation for the ETF manager.
Further, there may be pricing issues when ETF managers attempt to adjust their portfolios.
The Buffets of the world have some protection as there are delays between trades and regulatory disclosures. If they had to disclose in real-time, other investors would compete for the same investments (almost) simultaneously. This form of front running impacts supply and demand for investments and may cause significant price fluctuations for ETF managers trying to buy or sell portfolio holdings.
A potential result of this transparency problem is that the vast majority of actively managed ETFs concentrate on currencies and fixed income investments. Areas where knowing the manager’s holdings is less of a problem for future transactions and pricing.
Style Drift May Cause Inefficient Portfolios
Finally, there can be substantial style drift in an actively managed ETF.
While there may be a benchmark index associated with the ETF, managers have significant leeway to deviate from the benchmark. Without closely monitoring the ETF’s holdings, individual investors may find that their own investment portfolio has become inefficient. That is, your expected returns may be too low for the level of risk assumed or vice-versa.
Also, there may be less than efficient portfolio diversification based on investments made within the ETF.
So be careful in monitoring an ETFs actual investments versus its stated benchmark.
Conclusion
It will take a few years and a few more funds to better assess the relative performance of actively managed ETFs.
I would suggest that you avoid being part of the test phase. Wait until the data is in before deciding if you want to invest in these ETFs.
If you cannot wait, no problem.
Just make sure you do your due diligence on any ETF you want to purchase. While there may be no track record for the ETF, review the experience and performance of the ETF managers in their previous positions. While the past is no guarantee of the future, it might provide some clues on the manager.