What s Inside Your ETF? A presentation to the University of Wisconsin Madison Retirement Association

Transcription

1 What s Inside Your ETF? A presentation to the University of Wisconsin Madison Retirement Association Michael Rawson, CFA Fund Analyst Morningstar Michael.rawson@morningstar.com February Morningstar, Inc. All rights reserved. <#>

2 Agenda ETF Market Evolution ETF Basics A Closer Look Strategy ETFs Fixed Income ETFs Exchange-Traded Notes (ETNs) Commodity Exchange-Traded Products (ETPs) Leveraged Funds Putting ETFs to Work

3 ETFs: A Growth Story

4 ETFs Still Only About 13% of Total ETF and Mutual Fund Assets Assets Under Management $ Bil 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 ETF Mutual Fund *Excludes money market funds. Source: Morningstar, Inc

5 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% Percent of Mutual Fund and ETF Assets Managed Passively 0% *Excludes money market funds. Source: Morningstar, Inc

6 10 Largest ETFs Name Ticker Total Assets $ Mil SPDR S&P 500 SPY 125,631 SPDR Gold Shares GLD 71,054 Vanguard FTSE Emerging Markets ETF VWO 61,434 ishares MSCI Emerging Markets Index EEM 52,185 ishares MSCI EAFE Index EFA 41,802 ishares Core S&P 500 ETF IVV 36,740 PowerShares QQQ QQQ 32,800 Vanguard Total Stock Market ETF VTI 26,762 ishares iboxx $ Invest Grade Corp Bond LQD 24,355 ishares Barclays TIPS Bond TIP 21,878 *As of 1/31/2013 Source: Morningstar, Inc 6

7 Over 80% of U.S. ETF Market Claimed by Top Three Providers

8 What is an ETF? Like a mutual fund Regulated just like a mutual fund Has a manager Has a structured package of assets But trades like a stock Listed on an exchange like a stock or closed-end fund Traded intraday Allows for stock like strategies such as shorting and margin investing, but this flexibility entails complexity

9 Advantages of ETFs Liquidity and Availability Mutual funds usually allow one trade execution time per day More precise portfolio management Cost Less overhead at fund provider Pass on economies of scale Tax Advantage In-kind creation and redemption process Low turnover of index funds

10 Availability ETFs have democratized exotic and previously difficult-toaccess markets Mutual Funds ETFs % Count % Assets % Count % Assets Alterna(ve 5% 1% 22% 3% Commodi(es 0% 1% 8% 9% Interna(onal Stock 15% 15% 18% 22% Sector Stock 6% 3% 22% 14% U.S. Stock 33% 33% 15% 36% Municipal Bond 8% 6% 2% 1% Taxable Bond 17% 25% 10% 16% Balanced 17% 17% 3% 0%

11 Passive, Long-Term Investing: Lowest Cost Wins

12 How a Mutual Fund Works

13 ETF Creation / Redemption

14 Intraday Premium/Discount in an ETF

15 ETF Creation / Redemption

16 Takeaways From the Flash Crash A CFTC-SEC report found that an unusually large automated trade of S&P futures drained liquidity and forced arbitrageurs to hedge the other side by selling stocks or ETFs such as SPY. Disproportionately affected ETFs Without timely quotes, market makers widened out bid-ask spreads Be cautious with stop-loss orders on ETFs A stop-loss order is an algorithmic trade a poor one at that Stop-loss orders became market orders when there was no liquidity and got matched with stub quotes Avoid trading during spikes in volatility Market rebounded within 20 minutes

17 ETF Trade Execution Gone Wrong

18 Liquidity General measures of liquidity More assets = more liquid Liquid underlying = more liquid Greater daily volume = more liquid (efficient execution) More precise measures of liquidity Premium/discount Bid-ask spread Market impact

19 Bid-Ask Spread

20 Trading Best Practices Use limit orders Avoid or be cautious with stop-loss orders Evaluate the market Premiums and discounts Bid-ask spread Avoid trading during extreme volatility (flash crash) Trade when the market for the securities underlying the ETF is open and functioning

21 Potential Drawbacks of ETFs Transaction fees (typically a small component of cost) Less advantageous within tax-protected accounts Do they encourage investors to trade too much or exert too much control? Total cost analysis is difficult Dividend reinvestment is not always available

22 ETFs vs. Mutual Funds: What Type of Investor Are You? This can be a key determinant in which vehicle is better for you. ETFs appeal most to two types of investors: those who prefer a passive index-based approach and those who like to actively manage their own portfolio through such strategies as market-timing. Mutual funds are more suited for investors who are looking for active management and for those who are looking to make regular frequent contributions (dollar-cost averaging).

23 Takeaways: ETFs vs. Mutual Funds Execution of ETFs is more complicated than with a mutual fund Costs can justify the effort and complexity Do your homework! Knowing what you own means more than just reading the name of the ETF

24 Passive Index Funds versus Strategy ETFs

25 The Case for Indexing "It must be the case that... after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar, William Sharpe, The Arithmetic of Active Management I don't rely on the efficient-markets hypothesis. I go by the "cost matters" hypothesis, Jack Bogle, Vanguard and founder of the first index mutual fund "If there is anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds, Russ Kinnel, Morningstar

26 Strategy ETFs: Not All Indexes Are Created Equal Two key considerations: What is the universe What is the selection and weighting methodology Traditional indexes market-cap weight a broad universe of stocks. Their diversified and passive approach makes them the ideal building blocks of a portfolio. These indexes are the basis for the efficient market hypothesis. The market portfolio is extremely hard to beat consistently you may not outperform, but you are guaranteed to not underperform the market. Strategy indexes may select from a subset of the entire stock universe and then employ a screen or different weighting method. There are no guarantees here.

27 Strategy ETFs Are More Expensive

28 Guggenheim S&P Equal Weight RSP vs. S&P 500 Each holds exactly the same stocks

29 Know the Appropriate Benchmark Can the same exposure be had for lower cost?

30 Know the Appropriate Benchmark Can the same exposure be had for lower cost?

31 Equally Weighted Can Be a Better Approach for Sector Funds XLE has 41% of assets in just 3 stocks Weight in XLE Weight in RYE

32 Fundamentally Weighted PowerShares FTSE RAFI US 1000 PRF vs. Russell 1000

33 Picks and Promising ETFs Vanguard Dividend Appreciation ETF VIG Dirt-cheap 0.13%; high quality Vanguard High Dividend Yield ETF VYM Also cheap 0.13%; efficient large-value tilt PowerShares S&P 500 Low Volatility SPLV 0.25% expense ratio; directly targets low-volatility stocks WisdomTree Emerging Markets Equity Income DEM Not cheap, but cheapest emerging-markets dividend fund at 0.63% Dividend strategies may work even better in emerging markets, where corporate governance may be less rigorous

34 Fixed Income ETFs

35 Fixed-Income ETFs Bond ETFs provide investors with a relatively liquid vehicle to gain access to illiquid over-the-counter fixed-income markets. Individual bonds trade on the OTC market infrequently, far less frequently than ETFs do. This liquidity mismatch will create premiums and discounts at times. Arbitrageurs cannot always fully hedge away these differences due to the high cost of trading individual bond securities. While there are diversified bond ETFs, many bond ETFs target specific exposures in fixed-income sectors, i.e. emerging-markets sovereign debt. These bond sector ETFs will be more volatile than diversified bond mutual funds and ETFs.

36 Fixed-Income ETFs Trading Characteristics Bond ETF NAV based on bid price

37 Fixed-Income ETF Premium and Discounts As the asset class becomes more illiquid the higher the premium or discount.

38 Exchange-Traded Notes (ETNs)

39 Exchange-Traded Notes (ETNs) Advantages ETNs can have tax advantages over ETFs for certain asset classes, such as commodity futures or MLPs ETNs promise the return on a given index, typically an index that is harder to track within another structure Disadvantages Whereas ETFs earned a good reputation from being low cost, transparent and simple, ETNs are just the opposite ETNs carry the credit risk of the issuing bank ETNs can be called away when it is convenient for the issuing bank to do so Some ETNs have path dependent fees

40 Comparisons Between ETNs and ETFs ETNs ETFs Liquidity Daily on exchange Daily on exchange Registration Securities Act of 1933 Investment Company Act of 1940 Recourse Issuer credit Portfolio of securities Principal Risk Market and issuer risk Market risk Short Sales Yes, on an uptick or downtick Path Dependent Fees On Some No Tracking Error Moderate, due to fees Minimal Yes, on an uptick or downtick

41 An ETN Warning

42 Commodity Exchange-Traded Products (ETPs)

43 Commodity Exchange Traded Products: Outline of Key Topics Commodities as an asset class Do asset class level benefits remain intact? Three ways to gain exposure: Equity-based Futures-based Physically backed

44 Commodity ETPs: Commodities as an Asset Class Do diversification benefits still remain? Influx of investor interest have driven correlations higher

45 Commodity ETPs: Equity-Based Exposure Hold a basket of equity securities Equity-based offerings only roughly track spot performance. Non commodity specific drivers Operational Leverage Miners vs. Gold varying performance

46 Commodity ETPs: Futures-Based Exposure Futures Contracts: Obligate the purchase or sale of a set quantity of a commodity, at a set date in the future and at a set price. Historically: Three Return Drivers Spot Return Collateral Yield Roll Yield ETPs are look through delivery vehicles for tax purposes a fund that holds commodity futures is subject to 60/40 long-term/shortterm capital gains treatment and that gains and losses must be marked to market at the end of every year. Because they are structured as limited partnerships, investors also receive K-1 statements in the mail although none have posted non-qualified income to date.

47 Commodity ETPs: Futures-Based Exposure Roll Yield: Return produced by rolling positions further into the future. Backwardation and Contango: Overall shape of the curve

48 Commodity ETPs: Futures-Based Exposure Contango has proven to be pernicious but dynamic strategies have managed better

49 Commodity ETPs: Physically Backed Exposure Hold the underlying commodity and thus offer perfect tracking (net a management fee). Only feasible for high Value/Size ratio commodities: gold, silver, etc Structured as grantor s trusts, so they are taxed as collectables there is no credit risk because they actually hold and warehouse the underlying commodities

50 Leveraged Funds

51 The Effects of Compounding and Volatility Drag Since inception, many positive (bullish) and negative (bearish) leveraged pairs BOTH have losses. A real example, since inception: Underlying index (IYF) is up about 35% Direxion Daily Financial Bull 3X Shares (FAS) down 70% Direxion Daily Financial Bear 3X Shares (FAZ) down 99%

52 Leveraged and Inverse ETFs Example Over long periods of time, the return will not equal the multiple of compound index return because of the volatility drag, which is magnified by the leverage. Day Index Net Return 3x Index Net Return Cumulative Index Return Cumulative 3x Index Return 1 10% 30% % 30% % 30% % 30% Total Net Return 2% 17%

53 Putting ETFs to Work

54 Core and Explore Low cost and broadly diversified passive ETFs cover a variety of indexes, making them ideally suited to form the core of a portfolio. Active mutual funds that seek alpha can form the explore sleeve of a portfolio. Focused, niche ETFs can also be used by a portfolio manager seeking alpha by making tactical tilts.

55 A Diversified Core Portfolio with Five ETFs ETF Ticker Weight Expense Ratio Vanguard Total Stock Market VTI 30% 0.06 Vanguard Total International Stock VXUS 20% 0.18 Schwab U.S. Dividend Equity SCHD 5% 0.07 Pimco Total Return Bond BOND 40% 0.55 ishares Gold Trust IAU 5% % 0.29

56 Core and Explore Portfolio Example Fund Ticker Weight R-Squared Core Vanguard Total Stock Market VTI Vanguard Total International VXUS Stock Vanguard Total Bond Market BND Explore Equity Sequoia SEQUX 5 86 Royce Special Equity RYSEX 5 95 Investment Oakmark International OAKIX 5 93 Explore Fixed Income Loomis Sayles Bond LSBDX 5 86 Templeton Global Bond TGBAX 5 76 R-Squared is to the best fit index, giving an indication of the degree to which a fund matches an index.

57 Investment Flows: past five years, outflows from U.S. stocks, strong inflows into fixed income 600 Mutual Fund and ETF Flows in $Bil Other U.S. Stock Bond (100) Other includes commodities, alternative, balanced, international stock and sector stock

58 Within Fixed Income, Strong Flows into High Yield and Emerging Markets 70 Long Term OEF and ETF Flows in $Bil High Yield Bond Emerging Markets Bond 0 (10) (20)

59 High Yield Corporate Bond Credit Spreads Long-term average credit spread is 6.0%, median is 5.5% Current spread is 5.0% Source: FRED Federal Reserve Bank of St. Louis

60 High Yield Bonds Part of your stock or your bond allocation? High Yield bonds positively correlated to stocks, negatively correlated to Treasury Bonds

61 The Risk in High Yield Monthly return distribution for the past 25 years of High Yield and 3-7 Year US Treasury Bonds

62 Still Interested in High Yield? PIMCO 0-5 Year High Yield Corporate Bond HYS Lower interest rate risk than longer duration competitors Higher returns when compared to Master II index Holds bonds to maturity which reduces transaction costs PowerShares Fundamental High Yield Corp PHB Slightly lower yield but higher quality

63 US Treasury Bonds Don t Protect Against a Declining Dollar

64 Lower Debt and Higher Growth in Emerging Market Countries 100% Government Gross Debt / GDP (2010) 80% 60% 40% 20% 0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% Expected Real GDP Growth ( ) Advanced Emerging Source: IMF World Economic Outlook, Oct. 2010

65 ETFs for Non U.S. Dollar Exposure WisdomTree Emerging Markets Local Debt ELD Actively managed foreign currency bonds from 15 emerging market countries selected based on fundamentals Investment grade WisdomTree Emerging Markets Equity Income DEM Weights emerging market stocks by dividends paid

66 Morningstar ETFInvestor Editor Picture Samuel Lee ETF Analyst Editor, Morningstar ETFInvestor Start an introductory 3-month subscription to ETFInvestor for only $14.95: Quarterly digital subscription (3 monthly issues) Timely buy/sell transaction alerts Analysts favorite ETFs Real-world application of strategy in model portfolios Industry-leading editorial and analysis 24/7 online resources via subscriber website To purchase, visit: AAII2013 A global approach to investing in discounted markets with improving fundamentals Morningstar ETFInvestor scans the globe for value and improving fundamentals across virtually all asset classes. Editor Samuel Lee draws upon academic and practitioner research--including Morningstar's sizeable bench of stock, bond and fund analysts to find reliable drivers of outperformance.