PWLCapital

Recently, the press has been sounding the alarm about exchange-traded funds (ETFs). These criticisms target the two types of ETFs representing the vast majority of assets under management worldwide: “physical” and “synthetic” ETFs. In the January 2012 edition, we’ll take a look at the concerns about synthetic ETFs, but today, we’ll review the criticisms of physical ETFs.

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If you judge it by the ETF market, the answer is “yes”. Please review the list of the top five ETFs, ranked by asset under management:

The two Emerging Markets ETFs above add up to $92 billion, coming close to the total asset under management for the two S&P500 funds ($116 billion). In addition, Emerging Markets ETFs add up to more than twice the AUM of the only EAFE (Europe, Australia, and Far East) fund on this short list. These numbers are not near the proportions of worldwide markets, as EM countries make up roughly a half of the market cap of either the S&P500 or the EAFE index.

This may reflect:
a) Excess enthusiasm towards EM equity, and/or

b) Investors may be more prone to use index products (relative to actively managed funds) to invest in EM than in developed equities.

Time will tell.

A new paper published on the Social Science Network (a Web-based network where a lot of the most rigorous economics and finance papers can be found; registration is required in order to obtain the article for free) studies the relative performance of fundamental indexing, equal-weight indexing and a variety of other quantitative portfolio management techniques which present themselves as alternatives to good old market-cap indexing. The paper finds that while all the techniques studied produce excess returns above market-cap weighted benchmarks, none of them produce any alpha (excess return) when they are analyzed with the Fama-French 3-factor methodology. In other words, fundamental indexing excess returns are not the result of superior portfolio engineering that exploits market inefficiencies, but rather the result of higher exposure to riskier value and small-cap stocks. These results are not surprising, as several authors have highlighted this possibility in the past. But the surprise is that the paper was published by Research Affiliates LLC, the very firm that has promoted for many years fundamental indexing, claiming it is all about exploiting market inefficiencies.

The paper also warns the readers about the risk of experiencing higher trading costs due to the higher turnover entailed by these so-called “alternative index strategies”. Not surprisingly, the paper found that fundamental indexing produced by far the lowest turnover rate among all the portfolio management techniques studied. I would like to mention that another alternative technique (not covered by the study) aiming to capture the market return with a value and small cap tilt is provided by Dimensional Fund Advisors. Please find below the turnover history of two closely comparable Canadian Equity Funds: the Claymore Canadian Fundamental Index ETF (using fundamental indexing) and the DFA Core Canadian Equity Fund (proprietary methodology).

A similar comparison between the Claymore and DFA Canada US and International Equity funds deliver the same evidence: DFA Core Equity methodology provides a small cap and value-tilted portfolio with far lower portfolio turnover.

Horizon BetaPro has recently announced the launch of a new S&P/TSX60 ETF with a very appealing 0.07% Management fee, which compares favorably to a 0.17% MER for the iShares S&P/TSX60 ETF. The Canadian Capitalist blog does a reasonable job of highlighting the important differences between the iShares product and the new Horizon product. A key point is that the latter does not actually hold the common stocks that constitute the index: it rather holds a combination of a Total Return Swap on the S&P/TSX60 Index and money market securities. In addition to the complexity and the counterparty risk involved in this new investment vehicle, it should be noted that holders are going to bear the credit risk of the money market securities held by the fund. I think investors should understand these differences and their implications before investing in the Horizon product.

The Bloomberg Business Week magazine published an article about the serious flaws of commodity exchange-traded funds. Investors have sometimes lost money even when commodity prices were rising. In fact, many of these ETFs invest in commodity futures rather than in actual physical commodities. The differential between futures and spot prices sometimes lead these ETFs to recurring losses. Futhermore, the article claims that some institutions have organized themselves to take advantage of these flaws at the expense of commodity ETF investors.