Why Buy A More Expensive ETF When A Similar Cheaper One Is Available?

The lowering of expense ratios is one of the biggest trends in the exchange traded fund industry today.

 

Yet two of the biggest ETF providers, BlackRock’s iShares and State Street Global Advisors, offer funds that charge significantly more than other funds they offer with similar exposures. Why would an investor choose the more expensive fund?

A prime example is iShares MSCI Emerging Markets (EEM), which tracks the MSCI Emerging Markets Index, the most widely followed benchmark in the emerging-market sector. It charges an expense ratio of 0.72%.

But the company offers a very similar fund, iShares Core MSCI Emerging Markets (IEMG), which only charges 0.14%. What’s the difference? While the MSCI Emerging Markets Index is primarily made up of large-cap stocks, the cheaper fund follows a multicap index, the MSCI Emerging Markets Investable Markets Index, which holds more than twice as many components, including all the stocks in the first index plus midcap and small-cap stocks.

With broader market exposure and a lower expense ratio, IEMG, which was launched in October 2012, is the more popular fund, with $40 billion in assets. But even with its drawbacks, EEM (which dates back to April 2003) still weighs in with $37.7 billion in assets.

Why does iShares continue to offer such an expensive fund — and why does it still attract investors?

Five years ago, iShares launched its Core Series of ETFs, a suite of 10 equity and fixed-income funds aimed at the buy-and-hold investor with dramatically lowered expense ratios. There are now 25 Core ETFs. The majority have expense ratios lower than 0.1%, and none is higher than 0.25%.

“IShares launched their Core Series at a time when they were losing market share to Vanguard because many of their core products chiefly were not priced competitively,” said Ben Johnson, Morningstar’s director of global ETF research. “It was part defense, part offense to stop the bleeding of the market-share losses to Vanguard.”

And fees play a major but not absolute role in the returns of the similar but not identical emerging-market ETFs, much as one would expect. In the year ended Oct. 31, EEM actually inched higher with a 25.64% return vs. 25.58% for IEMG. But over time, the cheaper fund has posted better results: an average annual 5.6% vs. 5.06% for the past three years and 4.92% vs. 4.22% for the past five years. The difference is practically the difference in the expense ratios.

Funds like EEM that track established benchmarks seem to be attracting traders and institutional investors who hold ETFs for shorter periods of time and aren’t as concerned about the expense ratio. Traders may use these ETFs because they are more available for borrowing to sell short and have a much deeper options and swaps ecosystem.

“There is an appeal for that product, which they are more familiar with and continue to use,” said Todd Rosenbluth, director of ETF and mutual fund research at CFRA Research. “For others the appeal is the considerably more volume and greater liquidity.” EEM trades 49 million shares a day, while IEMG has an average daily volume of 7 million shares.

Rosenbluth says the situation is the same with iShares MSCI EAFE (EFA), which tracks the widely followed benchmark for the developed nations, the MSCI EAFE Index, and has an expense ratio of 0.33%. That compares with iShares Core MSCI EAFE (IEFA). The core fund tracks the broader MSCI EAFE IMI Index and charges only 0.08%.

EFA is much more liquid, with average daily volume of 15 million shares vs. IEFA’s 4 million shares.

Meanwhile, State Street, realizing it was already late to the game where investors were demanding lower fees, decided that it would take too long to build assets and get onto important trading platforms if it created a new line of funds, said Matthew Bartolini, head of SPDR Americas research.

Instead, the firm decided to restructure a group of existing funds that already had assets and a user base. They rebranded 15 funds to make a consistent suite called the SPDR Portfolio, cut the fees, split the share prices so that they all started at $30, and if needed changed the index. Well-known funds such as SPDR S&P 500 (SPY) and SPDR S&P MidCap 400 ETF (MDY) weren’t changed for the same reasons EEM still exists.

“In order to be successful and have an impact for clients in a low-cost arena, you can’t just cut fees,” said Bartolini. “So we restructured 15 funds across every key asset class in equity and fixed income and aggressively cut costs to be the lowest or match the lowest price in the marketplace.”

The upshot is that traders might prefer the older indexes even if they’re a bit more expensive, while buy-and-hold investors might prefer the cheaper versions.

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ING Offers Positive Outlook for 2012

Europe, Shmeurope. If you looking for good news, ING has it.

“Don’t listen to noise coming out of Europe,” said Douglas Cote, chief market strategist of ING, at a press conference Wednesday where the firm offered its outlook for the new year. “The [European Central Bank] will be forced to jump in. I expect an end-of-year rally.”

Paul Zemsky, ING’s chief investment officer of Multi Asset Strategies, says while Europe may suffer a mild recession in 2012, the U.S. will experience tepid growth between 2% and 2.5% With housing weak and the Federal Reserve not raising interest rates until 2013, he says inflation won’t be a problem, staying around 2%. However, he says this growth won’t be enough to bring down the unemployment and if per-capital income remains stagnant, this could cause some social unrest. And while the housing sector has bottomed out, he says it may take another year before the market begins to see a sustained recovery. The main risk to the U.S. economy is the contagion of a European slowdown.

Still companies continue to post record profits, keeping expenses low by not hiring new workers. Zemsky expects the S&P 500 to surge 9% by the year’s end to 1325, and again to 1450 by the end of 2012. “Unless,” he adds, “ Europe blows up.”

You can track the benchmark with the largest ETF in the world, the SPDR S&P 500 (SPY).

“How can you not be in the market with earnings hitting record highs?” asked Cotes, suggesting market fundamentals will continue to be strong in the face of rising global risk. In addition to rising corporate profits, he sees U.S. manufacturing expanding and retail sales at their highest levels after seven consecutive monthly increases. “As far as eye can see we see positive quarters.”

Mid-capitalization stocks are the “sweet spot of the economy,” he says, because they have the financial wherewithal of large-caps and the growth of small-caps.” He also like emerging market stocks and global real estate investment trusts.

For mid-cap stocks take a look at SPDR S&P MidCap 400 ETF (MDY).

As for those global risks, Cote says Europe’s “bank recapitalization plan is an effective fence around the crisis.” In addition, if China begins to experience a slowdown, South Korea and Turkey will pick up the slack.

Really?

The Institute of International Finance said the recapitalization plan has “serious problems” that will hurt economic growth.

Meanwhile, China is one of South Korea’s major trading partners. If China stops buying South Korea is going to have to find a lot of other clients just to break even.

Christine Hurt sellers, ING’s fixed income chief, continued the trend of discounting Europe, “there are a lot of good opportunities, unless you think there will be a massive global recession.” U.S. companies are well prepared for any credit crunch because they have nearly $1.5 trillion in cash on their balance sheets.

She likes high-yield bonds, because spreads are wide, but not consumer cyclicals. She also recommends buying sovereign debt in emerging markets. With emerging markets seeing inflation declining and credit quality increasing people should “take advantage of the shift in liquidity out of Europe.”

She expects the ECB to come save the euro zone, but if you wait until the ECB acts, it will be too late. Because there is very little liquidity in the credit markets, she says you need to buy bonds you are willing to hold for a long time.

I wasn’t very satisfied with their optimistic answers about Europe’s problems. Even though the ECB is the chief monetary authority for counties that use the euro, European Union treaties forbid it from being the lender of last resort for member countries. And as Roubini said last week, that’s not going to change.

Hurtsellers said Italy’s high bond yields are worrisome and if Italy doesn’t get enough tie to restructure, the whole thing could balloon out of control. If that happens, “market’s can create their own chaos and we’ll see more pressure on Germany.”

Zemsky added that while the ECB has remained out of the picture in terms of directly financing governments, if the European banking system seizes up, the ECB would supply quantitative easing. Why did he think that? “Because in 2008, the Fed stepped in to where we never would have expected it before, but they did it to save the world.” True, but the Fed had the power to do that and the ECB doesn’t.

“The ECB will stand behind a bank if they have enough collateral. If that doesn’t happen,” said Zemsky, “that’s the worst case scenario and will lead to a much worse recession of possibly negative 4% gdp growth in Europe.”

That should put our minds to ease.

Indexes Beaten by Small-Cap & Large-Cap Value

The indexing and ETF communities received a significant blow when, in an extremely rare occurrence, slightly more than half the actively managed mutual funds holding stocks outperformed their benchmark indexes.

According to the Standard & Poor’s Indices Versus Active Funds Scorecard (SPIVA), for the year ended June 30, the S&P Composite 1500 Index, tracked by the iShares S&P 1500 Index Fund (ISI) outperformed only 48.99% of all the domestic equity funds. Small-capitalization stocks were responsible for pushing active managers over the 50% mark, with the S&P SmallCap 600 Index, tracked by the iShares S&P SmallCap 600 Index Fund (IJR), beating only 47.5% of all small-cap funds.

This plays into one of the main reasons for using active fund managers: they can spot inefficient pricings in markets ignored by Wall Street analysts and institutions. This strategy typically works well with small stocks and equities in emerging markets.

But fans of active management shouldn’t crow too loudly, in all the other categories, the indexes won. The S&P 500 Index, tracked by the SPDR (SPY), beat 60.5% of the active managers, the S&P MidCap 400 – SPDR S&P MidCap 400 ETF (MDY) – beat 66.7% of the active managers.

Breaking it down further, between growth, core and value, small-cap value was the true hero, with 60.4% of the funds beating the S&P SmallCap 600 Value Index and the iShares S&P SmallCap 600 Value Index Fund (IJS). However, over three years, the index beat 52.3% of the funds.

Most shocking was large-cap value funds. Over the past year, 54.6% of the large-cap value funds posted better returns that the S&P 500 Value Index — iShares S&P 500 Value Index Fund (IVE). For the 3-year and 5-year periods, the percentage of large-cap value funds that topped the index were 55.9 and 64.7, respectively.

But investors in ETFs and an indexing strategy shouldn’t worry, the results don’t include the recent stock swoon. And in the 2008 crash, the average equity fund plunged 39.5%, according to Lipper, compared with the 37% drop in the S&P 500.

However, one of the big reasons for not buying actively managed funds is that few can consistently beat the indexes. So, a one-year record might just be a bit of luck. And the long-term results bear it out. Over three-years, small-cap funds still had the best record, but the indexes beat 63.1% of the funds. That only increased for the other categories, with 75% of all midcap funds beaten by its benchmark.

Meanwhile, growth funds took a kick to the teeth. Over the three-year period, the indexes beat 75% of the large-cap growth funds, 84.1% of the mid-cap growth funds and 69.6% of the small-cap growth funds. And for the five-year periods, all the growth sectors fared worse. These funds track the winning indexes: S&P 500 Growth Index Fund (IVW), S&P MidCap 400 Growth Index Fund (IJK) and S&P SmallCap 600 Growth Index Fund (IJT)

BGi’s Diamond Scores $36.5 Million; Vanguard Investors Pissed Off

Here’s a round-up of second day stories about the Blackrock purchase of BGI.

The Wall Street Journal says more than 400 top executives at Barclays will walk away from the deal pocketing a total of $630.3 million. It seems there was some sort of unusual management incentive plan in place at BGI that would have started to expire in 2010. They needed to do something quick to cash out. Barclays President Robert Diamond alone will walk away with $36.5 million.

WSJ’s Jason Zweig reports that Vanguard’s investors are furious with the mutual fund/ETF company for even making a bid on iShares. Zweig says this could have been a good move for Vanguard and I agree. Already the No. 3 ETF provider, Vanguard could have become the market leader. More important, Vanguard would have probably cut the expense ratios on the ETFs, which could have brought in even more investors. Few people realize that Vanguard doesn’t have an ETF to partner with its S&P 500 fund. Vanguard came to ETFs late in the game and wanted to make an ETF for its flagship index fund. However, S&P had already given an exclusive license to BGI for the iShares S&P 500 Index (IVV).This would have given Vanguard the S&P 500 ETF they’ve always wanted. Also, S&P sued Vanguard over basing the ETF on the index without giving S&P any additional licensing money That full story is in ETFs for the Long Run.

The Financial Times says Larry Fink, Blackrock’s CEO, has been trying to buy BGI for eight years, and capitalized on the financial crisis to make his dream come true.

Reuters’ Svea Herbst-Bayliss suggests the BGI deal will spark a buying spree as envious rivals figure out how to compete. Bank of New York Mellon (does that taste as good as a honeydew melon?) is expected to be the next buyer. BNY already plays a big part in the ETF industry as a trustee and custodian of many funds. BNY is the trustee and administrator of the second ETF, the MidCap SPDR (MDY).

DealJournal’s Michael Corkery says besides CVC, the big loser is Goldman Sachs, which advised CVC.

Jim Wiandt of IndexUniverse.com says by using an ETF company to create the largest asset manager in the world is a huge boost for the ETF industry and proves how big basis-point-linked passive assets have gotten. He asks a lot of questions, but doesn’t give any anawers. Questions like will Blackrock keep the ETF expense ratios low and what does this mean for the active ETFs?

What are your thoughts? I would love to hear them.

GM Booted From S&P 500

Standard & Poor’s finally removed General Motors from the S&P 500. Starting Wednesday morning, GM is out.

DeVry gets promoted from the S&P MidCap 400 to take GM’s place in the S&P 500 after the market closes June 8. The same day, Aaron’s makes the leap to the MidCap 400 from the S&P SmallCap 600, and Cbeyond replaces Aaron’s in the small-cap index.

S&P made the announcement Monday after 5 p.m.

These ETFs track these indexes:

The SPDR Trust (SPY) and iShares S&P 500 Index (IVV) track the S&P 500.

The MidCap SPDRs (MDY) and iShares S&P MidCap 400 Index (IJH) track the S&P MidCap 400. The iShares S&P SmallCap 600 Index (IJR) tracks its eponymous index.

These indexes have a slew of style ETFs following them. Some ETFs allow you to track just the growth stocks in the index or the value stocks in the index. You can also buy inverse and leveraged ETFs for these indexes. They will all be changing their portfolios this week. I’m sure there will be a lot of trading in those stocks this week.

Was I responsible for S&P finally kicking GM out of the index? Check the progression.

• Get Out of GM Now
• Funds Hold GM to the Bitter End
• Dow Kicks Out GM; S&P Still Holds It

Obviously, I’m j0king. I don’t think I’m that powerful. But, just in case, I will be concentrating my powers tomorrow to persuade the Obama Administration to finally put some limits on TARP.