Tag Archives: PRF

Comparing ETFs? Don’t Just Look At Expense Ratios

The rule when buying ETFs is that when all things are equal, buy the one with the lowest expense ratio. But remember that similar sounding ETFs often aren’t equal. This means don’t let the expense ratio be the only factor in choosing an ETF.

“Our belief is expenses and past performance matter, but more important is understanding what’s inside the portfolio,” said Todd Rosenbluth, S&P Capital IQ director of ETF research.

SPDR S&P 500 ETF (SPY) tracks the S&P 500 stock index and charges a tiny expense ratio of 0.09%, commonly called nine basis points. One hundred basis points make up 1 percentage point. Guggenheim S&P 500 Equal Weight ETF (RSP) also tracks the S&P 500. But it charges a fee of 0.4% of assets.

Look At The Performance

“You might ask ‘Who in their right mind would pay 40 basis points vs. 9?'” said Ron Delegge, founder of ETFguide. “But then you take a look at the 10-year return.”

RSP returned an average annual 9.42% in the past 10 years, compared with 7.85% for SPY, according to Morningstar. In fact, RSP beats SPY in all periods reported on Morningstar.com, from one month on.

The big difference between the funds is the way the indexes are weighted. SPY follows the S&P 500’s classic market-capitalization weighting, which multiplies the stock price by the number of shares outstanding to get a stock’s market value. The biggest companies get a larger weighting, comprising a greater percentage of the index than the smaller ones. Thus a $1 move in Apple (AAPL), with a 3.98% weighting, will lift or drag down the index much more than a $1 move in the shares of Diamond Offshore Drilling (DO), which has a weighting of just 0.01%.

But RSP gives every stock in the index an equal weighting of 0.2%. This means a $1 rise in Diamond Offshore’s stock moves the index just as much as a $1 increase in Apple’s shares. By giving greater weight to the smaller stocks in the index, this has a big effect on the fund’s performance. Year to date, RSP is up 2.25% vs. SPY’s 1.29%, 96 basis points more — after paying the expense ratio.

“Would I be willing to pay more for those returns?” asks Delegge. “Definitely.”

Of course, SPY could just as easily outperform RSP in periods when the market favors large-cap stocks or other factors that can be found in SPY but not RSP.

But S&P 500 trackers aren’t alone. “One example that is much maligned is PowerShares FTSE RAFI U.S. 1000 ETF (PRF), said Michael Krause, president of AltaVista Research in New York, which runs the ETF Research Center website. “I calculate that cumulative since its inception in 2006, PRF has outperformed iShares Russell 1000 ETF (IWB) by 14 percentage points.”

ETF Research Center pegs PRF’s average annual return since 2006 at 8.9% vs. 8.1% for IWB.

PRF’s expense ratio is 0.39%, while IWB charges 0.15% of assets.

Not Alone

This trend happens a lot among the industry ETFs. SPDR S&P Homebuilders ETF (XHB) and iShares U.S. Home Construction ETF (ITB) sound like they track the same industry, meaning they should post similar results. XHB charges 0.35%, while ITB charges 0.45%, so XHB seems like a better choice.

Yet only 35% of the XHB holdings are actual homebuilding companies, and 28% building products. The rest of the stocks are home furnishing producers and retailers, home improvement retailers and household appliance makers. However, homebuilding companies make up 71% of the ITB portfolio, with building products at 13%.

ITB has risen by an annual average of 25.72% in the past three years vs. 21.01% for XHB. Year to date, ITB is up 8.32% vs. XHB’s 6.74%. That more than compensates for the extra 10 basis points.

“Cheaper hasn’t been better as of late,” said Rosenbluth.

Originally published in Investor’s Business Daily.

Arnott Makes Fundamental Bond Index

Bloomberg recently did a profile of Rob Arnott, the father of fundamental indexing.

Arnott, whose Research Affiliates Fundamental Index, or RAFI, provided the foundation for the first ETF based on an fundamental index, the PowerShares FTSE RAFI US 1000 Portfolio (PRF) and others, is now working on making fundamental indexes for bonds.

Instead of valuing stocks based on price, as in a market-cap weighted index like the S&P 500, the fundamental index uses fundamental metrics such as cash flow, book value, sales and dividends to determine a companies valuation.

According to Bloomberg, the PowerShares FTSE RAFI US 1000 Portfolio posted annualized returns of 5.3% from its inception on Dec. 19, 2005, through May 9, beating the 3.2% return of the Vanguard 500 Index Fund, which tracks the S&P 500.

The new bond indexes will measure a borrower’s health, such as GDP, assets available to service debt, a nation’s land mass and energy consumption. PowerShares last year began using Arnott’s bond index in the PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB). It returned 8.9% from Aug. 2 to May 9 vs. the 11.7% gain in the SPDR Barclays Capital High Yield Bond ETF (JNK). Let’s see how it does now that junk bonds appear to be peaking.

RAFI Wins Patent

Wow. So many great lead sentences that I don’t even know where to start.

Take that, market capitalization!

Take that, John Bogle!

Take that, Wisdomtree.

You get the point.

Research Affiliates, the asset management house that started the ETF Industry’s Index Wars, Wednesday received a U.S. patent on its Fundamental Index Investment Methodology. Vindication is sweet and I’m sure the folks at Research Affiliates poured champagne all over their heads as if they just won the World Series.

The Research Affiliates Fundamental Index, better known as the RAFI, selects and weights securities using four fundamental metrics of company size instead of market capitalization: total cash dividends, free cash flow, total sales and book equity value.

Whether or not this puts to rest who was the first to create an index or strategy based on fundamental metrics, it clearly says who has the rights to this methodology. The question now is does this extend to any index that follows a methodology based on fundamental metrics, or just ones using the same metrics as the RAFI? More important will there be a legal battle between Research Affiliates and its main competitor in the fundmal indexing space, the ETF firm WisdomTree.
Research Affiliates doesn’t manage any ETFs, but rather licenses indexes to ETF and mutual fund providers, its core business is developing and licensing new product ideas.

“So, unlike most asset managers, we have only our ideas to sell; we can protect these ideas as trade secrets or with patents,” said Robert Arnott, chairman and founder of Research Affiliates, in a written statement. “As we want to encourage wide use of these ideas, we favor the latter.”

Fundamental indexing has been a big deal to the ETF and indexing community ever since Arnott and his colleague Jason Hsu examined the concept in a 2005 issue of the Financial Analysts Journal. The basic premise is market-cap indexes overweight overpriced stocks and underweight under priced stocks which is exactly the opposite of what you the investor want to buy. It’s an interesting concept. I will publish I study I did on fundamental indexing later.

According to Research Affiliates’ original work, the historical return drag associated with this structural flaw is typically 2% to 4% per year, globally. Through October 31, Research Affiliates says the FTSI RAFI 1000 Index, which comprises large-cap U.S. equities, outperformed the S&P 500 by 14.39% in 2009, by 1.47% on an annualized basis for the last three years, and by 1.94% annualized since inception of the index. The FTSE RAFI Developed ex US 1000 Index, which comprises large-cap developed foreign market stocks, outperformed the MSCI EAFE Index by 12.71% for 2009, by 3.48% over three years annualized, and 3.18% since inception.

PowerShares is the only place to buy the RAFI in an ETF.

  • PowerShares FTSE RAFI US 1000 Portfolio (PRF). This ETF tracks the FTSI RAFI 1000 Index.
  • PowerShares FTSE RAFI US 1500 Small-Mid Portfolio (PRFZ)
  • PowerShares FTSE RAFI Asia Pacific ex-Japan Portfolio (PAF)
  • PowerShares FTSE RAFI Developed Markets ex-U.S. Portfolio (PXF). This tracks the above mentioned FTSE RAFI Developed ex US 1000 Index.
  • PowerShares FTSE RAFI Developed Markets ex-U.S. Small-MidPortfolio (PDN)
  • PowerShares FTSE RAFI Emerging Markets Portfolio (PXH)
  • PowerShares FTSE RAFI Europe Portfolio (PEF)
  • PowerShares FTSE RAFI Japan Portfolio (PJO)

How Did ETFs Fare in Market Turmoil

 

With cries of financial Armageddon and headlines screaming “heaven help us,” it shouldn’t have surprised anyone that the stock market took a head dive today.  The refusal of the House of Representatives to pass the $700 billion Wall Street bailout sent shivers through Wall Street. Everyone realizing the golden days are over made a mad dash for the exits.

 

“The first problem is the administration gave it the wrong name,” says Jerry Slusiewicz, president of Pacific Financial Planners of Newport Beach, Calif. “They should have called it the ‘economic stabilization plan’ or ‘liquidation enhancement plan,” instead they called it a ‘bailout’ and that was bad news. No one wants to bail out Wall Street.”

 

So, how did exchange-traded funds hold up amid the market turmoil?

 

“The ETFs followed the market,” says Kevin Mahn, chief investment officer of SmartGrowth Mutual Funds, which runs funds of ETFs. “The SPDR Gold Shares (GLD) was up as well as a lot of the short products from ProShares.” 

 

The truth of the matter is the ETF is only as good as the assets it’s holding. And if your ETF tracks the Dow Jones Industrial Average the day it plunges 777 points, like it did Monday in the largest one-day decline in history, you’re going to feel some pain, $6.40, or 5.76%, to be exact. Surprisingly, the Diamonds Trust, the ETF which holds every stock in the Dow, actually performed better than the index itself, which sank 6.98%. Who knew tracking error could work in your favor?

 

The same thing happened with the SPDR (SPY), the most heavily traded ETF on the market today, with 460 million shares trading hands. While its tracking index, the S&P 500 plummeted 8.79%, the SPDR tumbled just 7.84%, or $9.47.

 

The iShares S&P 500 Value Index Fund (IVE) beat the broader benchmark, and the growth sector, falling 6.76% to $57.85, on volume of 3.6 million shares, while the iShares S&P 500 Growth Index Fund (IVW) also beat it, sliding 7.1% to $54.66. And both closed at a premium to their net asset value, which was $56.34 for the value fund and $53.93 for growth, according to iShares.

 

And what of the fundamentally-focused ETFs which claim to do better than market-cap ETFs? How did they perform? PowerShares FTSE RAFI 1000 Portfolio (PRF) narrowly beat the S&P 500, with a decline of 7.46% to $44.02 on volume of 251,884 shares. The WisdomTree LargeCap Dividend Fund (DLN) slid 6.4% to $45.13 on 38,000 shares and the Spa MarketGrader LargeCap 100 (SZG) dropped just 5.34% to $17.55, with only 400 shares traded. All the fundamental ETFs also closed significantly higher than their NAVs.

 

“The House vote was basically a vote of no confidence for the credit markets,” says Slusiewicz. “Credit is drying up for short-term cash for the economy. We’ve backed ourselves into a corner.”

 

Overall the flight to quality led to an interesting divergence in the bond ETFs.

 

“The 0.4% move in the BIL was a hefty move,” says Jim Porter, the portfolio manager of Aston/New Century Absolute Return ETF Fund (ANENX).  “It broke out four days ago as there was definitely a sign of movement into the T-Bill ETFs. Meanwhile the Vanguard Intermediate Term Bond was actually down today. It’s obvious that no one wants to own the Intermediates. But the T-Bills and the long bonds are OK.”

 

n      The SPDR Lehman 1-3 Month T-Bill ETF (BIL) gained 20 cents, or 0.43%, to $46.24. This sent the yield down to 1.46% from 2.73% on Aug. 31.

 

n      The iShares Lehman 1-3 year Treasury Bond ETF (SHY) edged up 0.6% to $83.89, yielding 3.69%, up from 3.48% on Aug. 31.

 

n      The iShares Lehman 20+ year Treasury Bond ETF (TLT) climbed 2.9% to yield 4.68%, up from 4.53% on Aug. 31.

 

n      Meanwhile the Vanguard Intermediate Term Bond (BIV) fell 31 cents, or 0.42%, to 74.37. Since Aug. 31, when it yielded 4.63%, the BIV’s yield has plunged to a negative 1.64%.

 

So, what can we expect for the rest of the week? With the Jewish New Year occurring Tuesday and Wednesday, Congress won’t tackle any business until Thursday. In addition, with many market participants out, volume will probably be low, but that could create large price moves. The third quarter ends on Tuesday, so it should be an interesting day for mutual fund managers who need to shore up their portfolios for end-of-quarter reports.

 

“A lot of what we saw erased today will come back when the bill gets passed,” says SmartGrowth’s Mahn. “But there will be a lot of trepidation over the next few weeks to see if another bank fails and if this bailout works and how quickly it works.”   

 

Slusiewicz of Pacific Financial Planners thinks Congress will try to revive the deal because everyday that passes without one will see more market declines. He says the CBOE Volatility Index, or VIX, posting on Monday was “one of the top ten days for the fear index. The big fear number is an indication of a bottom. And the bottom will come with the passing of a new bailout bill.”

 

But, if there’s no bill Slusiewicz expects more days like Monday. With no bill, he predicts potential declines of 100 points on the S&P 500, 200 points on the NASDAQ and 700 points on the Dow.