ETFs: Which Approach Is Best?

As investors consider how to position their portfolios for the year ahead, the eternal debate between active and passive asset management strategies can't help but figure in their decision-making process, or more likely that of their financial advisers. Exchange-traded funds (ETFs), which can give investors fairly inexpensive exposure to an asset class tied to an index, continue to attract money. There was a 54% jump in assets held in U.S.-based ETFs in the year ended Nov. 30, to $752 billion, but that's still miniscule compared with the trillions of dollars invested in mutual funds, both actively and passively managed. Typically over time one-third of actively managed open-end equity mutual funds will beat index funds in their category, according to studies by Russ Kinnel, director of fund research at Morningstar (MORN). "It's a question of how likely are you to be in that one-third that outperforms and what's the downside of being wrong?" he says. "For some actively managed funds that have low costs and low turnover [in the portfolio], the cost of it underperforming won't be a lot." More often than not these days it doesn't have to be an either/or decision. "You're starting to see a combination of both active and passive approaches when constructing an asset allocation strategy because there are pros and cons to both [and] there's room for both," says Carl Resnick, managing director and portfolio strategies at Rydex SGI. Financial advisers first must decide to what extent to use actively or passively managed assets in a client's portfolio, with the mix determined according to each client's investment goals and risk tolerance, he adds. 100% EquitiesOne drawback of passively managed stock funds, for example, is that they have to be 100% invested in equities all the time, says Resnick. That was a recipe for disaster for much of 2008 and the first three months of 2009. By contrast, an active manager could have taken money off the table and put it into cash to ride out the storm. And a skilled manager could even have taken advantage of the market sell-off and carefully picked up other assets at bargain prices, such as high-yield corporate bonds, says Kinnel at Morningstar. One plus for conventional mutual funds is that you know they will trade at their net asset value (NAV) at the end of each day, while with ETFs there's a risk that you'll buy or sell it at the wrong time of the day, says Michael Goodman, president of Wealthstream Advisors in New York. "For the Average Joe investor who doesn't want that stress, mutual funds are more pleasing vehicles," he says. There's a general consensus among money managers that using a fund tied to an equity or fixed-income index doesn't hamstring your returns by linking them too closely to the market as long as you diversify the rest of your portfolio across a range of different asset classes. ETFs help individual investors to get exposure to assorted market-cap sizes, investing styles, yields, sectors, and geographic regions for a reasonable price. (Expenses are typically lower than open-end mutual funds.) They also provide access to long/short and market neutral strategies that a small investor would otherwise find hard to come by, says Kenneth Leon, head of Standard & Poor's ETF research team. He thinks ETFs make just as much sense for tactical allocations, such as currencies or commodities, as they do for an investor's core strategic allocation of stocks and bonds. Asset Allocation FactorMark Ragusa, president of Money Map Advisors in Conroe, Tex., cites the belief of William Sharpe, winner of the 1990 Nobel prize in economics, that, properly measured, the average actively managed dollar will underperform the average passive dollar in the long run. Rather than picking the right manager, Ragusa thinks an investor's most important decision is what asset allocation he chooses for his portfolio, which generally is responsible for 95% of his return. To boot, unlike mutual funds, there are no taxable capital gains on all the turnover in an ETF portfolio. Even if all things were equal in terms of performance, he says he'd prefer to avoid having to pay capital-gains taxes. He also points to research that's found that top-ranked active fund managers can't sustain their outsize returns over time. Scott Kubie, chief investment strategist at CLS Investments in Omaha, treats ETFs as an active investment, adjusting asset allocations within portfolios as market risks arise. The liquidity that ETFs provide makes them an effective tool for boosting or trimming exposures quickly, he says. "Since 2005, the granularity of ETFs has increased to the point where you can make some pretty specific allocations to subsectors or countries, and we take advantage of that for a portion of our portfolio to really get the allocation the way we want it." Equal-WeightedThere are now ways to maximize the returns on indexed ETFs based on how the weighting of the securities in an index is determined. Four years ago, Robert Arnott, chairman of Pasadena (Calif.)-based Research Affiliates and editor of The Financial Analysts Journal, came up with an alternative to weighting an index according to stocks' market capitalization. A cap-weighted index overweights every stock that trades above its fair value and underweights every stock that trades below its fair value, creating a structural drag on returns, he discovered. Rydex SGI and WisdomTree offer equal-weighted ETFs based on the S&P 500 index, which provide a broader representation of the companies within the index than the traditional market-weighted method, which tends to concentrate most of the market capitalization in the index's top 10 or 25 holdings, says Leon at S&P. "Especially in the large-cap category, that [strategy] can give you a 'growthier' profile" because it's more diversified, says Leon. The main argument for equal-weighted indexes is that they give you more exposure to smaller and midsize companies, which over time have been shown to outperform larger-cap stocks, says Resnick at Rydex SGI, which offers 10 equal-weighted index ETFs. The other reason they do better than market-weighted indexes is they are rebalanced quarterly instead of once a year. Fundamentally WeightedWeighting indexes by fundamental factors such as book value, revenue, or earnings is even better, especially for use on an institutional scale, Arnott said in 2005. The WisdomTree Emerging Markets Small-Cap Dividend Fund (DGS), which weights the index components according to their dividend yield, was up 72.57% year-to-date as of Dec. 10, outpacing the 65% return for the cap-weighted iShares Morgan Stanley Emerging Markets Index (EEM). Those returns are just for price, but if you include reinvested dividends, the WisdomTree ETF had gained 74.5% year-to-date as of Nov. 30. (Its current yield is 3.69%.) "Today, more than in the past 10 years, I think dividends are more important and 84% of your returns since 1950 have come from dividend reinvestment," says Ragusa. "It's a safer way to invest internationally. I trust dividends more than anything as a metric because you can't cheat on a dividend." Money Map Advisors also uses a fundamentally weighted index created by Arnott's company, Research Affiliates, and marketed by PowerShares. One problem with fundamentally weighted ETFs is they tend to end up with a tilt toward value as a result of the metrics they use, says Goodman at Wealthstream. He likes that bias because it matches his belief that value stocks will outperform growth over the long haul, but it wouldn't be as suitable for growth-oriented investors. Actively Managed ETFsThe latest trend in the evolving ETF market is actively managed funds whose holdings are handpicked by a manager instead of tracking an index. Just a handful of these funds have come to market so far, but there are more in the pipeline awaiting approval by the U.S. Securities & Exchange Commission. Actively managed ETFs are harder to use by portfolio managers who are used to fine-tuning risk levels with changes to asset allocations, says Kubie at CLS Investments. "There's a little less control [with actively managed ETFs]," he says. "We haven't figured out how to integrate them with our approach to management at this time." Plus, they have to add value to make up for the higher expense ratio they have compared with passive ETFs, he adds. Even in international markets, where you're more likely to find active mutual fund managers who outperform their benchmarks, the market inefficiencies that make that possible are dissipating at a faster pace, says Ragusa. "Going forward, trying to outperform the market is going to be difficult, especially with fees," he says. "I can buy an indexed ETF for a fee of [roughly] 0.5%, so I'm already ahead of the game vs. most active managers. Then you throw in fundamentally weighted [indexes] and it's even more so."

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