May 8, 2015

Is This the End of the Road for Fundamental ETFs?

End of the road for fundamental ETFs
Out of apparent boredom from cap-weighted index funds, alternative ETF weightings began picking up steam sometime in the mid-2000s. Many alternative weighting methodologies are pretty simple, equal weighting perhaps the most straightforward of all. And there's revenue, earnings, or dividends, among others.

For a time, "fundamental" ETFs seemed most promising of all. Instead of a more basic approach to portfolio weighting, these funds took a fundamental approach in an attempt to more accurately value each company based on some combination of factors, including those above plus book value, cash flow, and more. The main idea is that weighting by market cap is essentially inefficient and can vary widely from a company's intrinsic value. Tying weightings to fundamentals may instead be a better reflection of value, a better way to construct a fund, and may result is better returns.

Sounds great, right? Maybe, but somewhere along the line they may not have lived up to the hype since PowerShares recently announced it's discontinuing use of RAFI Fundamental indexes on many of its ETFs in favor of Russell Equal Weight and Pure Value/Growth indexes instead.

In additional to the PowerShares line of fundamental ETFs that had been based on the FTSE RAFI Indexes from Research Affiliates, Schwab's funds track the Russell Fundamental Index Series. Schwab's U.S. Fundamental Index ETFs for domestic and large international equities and have managed to gather between roughly $200 and $400 million each in assets with more modest AUM for international small cap and emerging markets variants.

Higher expenses are one of the first things that stand out to me in contrast with more garden variety cap weighted ETFs. PRF and PRFZ (the FTSE RAFI funds tracking large blend and small-mid blend market segments) each sport 0.39% expense ratios. That's not outrageous, but it puts these investments at an immediate disadvantage to the ultra low cost index funds charging half that, or as low as a quarter of that. Likewise with Schwab. The large cap variant, FNDX, charges 0.32%, but SCHX charges a paltry 0.04% in comparison!

So far, have the Schwab fundamental ETFs lived up to their goal of being a better mousetrap? They don't have a very long track record yet, but when we compare large and small cap funds against corresponding vanilla index ETFs, it appears to be a mixed bag so far.

Schwab Fundamental ETF Comparison: SCHX, FNDX, SCHA, FNDA

The core large cap ETF, SCHX, has slightly outperformed FNDX since fall of 2013. The reverse has held true for small caps (SCHA and FNDA). In both cases, you'll notice they track very closely to one another and exhibit a high degree of correlation.

What about international funds? As far as emerging markets go, FNDE and SCHE marched in lockstep until roughly the end of 2014, after which the fundamental version, FNDE, has fallen sharply behind SCHE. International developed market small caps funds exhibited the opposite behavior, with the fundamental version, FNDC, breaking away from SCHC by a few percent this year.

While there's nothing particularly wrong with fundamental ETFs, I have a hard time seeing any compelling reason to switch from core funds based on more conventional market-weighted indexes. This may change over longer periods of time, but even more established fundamental ETFs like PRFZ (the PowerShares FTSE RAFI US 1500 Small-Mid Portfolio) has correlated almost perfectly with IJH, one of the biggest S&P 400 ETFs, since late 2006. So all else being equal, I'm sticking with my low-cost index ETFs for now.

September 28, 2014

ETF P/E Ratios: Are Small Caps Overpriced?

There's been a lot of talk over the past couple of years about how small cap stocks are overpriced relative to large caps. Since the market bottomed in early 2009, the smaller end of the market cap spectrum has comfortably outperformed the S&P 500, returning about 253% and 208% respectively. After such a strong run, many have been left to wonder if it's time for large caps to shine again like they did for large stretches of the 80s and 90s. Indeed, since 2014 began, the Russell 2000 and the S&P SmallCap 600 have both fallen around 2.5% while the S&P 500 is up nearly 9% for the year, indicating reversion to the mean could be well underway.

So what's the best way to determine if small caps are indeed overpriced? We'd all be rich if it was that easy to predict, but P/E ratios seem to be the preferred method of many a pundit. And even that one metric can be calculated in numerous ways, looking at forward earnings, trailing 12 months, and so on. No matter how you calculate it, however, P/E doesn't seem to have all that much predictive power (particularly over the short-term). At best, the Shiller P/E (which looks at average inflation-adjusted earnings over the past 10 years) correlates very little with the next year's returns. Over 10 years, the r-squared for the Shiller P/E is 0.43, still leaving a lot to be desired.

Let's just assume, for a moment, that P/E ratios are valuable for making investment decisions. Looking at Morningstar forward-looking P/E data for iShares large, mid, and small cap ETFs, we see:
  • S&P 500 Large Cap (IVV): 17.51
  • S&P 400 Mid Cap (IJH): 20.69
  • S&P 600 Small Cap (IJR): 20.67
Wheel of Fortune, Price-to-Earnings Ratio
Interestingly, mid and small caps appear to be priced roughly equally based on P/E alone. If we assume all three should be roughly equal, small caps are about 18% more expensive than they should be. But that includes a lot of ifs. If earnings grow at the same rate for all three segments, most importantly.

What about other ratios? The Fama-French three-factor model uses price-to-book to determine what stocks fall into the value category. It's tough to make much of an argument for large value stocks outperforming large growth over time, but Fama-French found that the small value premium has been persistent over time. That said, let's look at P/B ratios for the same three ETFs:
  • S&P 500 Large Cap (IVV): 2.43
  • S&P 400 Mid Cap (IJH): 2.23
  • S&P 600 Small Cap (IJR): 2.02
Now small caps look significantly cheaper, with large caps appearing to be 20% more expensive. I'm not sure what P/B ratios have been historically for small and mid caps, but the S&P 500 looks reasonable based on the past 15 years or so. Perhaps goodwill is more valuable for large companies with well-known brands? I'm really not sure, but small caps don't look expensive by this measure.

Next, let's take a look at price-to-sales. P/S probably isn't all that useful to compare individual stocks. Most investors would probably much rather invest in a smaller company with huge profit margins rather than a bigger company (from a revenue standpoint) that operates on razor-thin margins. But it's a pretty interesting ratio to evaluate ETFs, when each fund holds hundreds of stocks. On average across a large sample size it might tell you something. So how about the P/S ratios:
  • S&P 500 Large Cap (IVV): 1.74
  • S&P 400 Mid Cap (IJH): 1.27
  • S&P 600 Small Cap (IJR): 1.16
Again we have another metric to murky the waters further, with large caps looking more expensive relative to mid and small caps. On the flip side of that, price/cash flow looks more favorable to large caps (similar to P/E) with the bigger companies looking more affordable. As if that weren't confusing enough, sales growth rates for mid and small cap stocks are predicted to be slightly higher than large caps (about 4% vs 3%) but cash-flow and book-value growth is anticipated to be higher for large caps.

In other words, I have no clue if small caps are overvalued relative to large caps. The talking heads may insist upon it, but I don't believe there's enough convincing evidence to definitively suggest that companies with large market cap sizes will outperform any other cap size over the next few years. As a whole, if you believe the market P/E ratio tells you something, we're a bit on the high side in comparison to historical values. If you think the Shiller P/E is more valuable, then the market could be really overpriced. But in terms of one asset class category outperforming, that seems like a gamble at best.

This is just my opinion. As always, consult a financial professional and do your own research at multiple sources before making any investment decisions.

September 21, 2014

Investing in IPOs with an ETF

The Renaissance IPO ETF is a pretty cool concept:
Here's how it works: New companies are added to the Renaissance IPO ETF on a fast entry basis on the fifth day of trading, or upon quarterly review, and are removed after two years when the IPOs become seasoned stocks.
Then there's the much bigger, and much older, First Trust US IPO Index Fund (FPX), that tracks the IPOX 100 US index. Rather than removing constituents after two years like the Renaissance fund, FPX tracks the 100 largest, most liquid IPOs and holds them for 1,000 trading days. The index is reconstituted quarterly. It also caps the largest constituents at 10% of holdings.

Both follow a passive indexing approach to IPOs. Just like I have no faith in my ability to pick stocks, I have no faith in my ability to figure out which IPOs are going to be hot and which ones are going to flop. For over a year after its IPO, it looked like Facebook was going to fall into the latter category. Investors who were lucky enough to get in near FB's low would have seen their money more than quadruple, or those who got in last summer would have seen it triple. Even buyers who got in right after the IPO would have doubled their investment. Then we've got cases like King Digital (KING) or Zynga (ZNGA). Both currently trade at significantly lower valuation than when they went public.

The Renaissance IPO ETF lets investors get exposure to stocks that have just gone public
IPOs tend to be volatile and cherry-picking the best is not for the faint-of-heart. That's where the idea of buying a broad basket of newly-public stocks is an intriguing idea. You can potentially smooth out your returns by offsetting the big losers with an occasional 300-400% gain (no guarantees, of course). The Renaissance ETF works by tracking the rules-based Renaissance IPO Index. According to Renaissance, the index:
...was designed to track the activity and performance of IPOs from developed and emerging markets. The Index Series is composed of a rolling two year population of IPOs and employs a float-adjusted market capitalization weighting scheme to account for only those shares that are publicly available for trading.
The ETF's fact sheet lists the top 10 holdings, which combine for a bit over 45% of its total assets. Currently, Twitter (TWTR) is the largest holding at 10.1% and Zoetis (ZTS) accounts for 9.8%. Nearly 20% tied up in just two stocks is pretty concentrated, but the rest of the top 10 holdings individually account for anywhere from 5.3% down to 2.3%. Renaissance Capital also offers an actively managed mutual fund (the Global IPO Fund - IPOSX) with 32 holdings. It's a different beast from the more passive approach of the ETF. It shows in the top 10 holdings, where Facebook, Envision Healthcare, and EQT Midstream are the largest at 7.9%, 5.3%, and 5.3% respectively.

IPO hasn't yet been trading for a full year, so time will tell how well this strategy works. It will be fascinating to see how it look 5-10 years out. With an expense ratio of 0.6%, it's significantly higher than a passive index fund, but somewhat reasonable considering there's not much else like it on the market. An individual investor attempting to replicate this strategy with individual stocks would quickly rack up some hefty commissions, so expenses seem fair. Currently, its average trading volume is just shy of 26,000 shares daily, and total net assets are a bit over $34 million, so it's still relatively small. We'll see if it can pick up some momentum over the next few years. In the limited history we do have, it's just about matched the performance of the S&P 500, albeit with more volatility. How about the more established FPX?

September 20, 2014

Robo-Advisors: Wealthfront, Betterment, Personal Capital, FutureAdvisor, SigFig, and LearnVest

Through 2022, the U.S. Bureau of Labor Statistics projects the change in employment for personal financial advisors will grow 27%. The average for all occupations is 11%. Why does the BLS believe the demand for professional financial advice will grow so rapidly? Namely, the population will continue to age and life expectancy is increasing, leading to increasing need for financial planning to navigate retirement. But what about younger generations who don't need the personal touch of working with in-person with an advisor, but aren't necessarily comfortable with a complete DIY approach?

Are robo-advisors like Wealthfront and Betterment the future of financial planning?Enter the "robo-advisors". This relatively recent advent falls somewhere in between a completely passive approach and active management. To give you an example, Wealthfront, one of the leaders in this space, recently crossed $1.4 billion in AUM. Even the 49ers offer the service to their employees! What is the company offering? Well, based on your individual risk tolerance, the company recommends an asset allocation for you based on Modern Portfolio Theory, then customizes a mix of low-cost ETFs (mostly from Vanguard). From an equities perspective, the firm uses VTI, VEA, and VWO to cover U.S., foreign, and emerging markets respectively. You'll find recommended asset allocations from virtually any self-serve broker, however. What really makes Wealthfront different is the services they offer beyond that. Directly on the company's homepage you'll find a performance chart that illustrates an annual excess return of 4.6% due to a combination of factors. First, 2.1% of that is due to using low-cost ETFs rather than mutual funds. Next, their automated tax-loss harvesting could potentially result in 1% of additional yearly gains. Another 0.5% is attributable to optimal asset allocation, 0.4% to automatic rebalancing, and 0.6% to tax-aware allocation. For all of this intelligence in your portfolio, Wealthfront charges nothing on the first $10,000 invested, and a mere 0.25% on anything above that. This is impressive considering that many financial advisors will charge 1-2% annually in comparison. The disclaimer on the company's site gives a bit of insight into how they came up with these excess return figures. It's worth debating whether or not the 2.1% attributed to low-cost ETFs instead of mutual funds is relevant. I don't see it as an either/or type of decision. In other words, it seems to be quite an assumption that if you invest elsewhere you'll have your money in a bunch of funds with expense ratios around 2%.

September 14, 2014

Invest in What You Know to Beat the Market?

The "invest in what you know" mantra espoused by the great Peter Lynch sounds great. After all, we'd all rather buy companies that give us the warm fuzzies than put money into confusing or boring companies we don't understand. Just about everyone has a friend or relative who claims to have made a killing getting into Apple at the right time. They just knew it was going to be the investment of the decade. The iPod was a massive hit and many people would rather die than part with their iPhone. Or how about shoes? There are over 7 billion pairs of feet in the world! We all need to cover them with something...maybe I'll invest in Nike! Come to think of it, I like burgers, cartoons, driving, and shopping online, so I'd better add some McDonald's, Disney, Ford, and Amazon to my portfolio too.

Pan Am was a big brand...but a good investment?
I could go on and on like this. People naturally like to gravitate toward familiarity and it's more fun to own a bunch of companies that sell products you love. Never mind whether or not it's wise to mix up your emotions with your investments. After all, it's only your retirement that's on the line. And there's the risk of taking Peter Lynch's advice a little too literally. While getting inspiration for investing ideas from your day-to-day life, due diligence is still critical to any investing decision. I may buy a lot from Amazon, but does that mean I should buy its stock with a 500+ P/E ratio?

Anyway, I thought it would be fun to do a little backtest to approximate a "buy what you know" investment strategy (much more of an active approach compared to passive indexing). Interbrand values and ranks the Best Global Brands each year, and tracks corresponding changes in value from the previous year. Taking a sample of 20 of the top brands from this list seemed like a good way to simulate investing in what you know. My guess is that most Americans are familiar with just about every name on it. I picked everything from the top 20 that's currently listed on a U.S. stock exchange as a stand-alone entity, removing five companies including Samsung, Mercedes, BMW, Gillette (part of P&G), and Louis Vuitton. I dipped further down that list to add Honda, Pepsi, American Express, Nike, SAP, and UPS.

September 6, 2014

The Biggest Exchange-Traded Fund and Mutual Fund Families

There are many products and industries where it's intuitive which products are the biggest brands. Coke and Pepsi, Nike and Adidas, Apple and Samsung, and so on. But which companies are the top of the heap when it comes to ETF and mutual fund assets? Although significantly more money is invested in mutual funds than exchange-traded funds, ETFs still have nearly $1.7 trillion in assets under management as of the end of 2013.

Despite this massive amount of money, there's been a lot of change among investment management companies over the past year. After lagging significantly behind SSgA (State Street Global Advisors, the management company responsible for bringing you SPDR ETFs) over the past few years, Vanguard is now poised to take the #2 spot in the very near future. Perhaps this is in small part to Warren Buffett's recent endorsement of the company's funds. But I suspect a strong combination of products in most market segments, extremely competitive costs, and continued growth in awareness about the merits of passive index investing (and questions surrounding the value of active management) have lead to the solid inflows. While solid market performance since the great recession have naturally driven an increase in assets under management, some ETF companies have seen stagnant growth during this time.

Top 20 ETF Sponsors by Asset Percentages: BlackRock, SSgA, Vanguard, PowerShares, and WisdomTreeIf we look at the data from ETF.com, the top 10 ETF sponsors (with Charles Schwab being the smallest of that group), make up about 96% of the total assets of the top 20. The next ten are individually pretty insignificant individually, adding up to less than 4% to total assets. This is an industry dominated by a handful of giants. There are a few smaller players with pretty solid niches (most notably PowerShares and WidsomTree, both with low growth during the past year), but between BlackRock's iShares family, State Street's SPDRs, and Vanguard ETFs, the three leaders combine for over 81% of the industry. First Trust, Guggenheim, and Schwab all experienced rapid growth over the previous year (42%, 24%, and 31% respectively), but starting from such a small base means they might be able to compete for the #5 spot in the near future, but it will be a while before they threaten PowerShares. In the top 3, BlackRock grew 8.5%, Vanguard 17.1%, but State Street was relatively flat at 1.1%.

What about the largest mutual fund sponsors?