August 31, 2014

Active Management vs. Passive Management: Does Stock Picking or Indexing Reign Supreme?

Ah, the age-old question: Which is better? Active or passive management?

Lately, the lines have become blurred between what exactly qualifies as active management. Most people would probably agree that funds tied to the most popular indexes, like the S&P 500 or Russell 2000, fall squarely into the passive category. The proliferation of alternative indexes, including those that "smart beta" ETFs are based on, confuses the issue. Is it active or passive management when you base a fund on a set of strict screening or filtering rules, but those criteria include metrics like, "rising sales, earnings, book value, dividends or cash flows?" Basing an index on rules that look nice when back-tested might appear to some to be just as active as a a stock-picking fund manager. So given that it's not always clear what ETFs or funds fall into each category, let's consider:
  1. According to ETFdb, the 35 equity ETFs that fall into the "active" category have an average expense ratio of 0.89%. That's a pretty huge hurdle to overcome for active management when there are 30 passive ETFs that have an expense ratio of 0.10% or less. Investors have to ask themselves if paying upward of 9X in expenses is worth any potential upside from active management. Would you be confident any particular active fund could consistently beat indexing by more than 0.80% each year?
  2. A look at the TradeKing mutual fund screener results in 4,892 equity mutual funds. The subset of that with expense ratios of 2% or higher is 1,000 funds! I took at look at 5 active mutual funds with expense ratios of 2% or higher, with over $1 billion in next assets. Over the past two-and-a-half years, the SPY S&P 500 ETF outperformed 4 of the 5 expensive active funds (a couple to the tune of around 30%). Only one beat the passive indexing approach, and by only 5% during that time. Picking active funds is like stock picking: are you confident you can pick the ones that will beat the market over the long-term?
  3. Some active funds in my company's 401(k) look like great performers over the past 10 years+. A closer examination of each reveals that there were usually 1-2 years of market outperformance that explain all of the long-term outperformance (often many years ago). Not to mention that many of the funds might be in the plan precisely for that reason. Funds with long-term underperformance were probably culled from the plan long ago - a kind of plan survivorship bias.
  4. Over a 20-year period going back from early 2014, the survivorship rate of actively managed funds was only 34% compared to the 55% rate for index fund share classes.
What else does the data show?

August 29, 2014

Comparing U.S. Small Cap Stock Indexes

It generally looks like selection of a particular large cap index doesn't matter much. The top holdings are pretty much the same across each, and having 500 or 750 stocks in a large cap index doesn't mean much when the top 100 make up well over 50% of the value of all of them.

So how about small cap indexes? Does the same conclusion hold true when we look at the smaller end of the market? Large caps can be valued well in to the hundreds of billions, whereas their smaller counterparts average just a tiny fraction of that value. For a little perspective, the Russell indexes, from mega cap to micro cap, cover $5.2 trillion in benchmarked assets. The Russell 3000, the largest 3,000 U.S. stocks, cover 98% of that value. The Russell 2000 small cap index is 9% of that 98%, so around 8.8% of the investable U.S. market. The total market cap of U.S. listed companies is over $18.6 trillion. With Apple on its own equally about 3.5% of the total S&P 500, it would only take about three Apples to equal the entirety of the 2,000 companies in the Russell 2000 (assuming my math is right).

To give you an idea of how big a typical Russell 2000 company is, the weighted average company value in the index is worth $1.7 billion, with an overall median of just under $700 million. The largest companies in the index, currently Puma Biotechnology and InterMune Inc., are each worth nearly $8 billion, but overall the constituents in the Russell 2000 are worth between $500 million and $2 billion.

While the Russell 2000 is the most well-known of all U.S. small cap indexes, it's not the end-all be-all and a number of ETFs are based on other small cap indexes, not limited to:
  • S&P 600
  • CRSP US Small Cap Index
  • Dow Jones U.S. Small-Cap Total Stock Market Index
There are others, including the Defined Small Cap Core Index from S&P which is a subset of the S&P 600, or small-mid indexes like the FTSE RAFI US 1500 Small-Mid Index. But the Russell 2000 and S&P 600 are by far the biggest names. I included the CRSP and Dow Jones indexes I named above primarily because the Vanguard Small-Cap ETF (VB) and Schwab U.S. Small Cap Fund (SCHA) are based on each index respectively and round out the four largest small cap ETFs, each with billions in assets.

How does each index differ?

August 27, 2014

City-Based Investing: The LocalShares Nashville Area ETF (NASH)

A story came on the radio today about a year-old ETF called the LocalShares Nashville Area ETF (NASH) that tracks stocks on a hyperlocal level. Admittedly, I hadn't heard of this one before, but the idea intrigues me. Typically when we think of slicing and dicing our portfolios geographically, it's done at the national level. We Americans more often than not have a majority of our investments in American companies and diversify into a catch-all "international" bucket. This might be accomplished through a broad ex-US developed markets ETF like the iShares MSCI EAFE (EFA) or segmented a bit further by region - maybe something like the Vanguard FTSE Europe ETF (VGK). And of course broad emerging markets funds and investments that track individual country indexes like if you want specific exposure to China, Brazil, or some other fast-growth countries.

But that's really about it. It's usually Americans stocks vs. not American stocks for most folks. When it comes to American companies, we can find ETFs that help us segment in an almost infinite number of ways. You can pinpoint by industry, company size, investing style, portfolio weighting, and on and on. But why not break things down by region within the U.S.? It seems like just as logical of a way as any to organize investments. For example, rather than just investing in a tech sector ETF, why not one that focuses just on companies in the San Francisco Bay Area? Bloomberg a Bay Area Index, why not build investments off of it? Or what about something that tracks stocks based in the Sun Belt? Yes we've got real estate ETFs, but maybe some investors want exposures specifically to some of the fastest-growing states in the country?

We often invest in American companies out of a sense of patriotism, so I can see there being a market for investing in your particular area of the country. LocalShares has taken a stab at this strategy by launching their Nashville, TN-focused ETF. It appears the particular choice to focus on Nashville was born out of their management team's connections to the area. Although so far the fund remains small with about $7 million in assets as of the end of July. NASH's 0.49% net expense ratio seems fair given the very specific, niche exposure the it provides.

August 24, 2014

Expense Ratios: How Do They Impact Your Returns?

As brokers and ETF families continue to up the ante and push expense ratios lower, we as investors benefit. But just how important is it to choose a fund with a low expense ratio? After all, many ETFs and mutual funds charge less than 1% annually, so is it really a big deal? Working with a financial advisor could set you back further, with many charging between 1% and 2% of your assets each year.

Vanguard is widely known as the pioneer of low-cost indexing through mutual funds, launched its first ETF in 2001. Schwab was a bit later to the game, with many of their core funds launching in late 2009. Across the board, both companies are usually among the lowest (if not the lowest) in just about every segment they compete it. So does it make sense to chase the lowest expense ratios possible? When you consider that a fund charging around 1% annually (pretty common among mutual funds, less so among exchange-traded varieties) charges more than ten times more than one charging 0.10% or less, it's pretty dramatic! Yes, that's pretty simple math, but I don't think many appreciate just how much more a fund with an expensive ER costs.

Guy getting hot under the collar from his ETF's big expense ratios.
Within my company's 401(k), there are a lot of mutual funds charging around 0.75% annually. Some would be considered somewhat active, but for the most part, none venture too far from their passively-indexed counterparts. Many 401(k) participants have most or all of their savings in company plans, sometime leaving money there after moving on to a different company, or simply rolling everything into their new employer's plan.

Given that many folks often overlook the importance of examining the expenses of their investments (and I was curious just how much of a difference they make), I thought I'd put together a simple chart with returns from three hypothetical funds ranging from a 0.50% expense ratio up to 1% (although there are many that far exceed this!). For the low expense ETFs, I used two real growth funds: Vanguard's VUG and Schwab's SCHG. I didn't pick growth funds for any particular reason other than the fact that I just happened to notice a large cap growth mutual fund offered in my company's retirement plan had an expense ratio of around 0.75% (as did many of the others in the plan - some higher). Both VUG and SCHG offer very low expenses, at 0.09% and 0.07%. Technically, VUG is over 28% more expensive, but there's not much lower out there outside of a handful of funds that charge 0.04% or 0.05% (from the same two companies). Nevertheless, I wanted to see if such a small difference was important.

I assumed a continued annual growth rate of 10.4% a year, which is what the S&P 500 has returned over the past few decades. Whether or not those gains continue into the future is up for debate, but the end result of expense ratio is similar either way: they can eat up a massive chunk of your gains. So what do we see below?

Best Large Cap ETFs

U.S. large cap stock index funds are often the core portfolio holdings for many investors. They're usually cheap and offer exposure to the majority of investable market in the U.S. The good news is large cap ETFs are pretty similar to one another. For the most part, it doesn't matter which large cap index your particular fund tracks. In the battle of large cap growth vs. large cap value, each has had stretches of outperformance, but I don't see any evidence that one style is particularly better than the other (especially in the long-run). For that reason, I prefer blend ETFs in the large cap space. Blend funds are about as close to passive investing as you can get and reduce your risk of too much portfolio overlap by purchasing too many different funds that own the same stocks. Take, for example, the growth and value variations of the S&P 500 SPDR, SPYG and SPVV, contain 343 and 339 stocks respectively. There an overlap of 179 equities between the two.

With not much to choose from between large blend ETFs, I tend to focus on expenses, liquidity, and assets. There are various weighting options, including the Guggenheim S&P 500 Equal Weight ETF (RSP) or the RevenueShares Large Cap Fund (RWL) but I'm focusing here entirely on cap weighted funds for two reasons. First, alternative weighting is less of a passive strategy - it assumes a portfolio weighting other than by market cap will beat the market. Second, investors can achieve nearly identical performance (to equal weight anyway) with lower cost mid cap funds. I've also ignored large cap indexes like the Dow Jones Industrial Average, which is price weighted, ETFs that only track the mega cap slice of the broader large cap market, or others that take a more active approach, including the Global X Guru Index.

Sticking with broad blend large cap indexes, I've come up with the nine funds below and sorted them by assets. SPY, the oldest and largest ETF, comes out on top in terms of size. However, six funds in the list have assets $3 billion and up along with over 100,000 shares/day in average trading volume. SPY conspicuously isn't offered commission-free by any brokers, but the next five largest (IVV, VOO, IWB, VV, and SCHX) are.

Comparison of US Large Cap Index ETFs:
Comparison chart of US Large Cap ETFs: SPY, IVV, VOO, IWB, VV, SCHX, JKD, EUSA, ONEK

August 23, 2014

Do Backtesting Trading Strategies Work?

As retail trading platforms continue to add more and more professional features, mom-and-pop investors have been gaining access to backtesting capabilities. thinkorswim (owned by TD Ameritrade) has long had robust stand-alone trading software with countless tools for active traders, including a feature called thinkBack that lets investors use years of historical data to place simulated option trades.

Using recognia Strategy Builder capabilities built into my TradeKing account I was able to develop a trading strategy within a few minutes that would have returned 38.4% annually over the past 5 years! Another customer found a strategy that would have resulted in a 91.5% annualized return!!! Take that, S&P 500, with your crummy 14.1% during the same time period. Interestingly, while the tool lets you choose from a variety of stock metrics to build your strategy, it only offers results based on buying-and-holding for 3 months at a time (or selling short for 3 months), with the ability to include trailing stops if you'd like. The ability to buy-and-hold for a year or longer does appear to exist. Conveniently, holding a position for only 3 months means investors would probably be racking up some pretty hefty trading commissions with all those transactions.

When backtesting stocks, hindsight is 20/20!Fidelity is in the backtesting mix as well. There's web-based strategy testing for all customers, or the Wealth-Lab Pro desktop platform for customers who have traded more than 36 times over a 12-month period (with at least $25,000 in assets). The web-based tool goes back 10 years, while the desktop software goes back 20. Fidelity will even send you alerts when opportunities arise that match your strategies!

Not to be outdone, Schwab also offers a Strategy Tester as part of the company's StreetSmart Edge software. You're probably beginning to see a pattern here. In spite of the age old adage, "past performance does not guarantee future results," there are plenty of tools to help you analyze past performance in search of identical future results.

Ultimately, there will always be traders that believe there's some magic formula that will help them beat the market and brokers have the right to offer capabilities to help them achieve this goal. But ultimately, there are people trading against you everyday who have been doing this for years, or who have a PhD is mathematics or some other hyper-quantitative discipline, with computers than exist solely to recognize patterns and operate within millionths of a second. And investors need to ask themselves why brokers offer these tools. More confidence in your trading ideas = more trades, and more trades = more commissions.

Frontier Markets ETFs: Should You Consider Adding Them to Your Portfolio?

You're a brave investor. You fear no volatility and you'll go to the ends of the earth in your quest for double-digit returns. You're willing to take on a high degree of risk for outsize gains, and in the battle of frontier markets vs. emerging markets, only pansies invest in emerging markets.

With inflows of $2.2 billion into frontier markets, should you jump on the bandwagon? In concept, the idea of investing in pre-emerging markets sounds like a great way to get in on the ground floor of some of the world's next booming economies. Even better, the Wall Street Journal quoted research claiming frontier markets were actually far less volatile than both emerging markets and developed markets? What? We can have our cake and eat it too?!

Okay, so let's say frontier markets really are the best of both worlds. What's the best best way for a guy like me to invest in them? And better yet, what exactly are frontier markets? To answer the second question first, there are no less than five frontier markets indexes in existence. The number of constituents in each ranges in the neighborhood from around 25 countries up to 40 or so. Whereas emerging markets indexes are often made up of larger, more established economies like China, Brazil, India and Taiwan, frontier markets tend to be those countries that do have investable companies but are much smaller and more difficult to access. So we're talking markets in the Middle East, Eastern Europe, Asia, and South America.

Individually, it's possible for U.S. investors to access individual countries within the frontier markets category (like the iShares MSCI Qatar Capped ETF - QAT, or the Global X MSCI Argentina ETF - ARGT). However, many of these funds have relatively low trading volume (think 5,000-20,000 shares/day) and assets (under $50 million). To give you an idea how small this is, top China and Brazil ETFs (FXI and EWZ) both have around $5 billion in assets and trade roughly 15 million shares daily. Frontier markets can be really small.
Looking out the window at frontier markets investing opportunities
That being the case, an interested investor would probably be better served looking at broader funds. There are far fewer choices than you'll find in either emerging or developed markets. Currently, the the iShares MSCI Frontier 100 ETF (FM) is by far the largest covering this segment, with about $800 million in assets. Both Global X and Guggeheim run frontier markets ETFs that are far smaller.

August 21, 2014

The Best Online Brokers with Commission-Free ETFs for Buy-and-Hold Investors

The number of online brokers can be daunting. The commission and fee structures offered can vary widely, and each broker often targets specific types of investors or traders. Trying to determine which broker will be the most cost-effective option for your specific needs can be tricky. Do you trade equities only? Do you have a preferred family of funds? Do you trade options or forex? How frequently do you trade? The answers to these questions can have a huge impact on which broker offers you the best overall package. Sometime, you may find it makes more sense to spread you investments across a few different brokers. Perhaps your retirement funds are with one broker, your cash account is somewhere else, and so on.

That being said, the brokers that tend to be of most interest to those of us who predominantly invest in ETFs are those that let us trade them for free. More specifically, I wanted to find out which brokers are most attractive to investors that not only want to trade ETFs for free, but hold them long-term. Whereas mutual fund investors tend to mostly be of the buy-and-hold variety, ETF investors are often split among the buy-and-hold crowd who love them for their low expenses, and traders who love that they can actively trade wide segments of the market.

There are currently seven online brokers that offer commission-free ETF trading. Their selections vary widely:

Comparing commission-free ETFs from Charles Schwab, E*TRADE, Fidelity, Firstrade, Interactive Brokers, TD Ameritrade, and Vanguard

August 18, 2014

The Case Against Mega Caps: Too Big to Succeed

I'm largely of the opinion that various investing styles are meaningless and have little chance of beating the market long-term. Despite there being countless growth and value ETFs available to investors, I haven't found much evidence that one is better than the other. Then there's the explosion of "smart beta" strategies that attempt to outperform based on some rule-based approach other than market cap weighting. Smart beta strategies are somewhere in between passive and active management. They're not quite as subjective as a purely actively managed fund since they tend to stick to a clear set of criteria or rules, but the mere existence of defining a set of rules other than cap weighting means the fund manager believes they can outperform based on some inefficiency in the market.

CNNMoney sums the idea up nicely:
The goal of smart beta is to boost returns by using a "rules based" approach that puts more weight on other factors, such as valuations, dividends, momentum or volatility to determine which companies to own and how much of their stock to buy.

Dropping another big one into the portfolioBut weighting by other metrics seems just as arbitrary as weighting by market cap. There are reasons different companies have difference valuation metrics and there's no guarantee that dividend growth or high dividend-paying companies will always beat the market. Momentum and volatility seem even more arbitrary. Low volatility stocks have their benefits, but in the long stretches, higher volatility small cap equities will do better. Many of these strategies might look pretty based on some convenient back-tested data and are used to justify higher expense ratios than pure passive index ETFs. But I suspect smart beta will end up succeeding about as much as most other active strategies before them: not very well over time.

But I digress. From what I can tell, there is one metric that consistently predicts over and under-performance relative to the market: size. And by that I mean the outliers in the market. Yes, the biggest public companies is the U.S. make up most of the market's value, but ultimately they're the biggest of the big. It's a legitimate question to ask if it makes sense to have most of your investment tied up in the extreme end of one spectrum of the market. And when you hold the market portfolio or something similar, like the S&P 500, most of your eggs are in mega (or giant) cap stocks.

August 17, 2014

ACWI vs. VT: The One-ETF Portfolio

Innovations in exchange-traded funds have made it so investors can easily (and cheaply) hold just one fund in their portfolio. Seriously - you can be well-diversified with just a single ETF in your account. Brokerage firms will often try to convince you that you must have your assets spread across as many funds and asset classes as possible. Why? Because the more holdings you have in your account, the more reluctant you might be more to move your money somewhere else. The idea of transferring too many securities over or liquidating everything and moving your cash may seem like too much of a headache.

Reduce your stress with a simplified, one-ETF portfolioBut the reality is that it's often unnecessary to have more than a small handful of investments to be broadly diversified. In fact, for the equity portion of your portfolio, you can realistically hold just a single ETF. If you're decades away from retirement and want to be 100% in equities, one holding might be all you need. If you're a bit closer to retirement, you might be able to get away with holding one equity ETF along with a Total Bond Market fund, like Vanguard's BND (and/or a Total International Bond ETF link Vanguard BNDX).

So what are these magical, all-in-one stock funds? The Vanguard Total World Stock ETF (VT) and the iShares MSCI ACWI ETF (ACWI). As of a few years ago, U.S. stocks made up around 46% of the world's total market cap. So if you like the idea of "buying the world" and having your assets split roughly 50/50 here at home and abroad, these two funds are for you.

So what's the difference between the two?

Comparing Vanguard VT to iShares ACWI: holdings, expense ratio, market cap, and trading volume

August 16, 2014

Are Gold ETFs an Overrated Investment?

The SPDR Gold Shares ETF (GLD) currently has over $33.5 billion in assets. The iShares Gold Trust (IAU) has nearly another $7 billion. Impressive in their own right, these numbers are probably insignificant in comparison with the amount of physical gold held by individual investors, governments, and businesses around the word for investment purposes. Clearly there are tons of people who love the stuff.

But why? Is it because investors have short-term memories and have forgotten everything that happened to gold prices more than 10 years ago? We often hear about how gold is a "safe" investment compared to those speculative, volatile stocks. We often hear about how gold is the best hedge against inflation. I beg to differ.

That is one huge gold nugget!I prefer to make investments based on the income-generating potential whatever assets I'm buying. When I invest in a broad index of public companies, I'm investing in entities that actually create value. These companies are run by people trying to make the most profit possible, and they're filled with people who do real things and create real value in the world. But gold is just a commodity. If I buy a gold bar today and throw it in a safe, it just sits there. Doing absolutely nothing. Creating absolutely no value. I'm just betting that someone in the future will pay me more than I paid for it based on supply and demand. It's useful in jewelry-making and in other applications on a limited scale. But for the most part it's only valuable because people think it is, not because of some intrinsic value. Other commodities, like oil, are essential to the day-to-day functioning of human civilization. If all the gold in the world disappeared tomorrow, a lot of people would be bummed, but essential services, products, and public functions would probably pretty easily find better replacements. So how on earth is gold safer than equities? When I buy equities, I'm betting on the continued ingenuity of humans to create new ways of doing things and find ways to make more money. To me, that's far safer than buy a pretty shiny metal.

But isn't gold a better hedge against inflation?

Comparing U.S. Large Cap Stock Indexes

If you're invested in U.S. stocks, chances are most (if not all) of your money is invested in large cap equities. These companies make up the vast majority of the investable universe and are typically extremely easy to invest in. They're mostly very liquid and available in countless varieties of large cap-focused ETFs. Large caps are so large, in fact, that the top 750 largest companies in the U.S., despite being only 15% of the total number of the 5,000 most actively-traded equities, make up around 89% of the total value of the Wilshire 5000. The next 4,250 stocks make up just around 11% combined.

What many novice investors may not realize is that all large cap funds are not equal. In fact, there are a number of large cap indexes that ETF issuers base their products upon, each with a different methodology.

Many of the most popular large cap ETFs are based on the following cap-weighted indexes (more to come later on equal weighting and other methodologies):
  • S&P 500
  • Russell 1000
  • CRSP US Large Cap Index
  • Dow Jones US Large-Cap Total Stock
Big fish, big stocksThere are other indexes, including the Dow Jones Industrial Average and the NASDAQ Composite, but these are less representative of the total large cap universe and are instead based on strange weightings or the exchange the stocks are listed on.

So what's the difference between the four indexes above? The S&P 500 is by far the most widely-followed and is considered one of the best barometers of total U.S. market performance, covering 75% of U.S. equities. It has a bit of subjectivity built-in, with an Index Committee determining which stocks get added or removed. Companies in the S&P 500 have to have a market cap of at least $4 billion, enough liquidity, and a public float of 50% or more, among other things.

The Russell 1000 is a bit simpler, and more rule-based. With twice the number of equities as the S&P 500, this index simply contains the largest 1,000 companies in the U.S.

CRSP indexes use a different approach. Rather than building indexes based on some specified number of stocks, CRSP tends to define their indexes based on percentiles. The CRSP US Large Cap Index, for example, covers the top 85% of the investable market. At this time, that consists of 665 constituents spanning from mega caps down through some mid caps.

The Dow Jones US Large-Cap Total Stock Index aims for including the top 750 largest companies that meet some basic liquidity requirements.

One might think there would be a substantial difference between an index covering 500 stocks compared to one consisting of 1,000.

What Happens When Your ETF Shuts Down?

Like most other types of businesses, ETFs can go out of business too. Generally speaking, an ETF needs at least $50 million in assets under management to be profitable.

These days it seems like there's an ETF available for just about every investment strategy imaginable. There are alternatives to cap weighting, investments that can expose you to publicly-traded stocks in tiny, faraway countries, and actively-managed options as well. Although many are intriguing investment options in their own right, think carefully before investing in ETFs with few AUM or very low trading volume. Aside from low liquidity and wide bid/ask spreads that can eat into your profits with every trade, you run the real risk of these funds shutting down.

Going out of businessAn ETF shutting down isn't catastrophic. It typically may just mean limited assets make the fund unprofitable to manage for its creator. In these cases, it's easier to liquidate and issue to cash to investors than maintain the fund. Funds about to shut down will notify shareholders in advance, giving them a chance to sell shares prior to the shut down, but ultimately this can create unwanted taxable events.

If you're like me, you invest with the intention of holding long-term. Making good investing choices early on means you won't keep getting hit with capital gains taxes each time you sell for a profit to reinvest in something else. If you intention is to buy-and-hold indefinitely, funds at risk of shutting down could thwart your plans by forcing you to pay taxes years earlier than you were expecting (unless they're held in a retirement account).

Timing the Market: No, You Don't Have a Time Machine, So Stop Pretending

The  internet is infested with investors who end articles, comments, and blog posts with phrases like, "timing is everything," or, "you just need to time it right," among endless other sentiments that imply market timing is easy or is somehow possible if you just do enough research. It doesn't help when we have a market crash or boom and a small percent of "experts" get lucky. 99% of the rest of the world probably made the wrong call, so these "experts" are deified and appear everywhere in the media. Everyone assumes since they were right the last time around, they'll get it right again. Instead of acknowledging that a broken clock is right two times a day, we all think market timing is easy if we just listed to the right people!

Timing the market as a whole is difficult enough, but there are those who are convinced they can easily time the market for individual stocks as well. I can't count the number of people who seem to think they're investing experts for participating in some part of the increase in Apple stock in recent years. These same people conveniently don't tell you about their big losers over the years.

But in any case, let's use Apple as a case study in market timing. "If I had only put all of my money into Apple when the first iPod came out. It was obvious they were going to make a ton of money!" The chart below maps Apple's adjusted close prices since going public at the end of 1980.

Never mind for a moment that AAPL was a mediocre investment for over 20 years. An investment in 1980 in an index fund like the Vanguard 500 Index (VFINX) would have outperformed an equal investment in Apple at that time all the way through mid-2005, nearly 25 years.

Critical investing opportunities and risks in the history of Apple's (AAPL) stock

A Bitcoin ETF? But Why?

The way I see it, ETFs are great vehicles for investing in assets or strategies that would otherwise be difficult to invest in. Case-in-point: I love mid-caps, but I don't want to individually buy each of the 400 stocks that make up the S&P 400. I also don't want to pay commissions on 400 stocks every time I have new money to invest, and I don't want to buy and sell whenever companies are added or removed from the index. The iShares Core S&P Mid-Cap ETF (IJH) is a far more appealing option.

Pondering the value of Bitcoin as a currencyGold is another good example. If you're a gold bug (I'm not), the SPDR Gold Trust ETF (GLD) is a nice alternative to holding physical gold yourself and figuring out a safe place to store it, maybe paying for a safe deposit box or hiding it under your mattress. Instead, investors can sleep safe knowing their shares are backed by real gold stashed away in a vault with top-notch security measures.

Foreign currency ETFs make sense since it's not easy to hold foreign denominations in a typical U.S. bank account.

Then there's the proposed Bitcoin exchange-traded fund, brought to you (if it gets approval) by none other than Mark Zuckerburg's arch nemeses, the Winklevoss twins. Regardless of your opinion about Bitcoin, I don't get why anyone would want this in ETF form when they could just, I don't know, hold actual Bitcoins instead?

If the beauty of Bitcoin is its utility in instant online peer-to-peer transactions, then why would I want to add an extra step to the process? If someone holds Bitcoins, they can freely pay for goods and services with the currency, in addition to speculating on the currency increasing in value. With the ETF version, I can speculate but not much else. If anything, it seems this ETF removes some of the utility that can be had by simply holding Bitcoins. If you want to buy something in Bitcoin, you'd have to sell some shares, take your dollars and convert them to actual Bitcoins, and only then can you make your purchase. Hmmm...

Growth vs. Value Stocks: Which Investing Style is Best?

Choosing investments is hard enough. There are endless equity indexes segmented by market cap, region, industry, in addition to fixed income and commodity funds.

Adding an additional layer of complexity, most investors are likely familiar with the Morningstar Style Box. Virtually every popular stock index seems to have a corresponding ETF to match value, growth, and blend categories.

Growth vs. Value Stocks: An Epic Battle for the AgesMany index investors seem to be particularly enamored with value investing, and specifically the small value stocks given their history (going back to at least 1927) of completely and utterly obliterating the returns of other equity classes. Old charts (link since removed) from Vanguard using Kenneth French data show that over the course of 77 years small value U.S. stocks returned and average of 15.1% per year, over 5% better than small growth and 1.6% better than small blend. Large value also outperformed large growth by 2.5% during that stretch (and 1.6% above large blend). So value investing seems like a no-brainer, right?

Kicking poor growth stocks while their down, take a look at this comparison between the Russell 1000 Growth Index (IWF) and the Russell 1000 Value Index (IWD). Over the course of the last 14 years, large value has again shown its dominance over growth. Reinvesting dividends, value has returned around 140% while growth has eked out just over 30%.

IWD vs. IWF: Comparing large cap growth to large cap value
Game over, right?

August 11, 2014

The Best Free Stock Charts

There are probably few investors who don't at least occasionally visit Yahoo Finance, Google Finance, MarketWatch, or one of a host of other finance sites. Visitors to each site no doubt fiddle with historical stock charts shown for every quote. Many investing decisions have likely been made partially due to those charts as well.

But are the stock charts on mainstream finance sites actually helpful? I would argue, it depends. Most charts you'll find online are standard price charts. They map the closing price of a given stock or ETF across time, but not much else.

Little girl upset about missing out on dividend reinvestmentMost importantly, most of them fail to factor in dividend reinvestment. If you're like me, you reinvest dividends from all of your ETFs to maximize gains over time. Yahoo Finance does factor this into the "adjusted close" price in the raw historical data CSV files, but no such luck in their charts. You have to create your own charts manually in Excel using the raw data if you want to see the total return of your investments over time.

What's does charting price only look like in comparison to total return? Let's take a look at two charts for the SPDR S&P 500 ETF going all the way back to January 29, 1999. The first chart is from Google Finance and shows price only. If one were to base an investing decision on this chart, he or she might thing large cap equity index ETFs are a mediocre asset choice. Dividend distributions are nicely shown along the bottom of the chart, but not factored into the price. In fact, based on this alone, it appears the SPY hit somewhere around $150/share in 2000 then didn't do so again until 2007. After crashing in 2008-2009, this ETF didn't return to peak 2000 levels until 2013. Over this roughly 15 1/2 year time period, it looks like SPY gained 57.67%.

Sample Google Finance stock chart of SPY

Now let's take a look at the chart below from

August 10, 2014

Covered Calls: The Pros and Cons of Selling Call Options on Your Stocks

Sticking with the option theme of the day, I often hear advice that selling covered calls is the most "conservative" options strategy and is a great way to "generate income". There are even ETFs dedicated to the buy-write strategy. The PowerShares BuyWrite Portfolio (PBP) is the biggest, but you'd have to expect significant excess returns with this strategy with its 0.75% expense ratio. A straight S&P 500 fund like Vanguard's VOO charges less than a tenth of that, at only 0.05%!

Ultimately the idea of implementing a buy-write strategy is that you'll pad your losses a bit if your portfolio goes down, make some extra cash if it stays even or potentially goes up a bit. If your stock goes up significantly, hopefully the covered calls were out-of-the-money and you still get the premium too. What could go wrong?

If you're a long-term investor with a portfolio full of ETFs, the downsides to selling calls, in my opinion, far outweigh the risks. The problems with covered calls come down to three things:
  1. Altered risk/reward profile and opportunity costs
  2. Speculation vs. long-term investing
  3. Tax consequences
Covered calls, covered wagonLet's say you you've got a portfolio with a few low-cost ETFs and you're thinking you'd like to generate extra income selling calls. While SPY and IWM have some of the largest option trading volumes amongst all equities, many long-term investors are heavily invested in broad-based U.S. index ETFs from Vanguard and Schwab, like VTI and SCHB. Owners of many funds, like SCHB, have little in the way of choice if they'd like to sell covered calls. Trading volume is too low. ETFs like VTI do have a decent market for options at multiple expirations in the future.

What's the problem?

Using ETF Put Options to Bet on a Second Housing Crash

While housing prices are still more than 15% off of the highs set in the housing bubble according to the S&P/Case-Shiller 20-City Composite Home Price Index, we're up over 25% from the lows during the peak of the last bubble.

Meanwhile, many international markets are looking frothy, including Hong Kong and London. With international buyers now making up about 7% of the existing home sales market in the U.S., one might be justified in thinking we'll see the ripple effects if those markets face significant downturns.

Now I'm now much of a gambler, but occasionally I've been tempted to dabble in long-term ETF options. Shorting equities scares the hell out of me. Imagine shorting Tesla when it popped over $100 a share, then watching it march north of $250. For simpletons like me, the unlimited risk is too much.

Stock and real estate market fortune tellerIf you're bearish on U.S. housing over the next year or so, long put options are a relatively safer bet. Your maximum loss is the price of the option contracts. The iShares Residential Real Estate Capped (REZ) is dedicated to tracking residential real estate, but its trading volume is low and options volume is virtually non-existent. However, its performance tracks quite closely with the broader iShares U.S. Real Estate ETF (IYR),one of the most liquid REIT ETFs. IYR has a healthy options volume and is pretty diversified across all sectors of U.S. real estate (with heavy retail and office components, in addition to residential).

Since we don't know when (or if) real estate will crash again, LEAPS (Long Term Equity AnticiPation Security) are an interesting choice for two reasons. First, the odds of a crash at some point over the next year and a half or so is probably greater than hoping for a large dip in the next few months. Second, any gains on short-term options would be taxed at your short-term capital gains rate as ordinary income. Options expiring over a year from now get taxed at the long-term 15% federal rate.

The Dow Jones Industrial Average is a Weird Index

Financial reporting constantly baffles me. Talking heads on CNBC and market updates on the radio are always spouting off about what the Dow or the NASDAQ did on a given day. In reality the S&P 500 is really the only major index that actually gives an accurate overall benchmark of U.S. stock performance.

The NASDAQ is fairly useful if you're interested in how tech stocks have performed on a given day. While many non-tech names have crept into the NASDAQ over time, it's still very heavily-weighted toward to tech. Those who believe we're in the midst of Tech Bubble 2.0 may be watch it particularly closely. Like the S&P 500, the NASDAQ is market cap weighted.

Some of the big name stocks in the Dow Jones Industrial Average: Visa, IBM, 3M, Exxon, and NikeThe Dow Jones Industrial Average, however, is price-weighted (as is the Nikkei 225). Yes, the DJIA is based on the share price of each of its 30 constituents rather than market caps. I'm sure this seemed like a great idea back in the 1800's, but for the life of me I can't figure out why anybody cares about this index today. Yes, the 30 "major" American companies in the index are probably a decent approximation of blue chip stock performance. But Visa, roughly the 35th largest U.S. public company, is the largest component of the Dow at 8.2%. Meanwhile, Exxon, the 2nd largest public company by market cap, accounts for less than half as much of the DJIA (3.85%).

Visa's stock price at over $210 is twice that of Exxon at just under $100, but so what? Exxon is an over $425 billion company while Visa is around $132 billion. The Dow does factor in stock splits using the Dow Divisor, but overall the S&P 500 just seems so much more meaningful. While S&P Dow Jones states, "This application of grade-school arithmetic, while creative, is hardly useful more than a century later," I'll continue to tune out financial reporters as they spout off daily DJIA figures.

August 9, 2014

International Stocks: How Much of Your Portfolio Should be Invested Abroad?

According to Forbes, retail investors are scared of foreign stocks. Maybe it's because international stocks speak with accents or in a language you can't even understand? In fact, the article cites a NASDAQ OMX survey that found just around a third of investors own stocks outside of the U.S. and a major reason for that is, "lack of knowledge about international investing opportunities."

That's crazy when you consider 51% of the global equity market is made up of companies based outside of the U.S, according to Vanguard Research. The same study concludes that allocating 30% of your equity holdings to non-U.S. stocks provided the most diversification benefit.

Historical dude thinking about international investingOther experts tend to recommend anywhere from 10% to 50%. Many don't seem to have much rationale for their recommendation other than gut instinct.

These guys are probably more smarter than me, but I tend to prefer a 50% allocation to international equities. I figure in the long-run that will smooth out fluctuations in the dollar and it's amazing how closely U.S. stocks tend to track those abroad.

MSCI Index Performance data is an awesome resource. Comparing the MSCI North America Index (yea, there's nearly 7.5% Canadian stocks in this index, but I figure it's probably tracks the S&P 500 pretty closely) going back to December 1969 to the EAFE (Europe, Australasia and the Far East) over the same time period, we see pretty similar performance. Both are gross returns, including dividends.

MSCI North America Index vs the EAFE: Long-Term historical chart and total returns

August 8, 2014

Is it Worth Investing in Micro Cap ETFs?

Every so often, I'm tempted by the siren song of micro cap ETFs. The smallest investable securities, in theory, may give you outsized returns if you believe in the small cap premium. Recently I came across this old Forbes piece by Rick Ferri from 2010. Based on the CRSP Decile 10 Index, it looks like one would be justified in thinking the smaller the better. 81.7%, holy $#!*! Even the Wilshire Micro Cap Index returned 47.5% that year, smoking small caps to the tune of 10% and nearly doubling the bounce back of large caps after the crash.

Tiny stocks, tiny ponyIf you like to spend your free time playing with Excel, you can have some fun with all of the awesome historical data Ken French as made available here. The "Portfolios Formed on Size" data set includes returns going all the way back to 1926, broken out by deciles, quintiles, and a 30/40/30 split.

On average, the smallest decile appears to be consistently among the highest performers across many time periods.

So how come the available micro cap ETFs didn't hit the 81.7% return in real life? The biggest with almost $900 million assets under management, the iShares Micro-Cap ETF (IWC), returned just 23.7% that year. That's much closer to what large caps did that year. What happened? According to Ferri, most stocks in the micro-cap segment are not investable. With terrible liquidity, these stocks are hard for funds to buy, making it virtually impossible to create a fund that matches a true micro cap index. Many contain a large portion of small caps masquerading as micro cap stocks.

August 7, 2014

How to Make a Billion Dollars...

...or at least copy people who already have. The new iBillionaire Index ETF (IBLN) tracks the investments of up to 10 billionaires, selected from a pool of 50 potential billionaires.

Slick old timey investorIt sounds like a great marketing ploy, and you can tell people you invest like big ballers including Buffet, Icahn, and Soros. But most of the fund's 30 holdings look pretty much like vanilla blue chip fare.

The net expense ratio is 0.65%, which isn't terrible. Without much of a track record to go on, I'd take SPY at 0.09% any day. Returns look great so far, but the index's site shows performance back to October 2013. 9-10 months of history seems pretty meaningless unless you like hopping from fund to fund.

To top things off, holdings are based on publicly available information in 13F filings, released roughly 45 days after the end of each quarter. Investors far smarter than me probably have better ways to catch wind of these guys moving into a big position far ahead of that. So it's kind of like a time machine where you can invest like the big guys were a few months ago?

No my cup of tea.

August 6, 2014

Top Performing Mutual Funds of 2014

Kiplinger recently published their 2014 rankings highlighting the best-performing mutual funds through June 30th. The #1 performer for the Large-Company Stock Funds category was the Biondo Focus Investor fund (BFONX). Up 49.52% in one year! No wonder this fund charges a 2.82% expense ratio. For that kind of coin you must really be getting some kick-ass performance for your money. Imagine how rich you'd be if you went all-in on this fund back in March of 2010 instead of a lousy S&P 500 ETF. This fund may employ leverage, so it probably crushed the total return of the rest of the market during this bull run, right?

Active management + a large expense ratio FTW! Err....hmm. Well, this is embarrassing.

Studies  continually show that top active managers fail to repeat their performance in subsequent years, with many falling near the bottom of fund rankings after a stellar year or two.

Biondo Focus Fund (BFONX) Total Return Compared to S&P 500

How High Are Your Fund's Expense Ratios?

Zebras think high ETF expense ratios are absurd!