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ETF Confusion

As the popularity of exchange-traded funds (ETFs) grows, financial advisors are increasingly pressed to separate the wheat from the chaff, the meat from the gristle, the men from the boys or whatever other stale clich comes to mind. Industry growth has been near exponential, at least in the sheer number of new ETFs hitting the market. Last year ended with 359 in total; today there are over 600. Assets,

As the popularity of exchange-traded funds (ETFs) grows, financial advisors are increasingly pressed to separate the wheat from the chaff, the meat from the gristle, the men from the boys or whatever other stale cliché comes to mind.

Industry growth has been near exponential, at least in the sheer number of new ETFs hitting the market. Last year ended with 359 in total; today there are over 600. Assets, at $83 billion in 2001, currently stand at $500 billion, and are expected to hit $1 trillion in the next three years, according to Celent, a financial services consultancy.

Increasingly, financial advisors use them in client accounts. A Schwab Institutional poll taken in January found that nearly 76 percent of its advisors use ETFs in client portfolios. Moreover, 36 percent of the respondents said they expect ETFs to command a greater share of the investment pie. And of those advisors who don't use ETFs, one in five expects to start soon.

Growth has been fueled by sponsor willingness to expand the definition of an index (the underlying benchmark for any ETF). Many of the new indexes include virtually any combination of publicly traded securities, selected and weighted based on in-house rules. Indeed, critics argue that ETFs are not passive indexes at all, but represent various strategies. Take the BIR-50 Index: Composed of 50 stocks selected by a consortium of five independent research firms, it serves as the benchmark for the Claymore/BIR Leaders 50 Index.

Critics say that this approach perverts the whole point of ETF investing: “If you are weighing by dividends, or earnings or some other metric, that's not an index — that's a strategy,” says Rick Ferri, CEO of Portfolio Solutions in Troy, Mich.

Robert Arnott, chairman of Pasadena-Calif.-based Research Affiliates, a leader in fundamentally weighted ETFs, disagrees. “If you say anything that isn't cap-weighted is active, then call it active or call it a strategy. I have a more pragmatic definition of ETF investing: If it is formulaic, mechanistic, historically replicable, low turnover and objective, then it sounds pretty passive and index-like to me.”

Evaluating Risk And Efficiency

Theoretically, of course, ETFs should track their benchmarks before fees. And the point of many ETFs is to actually beat their benchmarks (create alpha), which is why the selection process can be so, well, selective, and sometimes result in concentrated holdings. The fewer the securities comprising the ETF, the more the ETF is exposed to unsystematic risk. Some highly concentrated ETFs have risk profiles that resemble individual stocks.

“You run into problems with narrowly focused ETFs where the percentage of stock in the index is greater than regulators allow,” says Sonya Morris, fund analyst at Morningstar. “For example, one company might be 40 percent of the index, but regulatory requirements might preclude that much concentration in the ETF.”

But that's not to say that concentration risk should always be avoided. Many advisors seek additional unsystematic risk to maximize tactical-allocation returns. Consider an advisor bullish on China last year: If he had chosen iShares FTSE/Xinhua China 25 (FXI), which holds 25 stocks, he would have realized a 50 percent annual return. On the other hand, if he had chosen a less concentrated vehicle, like the Eaton Vance Greater China Growth fund (which holds approximately 65 stocks), his return would have dropped to 35 percent.

Some advisors avoid concentration, some seek it, but most desire tax efficiency, especially for investments held outside of tax-deferred accounts. ETFs generally excel in this area; they don't need to cover redemptions by selling securities, and because they track an index that is passively managed, turnover occurs less frequently than it would in most actively managed mutual funds.

Tax efficiency on dividends is more difficult. To be qualified at the lower 15 percent rate, a dividend-paying stock has to be owned by both the investor, and the ETF, for at least 61 of the 121 days surrounding the ex-dividend date. Lower levels of qualified dividend income can produce a higher tax bill. And some dividends, such as real-estate investment trusts, and certain foreign-company ETFs, are simply ineligible for the lower rate.

Expenses are another front-burner issue. The more expensive the ETF, the less likely it will be able to track its stated benchmark. That said, expenses often correlate directly with activity and allocation sophistication; therefore, they shouldn't be compared in isolation.

“Of course, expenses matter,” says Arnott, “but they're not all that matters. A high price doesn't necessarily mean a bad product. A high price is justified if you are receiving high performance.”

Expenses also correlate directly with strategy, according to Ferri. “If you see 10 or 15 basis points, you have a passive, cap-weighted ETF,” he says. “If you have 50 or 60 basis points, you have a customized strategy.”

Anecdotal evidence supports Ferri's contention: Vanguard's Large-Cap ETF (VV) employs a cap-weighted passive investment approach, and sports a 0.07 percent expense ratio. UltraShort Technology ProShares (PEW), which involves leverage and more management participation, sports a 0.95 percent expense ratio.

Trading efficiency is another expense variable. Bid-ask spreads capture hidden transaction costs. The advisor buys at the ask price and sells at the bid, incurring a loss equal to the difference between the two prices.

Fortunately, ETFs trade efficiently. The S&P Deposit Receipts (SPY), which trades 130 million shares daily, rarely has a bid-ask spread greater than a penny. More importantly, trading efficiency is prevalent among smaller issues. Powershares' Dynamic Utilities Portfolio (PUI), for instance, trades on average less than 27,000 shares a day, yet its bid-ask spread rarely exceeds three cents.

Risk And Return

Measuring investment performance is obviously important. Many advisors use a Sharpe ratio, calculated by subtracting the risk-free rate from return, and dividing the result by the standard deviation as a gauge. In short, the Sharpe ratio measures return per unit of risk, which puts a large cap-weighted ETF on the same footing as a nanotechnology ETF.

An investment's Sharpe ratio is generally thought to improve as its value increases, and vice versa. Additional insight into the value of an investment's Sharpe ratio may be provided by careful consideration of all the components.

But some advisors question the legitimacy of applying Sharpe ratios to ETFs, because of their brief history. “If you attempt to run a standard deviation on something that has less than 12 years behind it, you are really just playing with numbers,” says Steven Evanson, founder of Carmel, Calif.-based Evanson Asset Management. “The idea of choosing ETFs on alpha or Sharpe ratios sounds scientifically rigorous, but it is based on data that is mushy and has yet to capture a serious stress test.”

For that reason, advisors like Evanson and Michael Krause, president of New York-based Alta Vista Independent Research, prefer a fundamental approach: “Because an ETF is transparent, you can easily address all the pertinent questions pertaining to financial statements,” says Krause. “A fundamental analysis gives a clearer picture of investment merit.”

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