Learning the ABCs of ETFs

By Daniel Mufson and Tara Siegel Bernard
Originally printed in The Wall Street Journal Europe, Fri./Sat./Sun., Sept. 30 – Oct. 2, 2005, p. P6.
Please note that this article is being published here as a writing sample; the information it contains is out of date.

Since the first exchange-traded fund was launched in the U.S. in 1993, ETFs have surged in popularity with investors and financial advisers. A similar story is starting to unfold in Europe, which only began listing ETFs five years ago.

In the U.S., investment in these funds—which resemble index-tracking mutual funds but trade just like stocks—is still just a sliver compared with America’s $8.12 trillion (€6.76 trillion) mutual-fund industry. However, assets held in ETFs in the U.S. rocketed nearly 50% last year. They now stand at about $240 billion and are expected to hit $812 billion by 2009, according to Financial Research Corp. in Boston.

Assets held in European ETFs are still small compared with those in the U.S., but last year grew nearly 67% from the year before, to around $34 billion (€28 billion), according to Morgan Stanley in London. This statistic underestimates the exposure Europeans have to ETFs, said Deborah Fuhr, investment strategist in Morgan Stanley’s London office, because European institutional investors can and do invest in U.S.-listed ETFs. This isn’t an option for European retail investors. (There also are rules against Europeans buying ETFs listed on EU exchanges outside their own countries.)

What’s behind the fascination? Like index funds, ETFs track the performance of a particular index, ranging from the large benchmarks such as the Standard & Poor’s Depositary Receipt, which mimics the S&P 500 stock index and is known as the “spider,” to those following different sectors, geographic regions, countries and styles.

True ETFs have yet to come to Spain, Austria, Denmark, Greece and Portugal, Ms. Fuhr said; there, some funds do trade on exchanges but they generally lack the transparency and redemption features that allow ETFs to trade close to their net asset value.

U.S. ETFs cover a greater variety of investments than those available in Europe, but European ETF issuers are rapidly broadening the range of funds. In the first seven months of this year, 25 new ETFs have been added on European exchanges. Although many of those offerings were copies of each other listed on different European exchanges, some of them have given European investors access to asset classes that U.S. investors can’t yet invest in. AXA Investment Managers and BNP Paribas, for example, jointly sponsor an ETF listed on the Swiss and German stock exchanges that tracks the Goldman Sachs  Commodity Index, while U.S. investors are still waiting for a similar ETF to be approved by the Securities and exchange Commission. The U.K. was the first country to offer ETFs tracking the price of gold and oil; a gold ETF has since become available in the U.S., but SEC approval of two ETFs tracking oil is still pending.

ETFs generally have lower expenses than traditional mutual funds (including index funds), and they trade throughout the day on an exchange, while mutual funds’ prices are set just once daily. They’re also generally more tax-efficient than mutual funds, and investors know exactly what they’re buying because holdings are completely transparent.

In the U.S., the average ETF has an expense ratio of 0.42% of assets annually, compared with an average expense ratio of 0.86% for index funds and 1.41% for actively managed mutual funds, according to Morningstar, a Chicago-based investment research firm. In Europe, the average ETF expense ratio is 0.43%, compared with 1.20% for index funds and 1.62% for actively managed funds, according to Fitzrovia and Morgan Stanley in London. And, as in the U.S., ETF issuers have been reducing their fees as assets under management have grown. Barclay’s iShares, for example, has steadily reduced the fee on its Dow Jones Eurostoxx 50 ETF, listed on six European exchanges, from 0.40% to 0.15%.

Despite the growing popularity of ETFs, many investors still aren’t sure how to fit the funds into their financial plans. Building a portfolio of ETFs alone or in combination with other investments may seem daunting at first, but it can be done, if you’re willing to do your homework.

Whether you go it alone or hire an expert, here’s a rundown of some basics you’ll need to know.

Getting Started

The first step to managing a portfolio of ETFs is to draw up an asset allocation based on widely used criteria, including your age, financial goals, risk tolerance, time horizon and the amount of the investment. (A variety of investment Web sites offer asset allocation calculators, but be aware that you may get different recommendations from different programs.)

Cultural norms and recent market history also influence allocation decisions; Germans, for example, tend to allocate less money to equities than Americans. Alexander Etterer, co-author of the book Exchange Traded Funds (co-authored with Hubert-Ralph Schmitt and Martin Wambach, Finanzbuch Verlag, 2003, €34.90) and an adviser in the Cologne office of international auditing, accounting and management consultancy Rödl & Partner, says his firm usually uses a variation of one-third equities, one-third real estate and one-third bonds for German clients.

Many German advisers don’t recommend ETFs to clients, instead favoring products that allow them to pocket a sales commission, says Mr. Etterer, whose firm is independent.

David F. Swensen, who has managed the endowment of Yale University in the U.S. for two decades with returns averaging more than 16% a year, recommends ETFs as a way for retail investors to create a low-cost, diversified portfolio. IN general comments on portfolio allocation in his just-published book, Unconventional Success (Free Press, 2005, €23), he suggests the following as a starting point: 30% domestic equity, 15% foreign developed equity, 5% emerging market equity, 20% real estate, 15% U.S. Treasury bonds, and 15% U.S. Treasury Inflation-Protected Securities. In an interview, he recommends that European investors concentrate their government bond investments in their domestic markets “to provide protection against financial crisis or deflation.”

But despite the popularity of commodity-based ETFs, he argues that, after accounting for inflation, long-term returns on commodity investments “approximate zero.”

Diversify, but Not Too Much

Once you figure out your allocation, you have to find the appropriate ETFs. IN the U.S., “if an investor wants to keep things simple and focus on the broadest asset classes, it si possible to construct a portfolio that is very well diversified and easy to manage with just four or five ETFs,” says J.D. Steinhilber, founder of AgileInvesting.com, a Nashville, Tenn., investment-advisory subscription service that provides advice on managing portfolios with ETFs.

For instance, a “moderate growth” or “balanced” portfolio, carrying an overall expense ratio of 0.22% of assets, might allocate 60% to stock ETFs, 25% to an aggregate-bond ETF and 15% to a Treasury-based ETF.

Large pan-European fund issuers such as Lyxor, iShares, and EasyETF have Internet portals with information on their own products, but the easiest thing to do may be to visit the Web site of your national stock exchange, which will usually have a section listing all the ETFs available in your market.

In Europe, however, two asset classes that many advisers consider to be essential are either underrepresented or absent from the European ETF universe: real estate and emerging market equity. In contrast with the four real estate investment trust ETFs in the U.S., there is only one eurozone real estate ETF—it’s issued by AXA and BNP Paribas and trades on Paris Euronext, tracking the European Public Real Estate Association’s index of property companies operating in the eurozone.

Bruno Guiot, head of EasyETF development at AXA Investment Managers in Paris, says AXA and BNP Paribas hope to list the eurozone real estate ETF in Germany, Italy and Switzerland by next summer.

At the moment, there is no global emerging markets equity ETF comparable to those issued b y Vanguard or iShares in the U.S., but iShares does offer a China ETF on several European exchanges and Germany’s IndEXchange offers an ETF covering Poland, Hungary, the Czech Republic and Slovenia.

According to Morgan Stanley’s Ms. Fuhr, it now takes less than a year for European issuers to bring an ETF to market, and a recent EU directive may speed up the cross-listing of ETFs on different European exchanges.

If on the other hand you can’t decide between tow similar ETFs, evaluate how the underlying indexes are constructed and what specific stocks or other assets each tracks. Trading volume and the reputation of the issuer also are important, says David Elan, a principal at Windward Investment Management, a Boston-based registered investment advisory firm.

Keep in mind there is a limit to how far you should diversify: The more securities and ETFs in your portfolio, the more potential trading costs you will have. “Once you get beyond the major asset classes, the law of diminishing returns definitely applies,” Mr. Steinhilber says.

And don’t forget to compare the fees. “One of the biggest—if not the biggest—difference makers in long-term returns will be expenses, because indexes track so closely together” in terms of performance, says Dan Culloton, a Morningstar analyst.

Combination Strategies

Some money managers who were once proponents of actively managed funds have taken to a hybrid approach to investing referred to as “core and satellite.” In this strategy, the majority, or core, of one’s holdings is put in index-tracking ETFs or low-cost index funds, while the portfolio’s smaller positions, or satellites, are invested in higher cost, actively managed funds or other areas that might outperform the market.

“A couple of years ago, we moved to a core-and-satellite design because we believe that equity returns will be modest over the next five to 10 years,” says Harold Evensky, a financial planner in Coral Gables, Fla.

Mr. Evensky puts half of his clients’ stock allocation in a broad-based market ETF like the iShares Russell 3000 Index Fund ETF. He puts 30% in a mix of domestic value, small cap and international funds, using both ETFs and traditional index funds. The rest, about 20%, he dedicates to satellites.

All-in-One, Online Products

If you don’t feel like assembling an ETF portfolio yourself, plenty of advisers and a growing number of large brokerage firms are happy to do it—for a fee. But, again, beware of high fees, which could defeat part of the reason for investing in ETFs in the first place.

As one example of how such services work, Raymond James Investment Services and Marlborough Fund Managers, operating under the trade name of iFunds, offer the ETF Total Return Fund—an actively managed international portfolio of ETFs. The retail Class A shares carry a purchasing fee of 4.5% and charge an annual fee of 1.5%, which doesn’t include the fees charged by the ETFs that the fund invests in.

The company says the fees are justified because it believes its proprietary market-timing technique will outperform other allocation and rebalancing models, and the fund expects a low turnover, which should keep transaction expenses low.

However, retail investors who put together and maintain their ETF portfolios themselves can save a considerable amount of money in fees.

When Is a Fee Too High?

At what level should a professional ETF manager’s fees be considered excessive?

“I don’t know what the magic number is, but I would start asking questions when [total fees approach] 1% or higher,” says Mr. Culloton of Morningstar. “At that point, once you factor in the expense ratios of the underlying funds, you’re approaching the average cost of a traditional actively managed mutual fund. You want to make sure you’re getting more advice and service than you can find on your own.”