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Using ETFs to Piggyback Fund Managers' Broader Ideas

Cost-conscious investors can use ETFs to implement themes similar to those of smart, well-respected active mutual fund managers.

Michael Rawson, ETF Analyst, 04/19/2011

U.S. equity markets have rebounded nicely from their mid-March dip. However, amid rising gasoline prices, fears of inflation, and increased global instability, equity investors have every right to be seriously concerned about the market going forward--and about what they are paying in order to invest in stocks.

Obviously, investors can buy a diversified basket of U.S. stocks either through an open-end mutual fund or through an exchange-traded fund. But with typical mutual fund expense ratios ranging from 1.2% to 1.7%--and even many institutional mutual fund expense ratios ranging from 0.5% to 0.8%--we like to highlight some ways that a cost-conscious investor can use ETFs to implement themes similar to those of smart, well-respected active mutual fund managers at a fraction of the cost.

Of course, this is just an exercise in replication that will only give you returns that are correlated with the active managers' recent bets. So, while you will pay lower fees, you won't have the benefit of the active manager as your investment steward. We also don't know their holdings in real time, and a primary reason you pay up for active managers is to have them change their holdings at opportune times. You'll have to adjust your holdings according to your own evolving judgement once you decide to use other instruments, like ETFs, to capitalize on their most recent ideas. For many investors, paying up to actually own those managers' funds may be a good idea.

Channeling Contrafund and Jensen with ETFs
Five-star mutual funds Fidelity Contrafund FCNTX and Jensen J JENSX have a lot in common. Both are run by former Morningstar Fund Manager of the Year award winners and both are firmly in the large-cap growth style. Digging beneath the surface, however, the two mutual funds have some substantial differences. At $79 billion in assets under management spread over 484 holdings, Contrafund, which charges 0.91%, is a giant. Although just 30% of Contrafund's assets are in its top 10 holdings, it has a large overweight in information technology, with a 7% position in Apple AAPL and a 5% position in Google GOOG. It also has an underweight to industrials and defensive sectors such as health care and consumer staples.

Meanwhile, Jensen, which charges 0.92%, has $3.9 billion in assets invested in just 28 stocks, with the top 10 holdings comprising 47% of assets. Though a growth fund, the portfolio is underweight technology and overweight industrials and consumer staples.

One ETF, PowerShares QQQ QQQ, also known as the "Cubes" or the Qs, is a great way for investors to replicate Contrafund's bullish view on tech, as QQQ has a large weight in Apple and Google and almost 64% of its assets invested in technology. However, we would note that that weight in Apple will fall once the NASDAQ-100 Index, which QQQ tracks, is rebalanced.

Jensen's view on high-quality consumer staples and industrials could be mimicked by one of two ETFs: Vanguard Dividend Appreciation VIG or iShares Dow Jones US Industrial Sector Index IYJ. Over the last four years, Jensen has had a higher correlation to VIG than it has had to the S&P 500. Of Jensen's 28 stock holdings, 19 also are in VIG, which has 142 holdings. Some of the biggest holdings of Jensen that are also large holdings in VIG include Abbott Laboratories ABT, 3M MMM, Emerson Electric EMR, and Medtronic MDT.

With a concentrated portfolio like Jensen, quality becomes more important. Nearly 75% of Jensen's assets are invested in firms with economic moats, which Morningstar's equity analysts define as sustainable competitive advantages. Remarkably, none of Jensen's holdings is rated as no-moat.

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