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Using ETFs to Mimic Mutual Fund Managers' Ideas

How to use ETFs to implement fund managers' current ideas at lower costs.

Robert Goldsborough, 09/09/2010

In the investment world, some active mutual fund managers are treated like sages--and sometimes rightly so, given the incredible returns some have been able to rack up over extended periods.

However, those returns do come at a cost to investors: Typical mutual fund expense ratios range from 1.2% to 1.7%, and even institutional mutual fund expense ratios range from 0.5% to 0.8%. Are there ways for a cost-conscious investor--already smarting from the S&P 500's 3% decline so far in 2010--to play some of the investment themes that smart active fund managers are promoting these days, but for a fraction of the cost?

The answer: Most definitely. Through inexpensive exchange-traded funds, investors can pursue similar investment strategies and potentially enjoy returns comparable to those generated by active mutual fund managers--and do so far more cheaply.

Let's start with legendary Legg Mason Value Trust LMVTX manager Bill Miller, who in recent commentary told investors that "U.S. large-cap stocks represent a once-in-a-lifetime opportunity, in my opinion, to buy the best-quality companies in the world at bargain prices. The last time they were this cheap relative to bonds was 1951." Miller, of course, guided Legg Mason Value Trust to 15 consecutive years of outperformance of the S&P 500. And, despite his recent string of significant underperformance, Miller still has outperformed the benchmark since taking the helm of the fund in 1982.

Miller is putting his money where his mouth is. For example, at the 2010 Morningstar Investment Conference in June, he praised one of his top holdings, IBM IBM, as "the most remarkably mispriced name in the market," and he also touted other large-cap names, as well. As of June 30, his fund's holdings held mega-cap names such as IBM, Goldman Sachs GS, Texas Instruments TXN, Time Warner TWX, Citigroup C, and Amazon.com AMZN.PAGEBREAK

With a fee of 1.69%, Legg Mason Value Trust should be viewed by investors as being on the expensive side. In the ETF universe, however, an investor can gain access to the same kinds of names far more cheaply. Investors might consider gaining similar exposure to Legg Mason Value Trust at a fraction of the cost by combining Vanguard Mega Cap 300 Index ETF MGC, which is an extremely low-cost, diversified, size-pure investment in large-cap U.S. stocks (at just a 0.13% expense ratio), with a bank ETF such as iShares Dow Jones U.S. Financial Services IYG (0.48% expense ratio). Such a combination would give an investor major exposure to ExxonMobil XOM, which Miller, in a July note to shareholders, said trades well below the market, has a yield greater than that of the 10-year Treasury, has above-market returns on capital, and sports a valuation that is "among the lowest the company has traded at in years." Additionally, investors IYG offers exposure to core Miller holdings such as General Electric GE, Microsoft MSFT, Goldman Sachs, Citigroup, Merck MRK, Bank of America BAC, IBM, Medtronic MDT, American Express AXP, Amgen AMGN, Hewlett-Packard HPQ, Amazon.com, Cisco Systems CSCO, Wells Fargo WFC, EMC EMC, UnitedHealth Group UNH, Gilead Sciences GILD, eBay EBAY, Texas Instruments, Aflac AFL, and Time Warner.

Another obviously influential investor is GMO's Jeremy Grantham, whose lengthy and often-contrarian quarterly missives are considered "must-reads" on Wall Street. Grantham's team includes portfolio managers William Joyce and Sam Wilderman. Grantham, who manages well-regarded and inexpensive (entirely because of their $10 million minimum required investment) mutual funds such as GMO US Core Equity GMCQX (0.37% fee) and GMO Quality GQLOX (0.39% fee), is also sounding the gong about the current attractiveness of high-quality stocks, particularly those in the large-cap space. In the case of GMO US Core Equity, Grantham's team focuses on trying to outperform the S&P 500 across a complete seven-year market cycle. GMO Quality, by contrast, aims to own high-quality names across all cap ranges, although, as a practical matter, almost 90% of the fund is invested in giant caps.

Using ETFs, investors have the ability to pursue the same types of strategies, but at a much cheaper cost. The best option for investors who are interested in owning a fund holding the companies GMO invests in--those with low debt, high returns on capital, and stable earnings--would be Vanguard Dividend Appreciation ETF VIG, which holds a diversified portfolio of high-quality U.S. large-cap equities and charges an expense ratio of just 0.23%.

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