Thu, 13 Oct 2011
Active ETFs may hold a tax advantage, but lack of 401(k) availability and the need to publish daily holdings have held back their growth versus their open-end brethren.
Christine Benz: Now, you're an ETF specialist, so I want to spend some time talking about ETFs. In particular active ETFs have recently gained interest. PIMCO has filed to run an ETF version of its big Total Return Fund. What's your take on those active ETF strategies and the viability of them?
Rick Ferri: Well, in aggregate, active ETF strategies have not really caught on yet.
Benz: To date.
Ferri: In aggregate. There has been a couple of funds like, PIMCO came up with a very short-term bond fund that’s being used as a substitute for cash. The symbol is MINT. And now, PIMCO is launching a Total Return Bond Fund, and the interesting thing about that, which none of the other companies have done yet, is that there is a brand-name manager, Bill Gross, who is going to be overseeing that fund. So I think that has a good chance, as an actively managed ETF, to do well.
Benz: To gather assets, anyway.
Ferri: To gather assets, because Bill Gross' name is on it. So that has a lot of viability.
But all of the other actively managed ETFs out there that are being launched by companies, you have a lot of mutual fund companies sort of just tipping their toe into this marketplace as another form of distribution for what they do, and I think that they need to do that. But the problem is that, with actively managed ETFs, you don't have a track record. So you don't have a Morningstar star rating. You are going to gather very little assets. Unless there is a brand-name manager like Bill Gross managing the portfolio, it's going to be difficult until you have a three-year track record and you can show you have a 5-star rating or a 4-star rating, and then it becomes competitive with all the other mutual funds out there.
The other issue is they are not in the 401(k) market. I mean, there are some products where you can put ETFs in a 401(k), but since ETFs are traded during the day like stocks, rather than at the end of the day ... Most 401(k)s are just using traditional mutual funds or variable annuities, which just trade at the end of the day at NAV, which is fine for 401(k)s because, I always say, as an employer, do I want my employees trading ETFs during the day in their 401(k), or do I want them working. Well, I'd rather have them working.
So, the idea of putting ETFs in a 401(k) is just not popular yet. I don’t know if it will be popular, the platforms to put these in there. So ... that whole distribution channel of the 401(k) market, which is dominated by mutual funds, I don’t think is going to change for a while. So there are going to be real tough headwinds for the actively managed ETFs to gain market share against open-end actively managed funds.
Benz: How about in terms of performance, though, without getting too "inside baseball," do you see any structural impediments to active ETFs working well?
Ferri: There's pluses and minuses to actively managed ETFs, and let's talk about just the equities. First off, in a taxable account, actively managed ETFs are a great idea because of the way that ETFs are structured, the fund managers are not buying and selling stocks within the ETF. So if there is a rally in the market and they are changing their portfolio around, they are not going to be distributing capital gains out like you would in an open-end fund, where there's cash coming in and cash coming out, and so the managers are buying and selling stocks, and that creates tax issues and capital gain distributions to investors.
You don’t have that in an ETF because the way that they trade stocks is they take the stock out of the ETF and they send it over to an authorized participant, a specialist, and they trade the stocks over there and then they bring other stocks back in, and that shields the ETF from capital gains. So it's a great structure for taxable accounts.
The disadvantage is, right now, the only types of actively managed equity ETFs we have, have to do daily disclosure of what they have in the fund, and active managers who are trying to build positions, who are trying to sell off positions, don’t really want to disclose what they're buying, what they're selling--but at least right now with the actively managed fund market as it stands today, actively managed ETF market, they have to disclose. There is a filing with the SEC for the first funds that don’t do public disclosure on a daily basis, but we’ll have to see where that goes.
Benz: Okay. Rick, I also want to ask about alternative weighting strategy. So funds that aren’t actively managed but still aren’t using cap-weighted style indexing. What’s your take on some of those types of strategies?
Ferri: Well, I wrote a blog on this. There was a recent study that was published, and two of the authors in the study were actually from one of the companies who specialized in doing alternative-weighted indexes. What they said in the study was that there is no excess return from alternative weighting once you adjust for risk. So, if you have 1,000 U.S. stocks, the largest 1,000 stocks in the U.S., and you weight them based on capitalization weight, which would be like the Russell 1,000, that has a certain risk and return. But if you take those 1,000 stocks and you equal weight them, so all 1,000 have 0.1% across the whole spectrum so that they are all equally weighted, it’s going to give you a different rate of return. It’s going to actually give you a higher rate of return than if you cap-weighted them, and the reason is because you are spreading the money down to the mid-cap and the small-cap area, and those mid-cap and small-cap stocks traditionally outperform the large-cap stocks, so you have a size premium there that you are getting. But you are taking more risk because you are investing now in mid-cap and small-cap stocks.
So once you adjust out the extra risk that you were taking with equal weighting, it comes back to the same risk and return, basically, of the cap-weighted index. If you are doing fundamental weighting, where you are saying, let’s look at price to earnings, price to book, price to cash flow, maybe dividends of these 1,000 stocks, and let’s weight them based on those fundamentals, now you are tilting the portfolio to value stocks, things that ... have lower price to book, lower price to earnings, lower price to cash flow. You are putting more money there than in the cap-weighted index.
Well, if you are looking at the return of value stocks over the very long term, value stocks outperformed growth stocks, but it’s widely accepted in the academia that value stocks also have more risk than growth stocks, so you should get a higher rate of return. So when you adjust out the extra risk, it comes out to the same risk-adjusted return as just cap-weighting, like a Russell 1000, and this is what the paper talked about. And people have done other papers which come to the same conclusion.
So it’s a question of, do you want small cap in your portfolio? Do you want value in your portfolio? And if you do, then is this way of doing it--fundamental indexing--is it a good efficient way of getting those exposures? And I would say the answer to that is, yes. It’s a nice efficient way of getting them, but you really have to know what you’re getting, what you’re going after, what the cost is and …
Benz: ... And know that you might be getting some extra volatility to book.
Ferri: You might. You might be getting some extra volatility.
Benz: So we discussed dividend payers, and I wanted to get your take on an index fund that would consist entirely of companies with a history of dividends and dividend growth, and Vanguard has a very good product along those lines. Is that something that you like and would use in client portfolios?
Ferri: There are a lot of these types of products out there. S&P has a type product, Vanguard has a type product. They are basically looking at the consistent dividend-payers and the consistent dividend growers, dividend achievers. There have all different names.
As long as it’s not overly weighted towards an industry, like financials, some of these get overly weighted. So, there would have to be caps on it, or they would have to do things to the index to make sure that you don’t take a lot of risk in one particular industry. Other than that, I think they are okay.
To me, personally, I’m a believer that total return is total return. Either you’re going to get it from dividends or you’re going to get it from the appreciation of the stock, or you’re going to get it from both, and in the end it all comes out in the wash. So, instead of buying stocks that pay higher dividends, you buy the whole market and then you sell a little bit of the capital gain down the road, you get the same return. And that’s my belief.
Benz: Okay. Well, Rick, always great to hear your insights. Thank you for being here.
Ferri: All right. Thank you. Appreciate it.