Archive for June, 2007

The Difference Between Mutual Funds and ETFs

Conventional mutual funds pool the resources of many investors into a fund that is managed as one portfolio. Each shareholder in the fund is entitled to a pro-rata share of the assets. New purchases and sales add or subtract from the total portfolio value. For an Exchange Traded Fund (ETF), the shares issued merely represent the value of the securities in the fund. They typically cannot be exchanged for cash, but can be freely traded between investors. Purchases and sales do not affect the assets held by the fund.

Since a mutual fund is pooling accounts, it must account for each shareholder’s stake individually. This can become expensive if there are many small shareholders. By contrast, the shareholders in an ETF are not able to cash in the shares from the portfolio manager. Therefore, the manager need not account for each shareholder’s position. Shareholders wanting to cash in their position can sell the shares to someone who wants to buy them, with no impact on the portfolio holdings.

ETFs, however, must generally pay higher index license fees. This offsets some of the cost advantage gained by not having to account for positions at the shareholder level.

ETFs tend to have a tax advantage, because mutual fund buyers are buying into a pool of assets, many of which may have a taxable basis below the current market value. They are essentially buying into taxable gains. Since ETF shares can only be redeemed by a broker through an in-kind transaction, the shares with significant gains tend to be those redeemed in-kind, reducing the taxable basis for new shareholders.

Also because of the fact that most ETF trades are between shareholders (rather than between one shareholder and the fund) redemptions do not force the fund to sell shares, potentially impacting the other investors in the fund.

Update: This article was included in the Carnival of Financial Planning.

Posted on 27th June 2007
Under: Asset Allocation, Investing in Stocks, Portfolio Management | No Comments »

Not All Indexed Portfolios Are Equal

Elton, Gruber and Busse compared the returns and expenses of various portfolios indexed to the S&P 500. They found the difference between the best-performing and worst performing S&P 500 fund was 2.09% annually from 1996 through 2001. The differences in return were the result of both the fee structure and other factors such as securities lending practices.

This difference is important, as investors in an indexed portfolio expect to receive approximately the return on the index each year. To the extent that there are substantial variances among indexed portfolios the purported tracking risk reduction relative to actively managed portfolios is lost.

Posted on 26th June 2007
Under: Asset Allocation, Investing in Stocks, Investment Returns, Portfolio Management, Security Selection | 1 Comment »

Passive Investment Vehicles

In order to replicate an index, there are several generic approaches:

  • Investing in an indexed portfolio
  • Futures contracts on the index
  • Swap positions on the index

The first category includes indexed mutual funds, exchange-traded funds and other accounts that attempt to mimic the underlying holdings in the index. The second two are most commonly used in conjunction with a cash portfolio.

Posted on 25th June 2007
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Dow Jones Industrial Average

The Dow Jones Industrial Average is a price-weighted index of 30 blue-chip companies traded in the United States. It is the oldest and most widely followed U.S. equity index. The stocks are chosen for inclusion by a panel of Wall Street Journal editors.

Posted on 24th June 2007
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Index Weighting Methods

There are several different methods for weighting the shares of each security in an index. The method chosen will result in certain biases and benefits. The three basic methods are price weighted, value weighted and equal weighted. Recently there has also been a surge in fundamentally weighted indices.

Price weighted indices are developed by adding the share price of each security and dividing the total by the number of securities in the index. The primary advantage of this method is that it is easy to calculate. It is also relatively easy to obtain historical pricing information, which allows back testing of the index. This method is equivalent to buying the same number of shares of each company in the index. For investors who follow such a strategy this method will provide a reasonable benchmark. Furthermore, since it is based on a constant number of shares it is not necessary to re-weight the index due to daily price fluctuations. Disadvantages of this weighting scheme include the fact that companies with high share prices receive higher weightings in the index for no fundamental reason. The performance of such stocks may not be representative of the performance of the overall group. Furthermore, corporate actions such as stock splits and dividends require re-weighting the index even though they do not alter the value of the securities.

Value weighted indices are based on the market capitalization of each company included in the index. In cases where certain shares (possibly resulting from family ownership) are not regularly traded the weighting may be based on the float, or traded shares. Value weighted indices returns track the return of all the publicly traded shares in the index. Advantages of this method are that it automatically adjusts for corporate actions and share price changes. It also reflects the economic changes in the overall stock market more accurately. One disadvantage is that many investors do not weight their holdings in such a manner. Furthermore, to the extent that there are inefficiencies in pricing this method assigns a higher weight to overvalued stocks and a lower weight to undervalued stocks.

Equal weighted indices invest the same dollar amount in each stock. The method is easy to initially construct and is probably more similar to the way many investors actually weight their holdings. However, daily price fluctuations can alter the weight of each security, necessitating frequent rebalancing (and associated transaction costs.) This method also assigns a higher relative weight to small companies than to larger ones.

Fundamentally weighted indices weight the securities according to fundamental factors such as sales, earnings or book value. The portfolio would only need to be rebalanced when such fundamental factors are reported (generally no more frequently than quarterly.) Such indices overweight shares of companies with high fundamental characteristics regardless of whether those characteristics translate into value. Another disadvantage is that few investors employ such a strategy, making its value as a benchmark questionable.

Posted on 23rd June 2007
Under: Asset Allocation, Investing in Stocks, Investment Returns, Portfolio Management, Security Selection | 1 Comment »

Passive Equity Investing

Passive equity investing refers to strategies that attempt to mimic the return on the market rather than selecting securities that will perform better than the average. Perhaps the best case for passive management was outlined by William F. Sharpe, who said that:

  • Before costs, the average active investor must earn the same return as the passive investment (which by definition consists of the weighted average of all active investments.
  • Since an active strategy incurs more transaction costs, the average after-cost return on active investments will be lower than the passive return.

Subsequent research has indeed shown that the average active management return is equal to the difference between the passive return and the active manager’s expenses. The differences can be magnified for taxable accounts since active strategies tend to generate more short-term (and less tax-efficient) gains.

Passive investing is particularly useful for those who do not believe they have sufficient advantage to select superior securities or managers. This may be due to the time or effort needed, lack of skill, or lack of experience in particular areas. For example, even a highly skilled stock selector may choose to passively invest for international or bond exposure.

Posted on 22nd June 2007
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The Information Ratio

The information ratio represents how efficiently a portfolio generates active return relative to the amount of risk taken. It is calculated as the portfolio’s mean active return, divided by tracking risk (the annualized standard deviation of active returns.) The active return is the return in excess of an appropriate benchmark.

Posted on 21st June 2007
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Types of Risk in Equity Portfolio Management

Depending on the portfolio management approach, equity portfolios face two general types of risk (each of which can have several subcategories): active risk and tracking risk.

Active risk relates to the performance of the selected securities relative to the benchmark portfolio. Portfolio stocks performing worse than the average stock in the index would be a form of active risk.

Tracking risk results when the benchmark portfolio has substantially different return patterns. The chosen benchmark should generally perform similarly to the managed portfolio. If a portfolio is consistently up when the benchmark is down it may be because the chosen benchmark does not represent the management style. The portfolio would be said to have a large tracking error relative to the benchmark, and therefore may mean that the manager is not investing in the types of securities he or she was hired to manage.

Posted on 20th June 2007
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Approaches to Equity Investment

There are three basic categories of equity portfolios: passive, active and semiactive.

A passively managed portfolio seeks to match the returns of a specified benchmark as closely as possible. For example, an S&P 500 index fund attempts to mimic the return on that index. The actual implementation of the strategy requires actively buying and selling stocks as the index constituents change, pay dividends and issue or repurchase shares. However, the manager does not try to earn returns above those of the index itself.

An actively managed portfolio seeks to earn returns better than those of the specified benchmark by applying skill, typically in the form of either security selection (choosing stocks that will earn higher returns) or market timing (investing more aggressively at times the market is expected to perform better). The risk to active management is two-fold. First, since the average opinion of active managers is by definition the market index, the average manager cannot beat the index. Second, since active management generally involves more trading it results in higher transaction costs. Therefore, the average active manager is expected to earn the index return, less the additional transaction costs. A superior manager must earn sufficiently higher returns to justify the higher transaction costs.

A semiactive approach seeks to mitigate the risks associated with active management by controlling certain factors such as industry weighting or market cap. For example, an industry-neutral fund may require the weight of each industry to be equal to that industry’s weight in the benchmark while allowing the manager to choose those stocks within the industry expected to offer the highest return.

Posted on 19th June 2007
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Why Invest in Equities

Equities (stocks) have greater risk than bonds because they represent the residual interest in a company after all other claims are paid. If a company goes bankrupt, short-term creditors such as employees and suppliers are first to be paid, followed by banks and other lenders, and only after those claims are settled are equity investors (owners) compensated. Given that there is greater risk, investors need an incentive to invest in equities.

This incentive comes in the form of higher returns. According to a study done by Dimson, Marsh and Staunton equity returns were higher than bond returns in each of the 17 countries studied over the 106-year period of the study.

A second reason to invest in equities is that they provide diversification. Even owning international equities provides a diversification benefit relative to a domestic-only equity portfolio. The benefits of diversification include higher average returns with lower average volatility (because some of the asset classes perform well when others are performing poorly, which smooths out the returns). When combined with other asset classes such as bonds, real estate or commodities the diversification benefits can be even greater.

Finally, equities are considered to offer protection against inflation. Although higher inflation often causes stock values to decline in the short term, over long time horizons equity returns have a positive relationship with inflation (equity returns are higher when inflation is higher). This is due partly to the fact that companies can increase prices in inflationary times, which in turn has the effect of increasing earnings. Bonds, by contrast, entail a fixed (nominal) contractual payment. The value of that fixed payment is eroded during inflationary times.

Posted on 18th June 2007
Under: Investing in Stocks, Investment Returns, Security Selection | No Comments »