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When ETFs are mousetraps

Aug. 12, 2013, 7:39 a.m. EDT

When ETFs are mousetraps

Commentary: How to avoid falling for the bait

By Chuck Jaffe, MarketWatch

In some respects, mutual fund companies are in the mousetrap business.

The question for investors is whether they are the rodent, getting snapped up by the contraptions that financial inventors are creating. That dichotomy was on full display Thursday when Charles Schwab (NYSE:SCHW)  Investment Management put out the cheese for its latest investment products, six new Schwab Fundamental Index ETFs that begin trading next week. There is no denying that the new products are cool and appealing, with the potential to prove themselves as “better.” It makes perfect sense that financial planners and money managers—Schwab officials said they had gotten a lot of requests from advisers for these new products—would be interested; it isn’t so clear, however, that the average fund/ETF investor should give a mouse’s whisker over the new products.To see why, let’s delve into the new products and the world of indexing.

Index funds are, in general, a way for investors to capture the return of a stock market—or a piece of a market—over time and at low cost. If you believe the market’s long-term direction is up—and don’t think active managers can outperform it—buy an index fund, strap yourself onto the stock-market roller coaster and hope to capture that long-term gain.

Exchange-traded funds are, effectively, mutual funds built to trade like stocks, typically built around an index. Because ETFs give investors more precise control over trading, and often have lower costs, many advisers and ordinary investors have hoped to see every flavor of index fund presented in an ETF version.

That is what Schwab is doing, expanding its lineup of 15 ETFs, all price-point leaders in their asset categories.

The big deal about the new ETFs is that they are based on “fundamental indexes.”

Traditional indexes—the Standard & Poor’s 500, for example—are “cap weighted,” meaning that the larger a stock’s total market value, the bigger a chunk it represents in the index. That is why, historically, the top 50 stocks in the S&P 500 make up 50% of the assets of the index.

Cap-weighting favors big-name growth stocks; the bigger something gets, the more influence it has on the index. Critics say that can make a benchmark more subject to runs, bubbles, and fads.

By comparison, “equal weighting”—a concept that is gaining in popularity—gives each index component the same weight in the fund. Thus, in something like the Guggenheim S&P 500 Equal Weight ETF(NAR:RSP)  , each security represents 0.2% of the portfolio; the 10 biggest companies, therefore, account for 2% of the total portfolio, giving smaller companies much more impact in how the index moves.

Fundamental indexes, by comparison, screen and weight the companies based on factors like adjusted sales, cash flow, as well asd dividend and buybacks. The most widely adopted fundamental index methodology was developed by Rob Arnott and Research Affiliates; that is precisely who Schwab is working with on the new ETFs, all based on indexes developed by Russell Investments.

Fundamental indexing—by removing any link to the stock’s price—typically favors value stocks. Just as studies have shown that value investing holds a slight edge over growth investing over the long haul, fundamental investing has shown an ability to outperform its traditional cap-weighted peers, although that history is not long once you throw out back-testing (results “proven” by looking backward and seeing how the strategy might have performed had it existed years ago).

Investors simply want to know which kind of indexing is best over time.

Sadly, there is no easy answer. At times, each type of indexing can do better than the other; right now, with the stock market on a long run to record highs, it’s hard to argue with traditional indexes.

The folks at Schwab made it clear Thursday that they believe investors should use both index structures, supplemented by active management. The reason to mix and match—aside from Schwab not wanting to upset people it does business with—itis that the various index styles perform differently across market cycles.

“The world is not black and white when it comes to indexing,” said Marie Chandoha, president of Charles Schwab Investment Management. “We believe the systematic approach inherent in fundamentally weighted methodologies, when used alongside cap-weighted strategies, enables investors to diversify and balance their exposure.”

For financial advisers and money managers, that sounds like a selling point for their services.

For average investors, it sounds like a way to short-circuit the thought process behind indexing.

After all, if you buy a fundamental index fund or an equal-weight issue because you think it will be better than a fund based on a traditional index, you’ve stopped trying to “capture the market’s return” in favor of trying to get something better.

From there, actively managing the portfolio—chasing performance—is a short step away, and the logic behind indexing is out the window.

“Say that you believe fundamental indexing is better and that, indeed, over the long haul it outperforms a traditional index by [3% or 5%],” said Jeff Weniger, senior investment analyst for BMO Global Asset Management. “The problem is that in any given year—on its way to that better long-term performance—it may underperform by [10%], and what are you thinking then?…You’re thinking you made a mistake and maybe you should get out, and buy the type of index that looked better that year.”

Ultimately, the average investor should be using index funds to “maintain discipline,”—staying in the market long-term, with a portfolio that regularly rebalances to accurately cover an asset class—rather than “optimize returns.”

If the mousetrap you’ve been using has been working, a new trap isn’t so much “better” as it is “different.”

Said Samuel Lee, editor of the Morningstar ETF Investor: “They’re all good approaches with their own selling points but, for the average guy, it really doesn’t matter much. You want to capture market returns over time…No one should change indexes just because some new product is available.”

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About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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