by Lars Kroijer
Index-tracking investments consist of approximately only 15% of stock-market investing so there is a lot of room to grow. This continued growth will benefit investors at the expense of the financial industry as the aggregate fees will decrease.2
I hope a future development in the world of index tracking will be a focus on lowering the costs of this essentially commodity product. There is today far too great a disparity between the charges imposed by index-tracking providers (like index funds, ETFs, etc.) and some are simply too expensive. Vanguard is at the forefront of an extreme focus on costs and that firm’s massive size suggests investors are receptive to the improvements. Competitors including iShares have responded to the challenge and lowered fees, leading to an encouraging industry trend. A rational portfolio should be driving a Volvo, not a Porsche. Taking cost reductions further, investors could be offered the chance of investing in a white-label index3 instead of a more well-established index like S&P or MSCI, and thus save the licence fees. In one of those moves that cause great ripples in the world of index investing, but hardly noticed elsewhere, Vanguard recently changed some of their products to track a FTSE index instead of an MSCI one to save money on licence fees. This kind of cost focus among the product providers ultimately benefits customers.
1 In my view there are many cases where it is in the employees’ but not the company’s interest to have these kinds of trading operations. The employee may get a bonus or share of the profit if there are gains, but will not share in the losses.
2 There is clearly an upper limit on indexing. If there was only index investing there would not be an efficient market with prices reflecting the future prospect of individual securities. However, I think index tracking could more than triple and still be very far from this point.
3 A white-label product is one that is produced by one company, which is then rebranded by others.
chapter 14
* * *
Products and implementation
To implement the rational portfolio:
We need to find the best products that give us exposure to geographically broadly diversified equity markets, minimal risk government bonds and other government and corporate bonds.
We want to do this in a way that is tax optimal.
We need to combine the securities in a way that reflects our risk preference.
The past decades have seen an explosion in the number of products available to the index-seeking investor, and this development continues unabated. As new products come to market there is a risk that the information outlined here grows stale quickly and I would strongly encourage the reader to survey the market for new and better products before making investments. With the large growth of index funds and exchange traded funds (ETF) investing over the past decades, the abundance of different product offerings leave even professional investors confused; it’s no wonder that many investors say ‘forget it’ and revert to doing what they have always done.
The two main ways to gain index-type exposure is through ETFs and index funds (this term covers a few different structures). The main difference between the two is that an ETF is traded like any stock while index funds are more akin to mutual funds or unit trusts in their structures.
If you can find a product provided by Vanguard, iShares, State Street or one of their major competitors that meets your needs from an exposure and tax perspective, this is probably a very good way to gain your exposure. These are clearly among the cheapest and largest providers of index exposure in the world; sort of the Ikea/Ryanair/Walmart of finance – no frills, but you are very likely to get the best price in town. Until recently Vanguard’s presence outside the US was limited, but that is rapidly changing. iShares recently lowered the prices of a number of its products as it was losing market share to Vanguard because of higher prices. The iShares CEO quite tellingly said that its overall margins (i.e. your costs) would still be good as there were lots of ETFs other than the major flagship ones where there was lower pricing pressure. (In comparison Vanguard is a mutual so owned by the investors and thus perhaps less inclined to charge higher fees.) You should not buy these specialised and expensive products even if they are called ‘index XYZ’ and sold as an ETF. Investors who buy an ETF that tracks EU insurance companies, Canadian mining companies, etc. essentially claim an edge by their selective exposure to the market, just like those buying Microsoft shares do.
Index-tracking products outside the US have historically been more expensive than in the US, but thankfully that is changing and in the future I would expect to see close to cost parity. Investors will be left better off as a result.
Total expense ratio tells you the cost of owning the product
When comparing different suitable products look at the total expense ratio (TER). The TER tells you the annual cost of owning the products including fees, custody, administration, etc. Additional costs not included in the TER mainly consist of trading costs (bid/offer, commissions, market impact, etc.) although these are small for index-tracking products because of the portfolio’s low churn.
TER (per year) Comment
< 0.3% Very good and increasingly the norm in the large and liquid products.
0.3%–0.6% Still OK if the product you are after is not straightforward.
> 0.6% Be sure you need to pay this much. Don’t forget trading costs come on top!
So if iShares has a TER of 0.3% for a product when Vanguard has a very similar one for 0.2% then that difference should be the deciding factor (disregarding tax and liquidity differences).
Investors can save quite a bit of money by looking at different products and selecting the index-replicating product with the lowest cost. I recently went to speak at a conference on ETF and index investing. At the conference all the product providers had large stands with gadgets and toys to lure investors. That was all fine. But what was also clear to me is how much some of the people that work for these providers get paid. Much like some of their peers in the investment banking divisions of the big banks, someone who works at a big ETF provider is no stranger to generous pay packages. When you add a culture of being paid like a banker to the large marketing budgets, licence fees to the index provider, administration and corporate profit margin, it’s no wonder that many of the ETFs or index products are not as cheap as they could be. Like any other for-profit business you can’t blame the providers for trying to create the most profitable product portfolio they can, but you may find equally good products at a cheaper price. And it is certainly worth our while looking for them. So while you have got 90% of the way there by picking an index-tracking product like an ETF for your rational portfolio you could do even better by picking the best and cheapest of those products.
It used to be that investment books suggested that people refrained from investing abroad (abroad to the US in most cases) because the costs were deemed prohibitive. Thankfully this is no longer a real issue as the easy movement of capital and investing in various domestic markets has increased significantly over the past decades. There are clearly some countries where trading is expensive or transaction taxes are an issue, but far fewer than in the past. However, also keep in mind that if you buy the broad world equity markets, around 70% of your money will be invested in the US, Canada, Western Europe, Japan and Australia, which all have cheap access. So if you found yourself paying 0.25% TER for access to these countries and 0.5% for an all-world product you would effectively be paying 1% TER for access to the rest of the world, which is too expensive.
While the TER is an important component in selecting an index-tracking product it is not the whole story. Some ETFs that track less liquid benchmarks could incur significant trading costs and impair returns as a result, just like you incur costs to trade the ETF (commission, etc.). Likewise you may incur costs like exit and up-front fees (you should avoid these except if they are very small and only relate to the costs the fund incurs in trading your additional money in the fund), or costs from advice or platform charges.
The best ETFs: liquid, tax efficient and low cost
The main difference between an index fund and an ETF is that the ETF is a traded product. You buy and sell the ETF like you would any stock. In the case of ETFs tracking world equities, the ETF will try to replicate the performance of that index by buying the individual stocks represented in the index. As a holder of the ETF you should then end up with the performance of that index, subject to a few things that we will return to later.
Advantages to owning ETFs
These are as follows:
They are easily traded like any stock (you should avoid trading your portfolio, but it’s nice to have the option). Even during the most volatile and distressing days of 2008 and 2009 there was liquidity in the markets for the biggest ETFs and the bid/offer spreads did not widen materially.
They almost always trade very close to the value of the underlying holdings.
ETFs are relatively easy to create; there is a huge array of product offering and far in excess of that of index funds, even if many of them are irrelevant to the rational portfolio.
In the UK ETFs don’t pay stamp duty.
The right ETF is a very low-cost vehicle.
Fee-chasing advisers and banks sometimes neglect to push them to you (there aren’t enough fees for them to get a cut), suggesting that they are definitely worth looking at!
ETFs have grown massively in prominence over the past couple of decades. In the mid-1990s they were still a fairly limited asset class, but in the early part of the following decade they exploded in number and size. There are today almost $2 trillion invested in ETFs, mainly in equity-related products, but increasingly in fixed-income funds. The assets are spread among literally thousands of different ETFs and you can use them to buy exposures to anything from the various standard indices, to volatility indices, gold bars, oil, sectors and more. This array of offerings is a good thing for the wider investor. It used to be practically very difficult for most investors to buy direct exposure to something like gold or oil without buying a gold mining or oil company stock. Now they can. However, this does not mean that these products are suitable for you: stick to the simple rational portfolio.
iShares is the largest ETF provider, although as the sector has grown a large number of competitors have entered the space. Table 14.1 shows the leading providers (Vanguard was a late entrant to ETFs but has since made up for lost time with impressive growth rates).
Table 14.1 Number of products and market share by provider
Based on data from Blackrock Industry Review, Q1 2013.
You need to peruse the websites of the market leaders outlined above for products that suit your needs (tax, regulatory, domicile, liquidity, cost, etc.).
Below are examples of products I would consider suitable for the generic rational investor (assuming you have no restrictions, which is obviously unrealistic), although other providers also have competitive and good alternatives. The ETFs listed here are probably good options at the time of writing, but there are many more products available so look around. As you do your own research on which ETFs best suit your needs, here is a list of things to consider:
Does the ETF track the right index for your portfolio?
Is the TER very low (< 0.3% a year)?
Is the ETF and underlying index liquid? Are there many assets in the ETF and it is frequently traded (look at the bid/offer spread and how much is traded daily compared to other ETFs)?
Is the ETF tax efficient for you?
Is the ETF in the right currency and jurisdiction for you?
Does the ETF have a history of performing very differently from the index it is tracking (tracking error)? Why?
Can you execute the ETF easily and cheaply?
Just like new product launches occur frequently in the index space, the fees of the various products can change continuously. Particularly the bond ETFs leave a lot to be desired and this is an area where a cheap and broad active fund with the perfect profile may make sense (if it exists), but this is a growth area for the ETF sector so hopefully there will soon be suitable index-tracking products available.
Traditionally, there have not been as many world equity or bond (government or corporate) ETFs available, but this is a fast-growing area of the indexing space (the best known index – the MSCI World – was not even created until 1970, much less followed by an array of product alternatives). Index exposure was more tied to the national markets where the products were offered, such as the DAX in Germany or the S&P 500 in the US. (The world’s largest ETF tracks the S&P500 with around $100 billion in assets under management.)
Physical or synthetic ETF?
ETFs are roughly divided into two kinds: synthetic and physical. Simply put, physical ETFs are those where the owner of the ETF owns all or a majority sample of the underlying securities through the ETF. So if you have an ETF on the S&P 500 then you are actually the owner of your representative number of shares in each of those 500 stocks. When an index-tracking ETF does not own all the constituents of the index in exactly the same proportions as the index all the time, this introduces a tracking error. This tracking error is entirely normal and unless a provider consistently underperforms an index as a result of it (suggesting other issues) it’s not something you should expect to make or lose a lot of money from at least among the major ETFs.
Synthetic ETFs are a little different. Here the provider, such as Deutsche Bank (their brand is DB Trackers) will aim to replicate the performance of the index, but you as an investor do not own the underlying securities. This creates a credit exposure to the provider (here Deutsche Bank) in case it goes bust. The synthetic ETF providers argue that they are better able to replicate the performance of the index they seek to produce by using certain derivative products. Furthermore they argue that there is a great deal of collateral backing the ETF. So if you have $100 in a synthetic ETF there may be $120 of collateral of other securities backing that ETF. The providers also argue that this renders the risk of the synthetic ETF minimal and well worth taking to get more accurate tracking of an index, and perhaps slightly better returns from the financial manoeuvring the synthetic provider can undertake.
I was recently helping an African development institution select some ETFs for their investment portfolio. As I tried to explain the difference between physical and synthetic ETFs one of the directors cut me off.
‘So you are saying that in one of the cases we own what we think we own, and in the other we may own a bunch of other stuff if Deutsche Bank goes bust. Try to explain to my minister that we invested in a synthetic or in any way a derivative product with taxpayers’ money. He would eat me alive.’
So we went with physical ETFs.
I see why many people choose physical ETFs. The synthetic somehow doesn’t feel right to a lot of people, and explaining it in simple terms often doesn’t make them feel much better. Personally I have no problem with the synthetic products and accept the minor extra risk that come with them. That said, from my perspective the decision between physical and synthetic ETFs is less important than selecting the right ETF on the basis of tax considerations, liquidity or cost.
Index-tracking funds
The index funds work like a regular mutual fund or unit trust, even the terminology and exact fund structure vary slightly between jurisdictions (in the UK, for example, they are often called unit trusts or OEICs – open-ended investment companies). In the case of the index funds, the simplest way to think about these is that you give them £1,000 to invest and they then take that £1,000 and buy the underlying securities that make up the index exposure. If you want to redeem or sell your index investment that same index fund will then sell shares in proportion to your index investment and give you back the proceeds from those sales.
The index fund sector is more local. Unlike the ETFs that you can buy from any location in the world, like you would a stock, index-tracking funds are typically local financial institutions and the major player in the US is thus not the same as that
in Germany, the UK or elsewhere. What this means in reality is that in some countries the choice of index funds is still far more limited than it is in major financial centres, to the detriment of the local investor.
In the US, the index space is dominated by Vanguard, but Fidelity, Blackrock, PIMCO (for bonds) and American Funds all have assets in excess of $100 billion (not all index tracking), and Dimensional Fund Advisors and State Street are potentially also worth a look. In the UK the leading players are Legal & General, Blackrock, State Street, HSBC and increasingly Vanguard.
If you are outside these two jurisdictions search the internet and look at the offerings from four or five asset managers or banks in your country, using the ETF checklist above as a rough guide. Keep in mind that if you call these companies and ask if they have some cheap index-tracking funds they may try to sell you a more expensive alternative, like an active fund or a structured product. Please don’t give up so easily.
The problem as I see it with the index trackers is that there is not as broad a range of products. Even a strong leader in its sector, like Legal & General in the UK, does not have a broadly diversified world portfolio. It has an index fund of the top 100 blue-chip companies, but this is quite different from any kind of world equity index. Also, that product comes at an annual charge of 1% plus extra expenses of 0.15%. John Bogle, the founder of Vanguard, would be aghast at those kinds of fees. So if you wanted to gain access to a world equity portfolio through Legal & General you would be forced to put a portfolio of index funds together yourself, instead of having a one-stop product like a world equity product.
