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indexes is an unfortunate decision, usually made by the fund issuer. Fortunately, it is easy for an investor to avoid funds that are based on noncompliant indexes and that, consequently, conceal the quality of their portfolio management process. If you already own shares in a non-RIC-compliant index fund and prefer not to change, suggest to the fund’s manager that they consider changing to a RIC-compliant version of the index. Optimized Portfolios Designed To Reduce Trading Costs Many ETFs based on a large number of stocks such as U.S. total market funds and multicountry funds often have portfolios that are optimized or sampled to reduce custodial costs and the administrative costs involved in handling a creation or redemption basket that might otherwise include as many as several thousand securities. While there is no universal pattern for optimized portfolios, they often underweight the smaller-capitalization stocks in the index. If small-caps are underweighted, the fund will outperform the benchmark when the small-cap components under-perform the balance of the index. When small-cap stocks outperform the large-cap stocks in the benchmark, the optimized fund will under-perform the benchmark. Some issuers of funds with a large number of issues in their benchmark resort to completion baskets or completion swaps covering the small-cap portion of the portfolio to improve tracking while simplifying fund management and reducing the cost of creation and redemption. Small And Illiquid Index Components A number of backtested “concept” indexes have been designed solely to serve as ETF templates. The resulting ETFs are often sold based on a combination of good backtested performance and an investment concept that suggests rapid future growth. The indexes—and the ETF portfolios—often include some small and illiquid issues. If the backtested fund succeeds in attracting substantial assets, the portfolio manager may—for reasons that include (1) the risk or difficulty of trading large positions in illiquid stocks, and (2) position reporting requirements—decide not to increase the fund’s position in a small company beyond 5 or 10 percent of the company’s outstanding shares as the assets of the ETF grow. If the portfolio manager does not hold shares in these positions at the index weighting, the performance of the fund will diverge from the performance of the index. The Lazy Portfolio Manager Lazy portfolio managers are probably the greatest single reason for index fund tracking errors that are consistently more favorable (positive) when the market is weak, and unfavorable (negative) when the market is strong. One of the important differences between investment company ETFs and mutual funds is that the ETF portfolio manager does not need to hold cash balances to meet cash redemptions. The ETF portfolio manager who wants to manage cash aggressively can be invested down to the fund’s last few dollars each day without any unusual cash flow management problems. In fact, however, many ETF portfolio managers do not invest their cash aggressively. Many funds show a pattern of returns that suggests the manager consistently holds excess cash. During years when the market rises, these funds lag the performance of their benchmark index because interest on cash balances is not keeping up with the return on positions in the index. The same index funds will look too good to be true in a year like 2008 when their cash balances earned modest positive returns while portfolio positions performed poorly. In retrospect, a cash balance would not have been a bad idea in 2008, but the long-term question is what the portfolio manager in an index ETF should be doing. Clearly, an important part of the mandate for an index fund manager is to deliver a return representative of the index. If the portfolio manager’s mandate is asset allocation or market timing (in the sense of reducing or increasing equity exposure to anticipate the direction of the market), then a cash balance is certainly appropriate—at times. In most index ETFs, however, holding cash balances all the time is not part of the portfolio manager’s job description. Figure 1 shows some suspiciously “lazy” returns in two strong market years and two weak market years. Figure 1 shows tracking error calculations for a group of 29 U.S. ETFs that have been in existence since at least the beginning of 2002. These funds all have domestic U.S. stock portfolios. While the S&P 500 annual performance indicated at the top of the column for each year studied may not be representative of the portfolio in each fund, it is a fair surmise that 2002 and 2008 were down years for all of these funds, and 2003 and 2006 were up years. As the column totals and the average tracking error for each fund in these years indicates, the tracking errors were smaller in the down years. In 2008, the average ETF even had a small positive tracking error. In the up years of 2003 and 2006, every one of the ETFs had a negative tracking error, and the size of the negative tracking error was usually greater than the size of the negative tracking errors in the comparable funds for 2002 and 2008. The only reasonable interpretation of these results is that, on balance, these funds carried significant cash balances in all four years. Leveraged Long And Leveraged Inverse Funds These funds track their leveraged benchmarks pretty well on a day-to-day basis, as they are designed to do. Tracking is not close when the funds’ performances are measured against a simple leveraged multiple of the target benchmark for periods longer than one day. This issue is explored in depth elsewhere, including in Joanne Hill and George Foster’s article in the September/October 2009 issue of the Journal of Indexes. Apart from showing how intensively an index fund manager is keeping your money at work, tracking error can be a useful framework for measuring how an active portfolio manager is doing. Breaking the total tracking error measure of the return difference between an index and a fund into positive and negative elements can be a useful way to evaluate what is going on in an actively managed fund and how well or poorly the fund’s investment process works. In that spirit, I turn next to analysis of differences in performance between 50 January/February 2010
INSIDE ETFs EUROPE CONFERENCE Lead Sponsor Designed Specifically for Institutional Investors and Consultants 12 - 13 April 2010 Mövenpick Hotel Amsterdam City Centre, The Netherlands The World’s Largest ETF Event Heads To Amsterdam The world’s largest and most informative ETF conference - Inside ETFs - moves to Amsterdam in April 2010 to stage its first European event. Targeted at an audience of institutional investors and consultants, the conference will address the major issues of interest to ETF users, including portfolio construction, how to compare ETFs, and the key areas of trading, liquidity, tracking and fund structure. Our agenda will be available shortly. Complimentary Attendance for Institutional Investors Please contact Ashli Smith at +44.20.3318.3006 or by email at asmith@indexuniverse.com Presented by IndexUniverse.eu To register visit www.InsideETFsEurope.com or call +44.20.3318.3006
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Page 3 and 4: Contributors Rob Arnott Rob Arnott
Page 5 and 6: FREE subscRiption oFFER! The Journa
Page 7 and 8: David Smith Publisher dsmith@fa-mag
Page 9 and 10: Editor’s Note Was 2008 A Last Gas
Page 11 and 12: Record-High Correlations Pose Chall
Page 13 and 14: Figure 4 Correlations Of Weekly Ret
Page 15 and 16: Diversification And Risk Management
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Page 43 and 44: Actively Passive? When a little act
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Page 49 and 50: Apparent Value Added By Fund Manage
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