ETFs: A Better Bet in a Bear Market

Amid the financial crisis, tax advantages are but one benefit of exchange-traded funds. Their transparency, liquidity, and lower fees also appeal to investors

By David Bogoslaw

Imagine having invested in the DWS Commodity Securities A Fund (SKNRX) in 2008. The mutual fund had an annual return of -45.9% and also distributed nearly two-thirds of its net asset value as capital gains, incurring a substantial tax bill for investors on top of the losses they suffered. Unfortunately, this wasn’t the only mutual fund to do so: More than three dozen funds with negative returns of at least 21% paid out over 30% of their net asset value as capital gains last year, according to Morningstar (MORN). Ouch and double ouch.

Making capital gains even higher than usual was the fact that most traditional mutual funds were forced to sell legacy holdings that had dramatically appreciated in value since being purchased in order to fund redemptions as nervous investors fled the market.

That may have prompted more people to switch to the mutual funds’ chief rival for the affections of diversification-minded retail investors, exchange-traded funds. Unlike mutual funds, ETFs incur zero capital gains until an investor actually sells his shares. While turnover in an ETF’s holdings can be high, it is done through in-kind exchanges of one security for another rather than through selling and buying.

But since the deepening of the financial crisis last September, the tax advantages of ETFs are just the icing on the cake.
Transparency, Liquidity, Lower Fees

The primary reason ETFs are more popular than ever is they give financial advisers the ability to better control their clients’ investment portfolios. First, there’s the transparency of knowing exactly what’s in an ETF on any given day, which matches advisers’ need for real-time management of investments in order to minimize wealth destruction. In this regard, ETFs have a clear advantage over mutual funds, which are required to disclose their holdings only four times a year. Of course, there are plenty of traditional index funds that are just as transparent as ETFs by virtue of the ability to see the contents of the underlying index on any chosen day, says Russ Kinnel, director of fund research at Morningstar.

ETFs’ inherent liquidity is also more valuable than ever in view of the continuing high volatility in stock and bond markets. Then there are the lower fees typically charged by ETF sponsors, which make a big difference in the current environment, where returns are mostly underwater.

The enormous volatility in equities last October and November prompted many financial advisers to increase their reliance on ETFs. “When returns are down and markets get treacherous, one of the few things you can control is what you’re paying from a fee perspective,” says Anthony Rochte, senior managing director at State Street Global Advisors (STT) in Boston.

The average annual expense for owning an ETF is about 0.25% of the portfolio’s value, while fees on mutual funds are often between 1% and 2%. Once you tack on sales fees, or loads, and trading fees, which mutual fund managers aren’t required to disclose, investors’ returns on mutual funds can be much lower than they expect. The reason ETF fees are lower is the funds are passively managed by tracking an index, while most mutual funds tend to be actively managed. Vanguard Group and Fidelity Investments have built reputations, however, on charging fees that rival, if not under price, those of most ETFs.

ETFs Outperform S&P 500

Total assets under management in U.S. ETFs fell $74 billion, or 12%, to about $534 billion at the end of 2008, compared with a -37% return for the Standard & Poor’s 500-stock index in 2008, according to a January 2009 report by Tom Anderson, head of strategy and research at State Street.

And while investors withdrew more than $170 billion from traditional U.S. mutual funds last year, they put $176 billion into ETFs, says Noel Archard, head of product research and development for iShares, a business unit of Barclays Global Investors (BCS). “Investors were voting with their feet, essentially,” he says.

Just as individual stocks took a beating in 2008, equity-based ETFs came under a lot of pressure, with international ETFs experiencing the biggest declines. Fixed-income, commodity-based, and inverse/leveraged ETFs had the largest increases in assets, according to Anderson’s report.

Targeted Asset Allocation

After the disappointing performance of most mutual funds last year, many investors are moving ETFs to the core of their asset allocation strategy from the fringes of their portfolios, says Archard at iShares. “Capturing that benchmark return in a cost-effective vehicle is going to do more to achieve your financial goals than going in another direction by putting [money] into a vehicle that’s less transparent,” he says.

Money Map Advisors, a financial advisory firm in Houston, switched to an all-ETF strategy for its clients in 2005 in order to more precisely target asset allocation and avoid distortions due to style drift within most mutual funds. Mark Ragusa, president of Money Map, found that as much as 14% of an international large-cap equity mutual fund was actually invested in emerging markets instead of the international developed markets it was supposed to be invested in.

Ragusa also likes the more precise allocation within commodities he can get through ETFs vs. mutual funds. There are single-commodity ETFs available and ETFs that combine different types of commodities. He prefers to own the PowerShares DB Commodity Index Tracking Fund (DBC), since the Deutsche Bank Liquid Commodity Index, which it tracks, has had average annual returns over the past 10 years of at least 10% more than the Dow Jones AIG Commodity Index and the Goldman Sachs Commodity Strategy, the main benchmark indexes that the typical commodity-based mutual fund would track.

Last fall as credit markets froze up, corporate bond prices plunged as very few investors wanted anything to do with individual corporate debt issues. But lots of investors poured money into fixed-income ETFs, seeing lower risk due to the diversification they offered and potential for a bounce in these funds. Since Nov. 20, the prior market low before the fresh one established on Feb. 23, the iShares iBoxx $ High Yield Corporate Bond (HYG) is up 10% and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) has rallied 6.3%.

“We increased our exposure to high-yield and investment-grade bonds because of liquidity-driven selling, and as liquidity has improved, that’s been very beneficial,” says Scott Kubie, chief investment strategist at CLS Investment Firm in Omaha. “You want to be able to get the trade done in an expeditious manner,” he says, which ETFs allow.

With inflation expected to be an issue in the future once economies around the world recover, there are also opportunities in international inflation-protected Treasury bonds, says Ragusa at Money Map.

Portability Can Minimize Tax Bite

Another advantage ETFs have over traditional mutual funds is that they’re very portable. That’s important at a time when investors are questioning their financial advisers’ performance and are more inclined to move their portfolios to a different firm, says Archard at iShares. The mutual fund complex of which you own shares may not be offered at your new firm, which means you would have to liquidate your holdings with tax consequences if that fund is held in a taxable portfolio, he says.

As for the tax benefits, ETFs also have an edge over mutual funds when it comes to taking tax losses during bear markets. Money Map Advisors harvested roughly 40% of the account value of its clients’ taxable accounts in 2008 without ever being uninvested, says Mike Bartlow, a principal at the firm. “We would simultaneously sell one index fund and buy a very similar index fund for 31 days and switch back to the first index fund after 31 days to avoid the wash sale rule,” he says. The total cost of staying invested during these periods: $14, using Scottrade, the price of two offsetting trades, says Ragusa.

It’s virtually impossible for a mutual fund manager to stay fully invested while harvesting tax losses, because it’s harder to temporarily replace an individual stock with a similar one than it is for a financial adviser using ETFs to substitute one broad index for another, says Bartlow.

For long-term investors, especially those in a high tax bracket, owning ETFs that have stored up tax losses will be a big plus down the road over owning mutual funds that don’t have tax losses to offset capital gains, he adds.

Some Risks

Still, there are potential pitfalls. One thing ETF investors need to be wary of this year is the likelihood of rising fees as more ETF sponsors close shop. While fixed-income and commodity-based funds are attracting lots of cash, it’s extremely hard these days for sponsors of equity ETFs to make any money on the assets under management in their funds, as investors are mostly trading rather than retaining them, says Daniel Freedman, managing director of SPA ETFs, based in New York and London. He expects to see as much as a 25% contraction in the number of ETFs available by the end of 2009, which will mean less competition.

A total of 57 ETFs shut down in 2008, according to Morningstar. Freedman expects to see more consolidation and delisting of funds this year.

Whether some of the smaller ETFs survive will come down to how willing fund sponsors are to support them in the marketplace, says Archard at iShares. Some firms underestimated the commitment they needed to make in order to bring ETFs to market properly, he says. Besides the need for ongoing investor education, sponsors have to continue to monitor how their products are trading in the secondary market and be ready to handle questions that arise about changing yields and other issues and they need to provide facilities to handle that, he says.

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