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| | Mutual Funds
Build a portfolio that repels fraud
Exchange-traded funds let you buy a slice of an index fund and trade it like a stock. They're simple, cheap and largely immune to the current mutual-fund sleaziness.
By Timothy Middleton
Dinosaurs died out 65 million years ago because some radical event, like a comet slamming into the Earth, changed the environment and allowed creatures smaller than a mouse to conquer a world formerly ruled by giants.
Evolution is endless, and now huge mutual funds are caught in a maelstrom of scandal over illegal and unethical trading in their shares. Patiently waiting to take their place is a mouse-sized rival called the exchange-traded fund. It has a strong dose of natural immunity to the greed virus felling its competitors.
ETFs are going to grow; the scandal is going to make them more and more attractive, says David Fry, publisher of ETF Digest, an online investment newsletter. Their expenses are so low that theres little money lying around to attract unscrupulous operators, he notes, and they're too small and illiquid for hedge funds to manipulate.
In addition to these two fraud-defeating attributes, ETFs have three more. To be sure, this immunity may not be perfect. Crooks always find new ways to steal. But ETFs have powerful protections against the scandals already uncovered.
The latest of these exploded Thursday, when Gary Pilgrim and Harold Baxter of the PBHG fund complex stepped down after the company they founded accused Pilgrim of trading PBHG funds improperly, and Baxter of condoning it.
A primer on ETFs
It's possible to build a core investment portfolio strictly from a small number of ETFs, and Ill recommend one. But since the first principle of investing is to know where you're putting your money, a little background is in order.
Exchange-traded funds are hybrid portfolios that invest like index funds but trade like stocks, meaning their prices change throughout the day. Mutual funds are priced just at the end of the trading day, which has enabled some of the improper trading to take place. ETFs also are cousins of closed-end funds, which also trade on exchanges, but with a key design difference that largely inoculates ETFs against scandal.
Stocks are heir to supply and demand, and so are closed-ends. But unlike closed-end funds, ETFs trade closer to the true value of their underlying securities. For instance, China stocks are so red-hot now that closed-end China Fund (CHN) trades at a premium of nearly 36% to the value of the securities it owns. iShares MSCI Hong Kong (EWH, news, msgs), an ETF, has a premium of only 1%.
ETFs are immune to artificial scarcity or abundance because they can be freely created and destroyed, through a mechanism called the creation unit, which is 50,000 or more shares of actual stocks or bonds in the same proportion as their weighting in the index that the fund tracks.
Institutions trade ETFs in creation units. You and I buy fund shares sliced out of them, which are typically priced in the range of $50 to $120.
Scandal defense
But now, the key attribute of ETFs is that they're much less likely to be manipulated than mutual funds. Here's why.
- Low expenses: ETFs tend to have expense ratios on the order of one-quarter of a percentage point, one-eighth the mutual fund average. One of the most popular, Standard and Poor's 500 Depositary Receipts (SPY, news, msgs), commonly called Spiders, have expenses of 12 basis points, or 0.12%. Vanguard 500 Index (VFINX), one of the lowest-cost mutual funds, has expenses of 18 basis points.
ETFs are a pure commodity; brokerage firms and fund complexes cant wring out a premium price, because someone else will do it cheaper. Also, theres no money to pay brokers to sell them, aside from pure stock commissions, which in the Internet age can go as low as a fraction of a cent per share.
- Limited liquidity: One ETF, the Nasdaq 100 Index Tracking Stock (QQQ, news, msgs), has become the nations most-liquid security, with 75 million shares trading hands on the usual day. But most trade little. On Thursday, for example, iShares MSCI EAFE (EFA, news, msgs), the most broadly based foreign-stock benchmark, traded just 520,600 shares. At their then-price of $127, thats a dollar volume of about $66.1 million.
Arbitrage hedge funds rely on scalping millions of pennies, not handfuls of dollars -- its a volume business. To make any meaningful money in iShares MSCI EAFE Index, their demand would force iShares MSCI EAFE Index issuers to manufacture more creation units, at an administrative cost in the case of EFA of $22,000 each, according to ETFConnect. The hedge fund would have to pay that fee.
Also, buying up 50,000 shares of the underlying stocks to manufacture an iShares MSCI EAFE Index creation unit could drive up the prices of those shares. Would-be manipulators would be manipulating themselves.
- Transparency: Mutual fund managers are notoriously tight-lipped about what they own. With ETFs, the portfolios are linked to indexes whose makeup is public knowledge. Some mutual funds have been dragged into the current scandals by leaking portfolio information so hedge funds could arbitrage their holdings. With ETFs, this is impossible.
- All-day trading: Mutual funds are priced only once a day, at 4 p.m. Eastern. Those prices, especially for funds whose underlying shares trade in other time zones, as in Asia, can be stale. ETFs, however, are priced dynamically because they trade throughout the day. Their market value accurately reflects at-the-moment pricing globally.
- Moron-proof: One of the saddest dimensions to the fund scandal is that companies like Janus and Putnam served up malfeasance as a side order to a blue-plate of lousy performance. Indeed, the poor performance almost certainly contributed to the scandal, by dragging down asset-based fees at fund companies and performance-based bonuses of fund managers. Some people will steal rather than take a pay cut.
That funds can do so poorly is no mystery: The number of mutual funds has roughly trebled in the last decade, and the pool of talent capable of running them has barely budged.
A do-it-yourself core portfolio
Index funds are idiot-proof. Assuming hes a math and computer whiz, your brother-in-law could spend half an hour in the morning and another half hour in the afternoon at a keyboard running an index fund.
You could construct an outstanding core investment portfolio using a maximum of five ETFs, and your annual fees would be less than 0.19% of your assets -- a figure no similar mix of mutual funds could match.
The five funds are Spiders, Nasdaq 100 tracking stock, iShares Russell 2000 (IWM, news, msgs), iShares MSCI EAFE Index and iShares Lehman Aggregate Bond Fund (AGG, news, msgs). If I were mixing them up for someone with a moderate appetite for risk, I would do it like this:
| Do-it-yourself ETF portfolio | | Fund | Portfolio allocation (%) | Expense ratio (%) | | S&P 500 Depositary Receipts (SPY, news, msgs) | 35 | 0.12 | | Nasdaq 100 tracking stock (QQQ, news, msgs) | 15 | 0.18 | | iShares Russell 2000 (IWM, news, msgs) | 15 | 0.20 | | iShares MSCI EAFE (EFA, news, msgs) | 10 | 0.35 | | iShares Lehman Bond Fund (AGG, news, msgs) | 25 | 0.20 |
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This could be the entire portfolio for a somewhat aggressive investor -- owing to the significant overweighting of Nasdaq and small stocks -- but I regard the core as the 40% of my assets that I virtually never trade.
The other 60% I would trade much more actively, and next week Ill outline a strategy for using ETFs to round out the flexible portion of your portfolio.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: PBHG Clipper Focus. This fund is distributed by PBHG but managed by Pacific Financial Research, sponsors of Clipper Fund. It does not appear to be implicated in the scandal, but Middleton is considering selling it and buying Clipper Fund.
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