Why is ETF Management Fee/Expense Ratio Lower?

The 21st century has seen a phenomenal rise in the popularity of ETFs as an investment tool. From virtually nowhere, it has become a platform that can rival mutual funds/Unit Trust in terms of assets under management (AUM) and diversity of the asset classes it covers. One of the key feature (most will say its benefit) of ETFs is that ETFs, on the whole, usually sport a lower management fee compared to mutual funds given the same asset class and AUM. There are, I think, 4 main reasons why this is so, which I shall explain shortly.

Firstly, ETFs are Index Funds. While there might be some ETFs that are managed funds (are there?), most ETFs are index funds, i.e. the underlying portfolio/prices follow that of published stock indexes. Index funds are in general cheaper to manage as there are fewer trades to deal with. They are, in investment speak, passive in nature. This lowers their brokerage fees and trading slippage. Also, they do not need the service of an army of security analyst to dissect the individual stocks and try to beat the market. Index funds do not beat the market; they’re the market! Given the academia overwhelming evidences that markets are efficient and market timings and security selections are a fool’s errand, index funds in general and ETFs in particular have become the investment tools of choice with more converts flocking to its open arms by the moments.

Secondly, even after accounting for its index fund nature, ETFs are still cheaper in terms of management fees compared to its index mutual funds brethren. One reason could be because in the setup of ETFs, there is division of labour which makes it cheaper to operate compared to a mutual fund. For example, mutual fund companies are required to setup and operate a sales channel. It needs employees and office space to man the phone calls and take in orders. Even if it’s done through the internet via electronic means, mutual funds still need to hire IT staff and expansive computer software and hardware to operate. ETFs do not have such a drawback as it’s traded via brokers. So, you’ll have to consider brokerage fees (if there’s one) as a sale charges on your ETFs you trade. However, brokerages and stock exchanges (the platform on which ETFs are traded) are optimized for such a task and can do it efficiently given the volume they handles. ETF companies can further save money on the accounting and upkeep of customers’ records as it’s offloaded to the exchanges and stock brokers.

Thirdly, ETF management companies can act as authorized participants. Authorized participants are empowered to create or redeem ETF creation units. They serve a useful purpose of bringing the ETF prices in line with the underlying stocks prices that comprise the ETFs. They create ETF shares when ETF prices exceed the underlying stock prices and vice versus. Through this act of arbitrage they generate liquidity and a fairer market where the prices of ETFs are based on the underlying securities. Along, the way, they also generate a tiny arbitrage profit for themselves. Given the depth and breadth of the ETF market, I reckon that this arbitrage profit is fairly size-able if the inflow/outflow of funds to/from the ETFs are huge.

Fourthly, there exists a huge ETF derivative market in the synthetic ETF arena. Synthetic ETFs do not buy the underlying securities with its funds. Instead, synthetic ETFs are swaps that use the funding as collateral and the ETF sponsors promise you the performance of the indexes. I shall dealt with the actual risk of being synthetic in another post but suffice to say, this arrangement increases the flexibility of the fund management companies and allows them to offer the product at reduced management fees since they can earn profits elsewhere as a swap counter-party and sell financial equity-linked products.

Considering these factors, I expect the management fees of ETFs to continue at its current lower level. It’s even plausible that the expense ratios might fall to zero if the ETFs have a really large AUM and profits from businesses such as arbitrage are huge.

Diversification: the Japanese and Technology Stocks Case Study

From Wikipedia: In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents. Therefore, any risk-averse investor will diversify to at least some extent, with more risk-averse investors diversifying more completely than less risk-averse investors.

Basically, diversification is all about not putting all your eggs in one basket or else you risk breaking all your eggs at a go if you fall. However, one thing to note is that diversification does not increase your returns; it only reduces the deviation around your portfolio’s average returns. If you’re lucky (that is, a big IF), a narrow, concentrated portfolio could reap you a higher reward. This mentality is however, unwise – we seek certain rewards by taking calculated risk, not by gambling and seeking higher returns. If you want to gamble, you can always bring some money to the casino for some thrills. At the very least, if you lose all your money you brought along, you can call it quits and not risk your life savings.

There are many ways and degrees of diversification. Some books, for example, suggest that a dozen stocks are good enough. As we shall see from the Japanese and technology experience, even hundreds of stocks diversified over a continental force are often not good enough. Let us first review the Japanese experience.

In 1989, Japan was truly a Land of the Rising Sun. Its people are smart, hardworking and enterprising. From a war-torn era, they build a rich and prosperous continental force whose economy is second only to the United States in size. They designed and built cars and electronics products that thrashed their competitors’. Even patriotic Americans and ex-war rivals such as the Chinese bought better built made-in-Japan products in favor of their national products. In that epic year, the Nikkei 225 stock index hits an apex of 38,916 points. Japanese and overseas investors alike were hysterical. Having made some money from the stocks and buoy property market, they prophesy that the best is yet to be and Japan as a nation will rightly rule the world from a small corner in North-East Asia. However, the miracle was never to be and the economy plummeted. The stock market and land prices dived to unprecedented lows. Japanese investors who are fully invested lost their retirement funds. More than 2 decades later today, the Japanese stock market still has not recovered. At of 23 Jan 2012, the Nikkei 225 stands at 8765. If you were to invest at the Japanese peak, you would have lost a whopping 77%.

The other example I would like to quote is the infamous dot-com boom-and-bust. The dot-com boom era starts in the mid-90s. Internet companies such as Yahoo! and Amazon come into being and revolutionize the way we work and play. While Yahoo! and Amazon survived the era, there’re many other Internet companies with dubious business model which didn’t. They bankrupted when the funding went dry and brought the stocks investors down with them. An example is pet.com which sells pet supplies. The stock index that most closely tracks the technology sector is the US Nasdaq composite index. From a high of 5048 attained in 10 Mar 2000, it dropped precipitately to 1114 in 9 Oct 2002. Right now, more than a decade later, it still stood at a low of 2784 as at 23 Jan 2012.

Much has been talked about the 2 different eras. Some foresee the imminent crashes coming during their time. Tell-tale signs of the 2 bubbles are fundamental valuations such as the PE and price-to-book ratios. While valuations during most periods range from 10 to 20 for the PE ratios, many companies during those periods were out of whack in this regard. Some companies were valued at hundreds of times of their earnings. For the case of dot-com companies, the situation is even worse; most dot-com companies were burning cash and did not have a profit margin to speak of.

It’s now easy to view the bubble using the historical rear-view mirror. However, while we are in the midst of a major current bubble of our time, we tend to forget the norms and get too engrossed in the “next-big-thing”. Some of the more enlightened ones will see the light at the end of the tunnel but most will lose sight of the future and our gambler animal instinct will take over. We’ll ignore financial history and purge into the would-be bubbles head-first.

How should we avoid bubbles then? IMHO, the best way to circumvent the mania is to have a stable asset-allocation strategy that you can hold tight through thick and thin, whether the markets wane or bane is irrelevant. We first decide on the percentage we would like to allocate to stocks and bonds/cash. While the bonds and cash portion of our portfolio will have lower returns than stocks, they do a great service stabilizing the entire portfolio. By maintaining a fixed stocks/bonds ratio, we will convert bonds into stocks during years when stocks is doing poorly and exchange stocks to bonds when stocks have a bull run. This naturally results in a buy-low-sell-high cycle for stocks (buy low when stocks drop and sell high when stocks boom). Using the Japanese and technology bubble as an analogy, a discipline investor with a balanced portfolio of stocks and bonds would have offload at least part of the inflated stocks as the bubble become manic. As the stocks plunged into oblivion, the patient investor could now pick some of the equities at a deep discount and wait for the stock market to recover. Given the lower price levels the Japanese and technology stocks prices are right now, their future returns should be higher than when they are at their all-time highs.

After deciding on the asset allocation strategy, we next decide on the stocks allocation. Most of us have a home bias. For example, an American will invest most of his/her stocks in American companies while a Singaporean will do likewise in a Singapore companies. However, as we have seen, this is full of problems. What happens if you were to invest your retirement savings in Japanese stocks in 1989? Of course, you’ll not be able to retire! The best strategy IMHO is to diversify as widely as possible – that is, to be globally diversified. The funds we invest in should best encompass all the major companies in the world so that when one economy or sector zigs, others might zag. There are a number of ETFs and Unit Trusts (mutual funds) in Singapore and US that index the world stock markets. Such funds are frequently large and have low expense ratio. Be sure to check the prospectus that they are index funds so that there will not be tracking errors from the world economy and the fund managers will not have leeway to speculate with your money.

Investments are all inherently risky. But, if we diversify prudently and wisely, we should be able to lower non-systematic risks while enjoying the fruits of calculated risks.

Meet the Bogleheads

http://bogleheads.org

Quote: “The Bogleheads forum is dedicated to the civil discussion of investing, personal finance, and consumer issues.”

There’re many investing forums on the net, but this is perhaps the best investment site.

The investment strategy of this finance forum espouses the investment philosophy of Jack Bogle (hence the domain name), i.e. simplified, low-cost, passive and widely-diversified investing. The philosophy is derived from academic studies and papers published from major universities from around the world. It’s also the best practice adopted by major financial institutions such as endowment and pension funds. The investment vehicles of choice for Bogleheads are ETFs and mutual funds in bonds and equities. Their favorite investment company is Vanguard, which is a low-cost, index-oriented investment provider which is previously helmed by Jack Bogle. While Singaporeans can’t buy USA’s mutual funds, we’re able to invest in Vanguard’s ETFs (or any other USA ETFs) via a brokerage such as E*Trade (which has a Singapore local office) or Vanguard in USA (which provides select free trades).

Among all the topics, one of the most talked about topic on this forum is saving and investing for retirement. Other possible reasons for saving and investing are education for our children, paying off for a house or general wealth enhancements. You can create an account for free and join in the discussion or if you’ve any questions, you can ask the folks. The advice of Bogleheads can be very sage, besides, more heads are better than one!

Bogleheads in general are nice, civil netizens. However, Bogleheads eschew high-frequency trading, market timing, securities selection, penny stock investing, alternative investments, and narrow-concentration investments. You can discuss such “forbidden” topics on the forum itself but if you insist that such investment techniques are good strategies, be prepared to be flamed or at least receive a heated argument from fellow forumers. Bogleheads follow a very orthodox investment strategy as favored by academics, if you don’t like the philosophy or have different opinions, you can always join an alternative investment forum with an ideology that meshes with yours.

While there are all kinds of Bogleheads on this forum given the open nature of the Internet, there are certain demographic traits of Boglehead forumers which I observed. Bogleheads in general are talented (plenty of Mensans), financially well off (plenty of millionaires), frugal, white and American. There are also quite a number of finance professionals such as financial advisors lurking around on the forum. You’ll come to know of them as you read more. I have learned a lot from these people and considering the forum and the advices are free, I’m especially grateful. While I can’t be considered as rich by developed-countries standard, I’m on my way to a comfortable retirement. So, kudos to the Bogleheads!

Most of the topics posted on the forum are finance related. However, Bogleheads do have a life outside investing and they frequently post many eclectic topics of various nature on the forum. The moderators do not seem to mind them and I find them to be a refreshing respite from all the financial matters. The topics can be legal, computer related or relating to household enhancements.

Over the years, the forum has done a great job educating the public on saving and investing. Some of the more talented members have further taken the task at hand and written not one but two investment books – “The Bogleheads’ Guide to Retirement Planning” and “The Bogleheads’ Guide to Investing”. They are great books per se but they tend to be a little on the American-centric side. Besides these 2 books, there are many other good books that gel while with the Bogleheads philosophy. You can read the recommendations on the wiki here:

http://www.bogleheads.org/wiki/Books:_Recommendations_and_Reviews

So, come on board the forum and set yourself financially free!

Downloading Stock Prices into Excel Spreadsheet

With the advent of fast and affordable computing power on the one hand and the availability of powerful, feature-complete spreadsheet on the other hand, financial calculation and modeling have increasingly been performed on Microsoft Excel, the industry-leading spreadsheet of choice.

Investors and investment professionals alike now massage investment-related information on Excel. A function of Excel is to import stock information. There are chiefly 2 ways to retrieve stock/ETF/mutual fund prices into your spreadsheet. One way is via MSN MoneyCentral database connection. The other is through Yahoo! Finance Excel macro.

You can view the MSN MoneyCentral way through this hyperlink.

However, the MSN MoneyCentral approach might not be suitable for some people as it doesn’t list a number of foreign stocks outside USA. For example, Singapore stocks are not included by MSN MoneyCentral. Fortunately, Yahoo! Finance has most of such data and thus the Yahoo! Finance Excel macro is my preferred tool to import stock quotes. You can download the sample Excel spreadsheet here (if you’ve MS Office 2007 or above, get this spreadsheet instead).

The spreadsheet contains sample macros and stock tickers which you can modify to suit your needs. You’ve to remember to enable macros in Excel in order for it to work. As the data source is from Yahoo! Finance, you’ve to check with Yahoo! Finance for the stock ticker information, it might differ from MSN MoneyCentral. For advance users, the Yahoo! Finance Excel macro is the preferred way as Excel macro in infinitely customisable.

You can browse the author’s documentation page at this link.

If you want to import historical quotes, you can download a sample Excel macro spreadsheet for viewing here (if you’ve MS Office 2007 or above, get this spreadsheet instead).  As always, remember to enable the macros.  This particular macro uses Yahoo! Finance symbols and data.