As the popularity of exchange traded funds continues to grow, more advisors are offering model ETF portfolios as a service.
Forbes‘ Richard Ferri takes a look at this trend in his recent article The Next Big Thing: Model ETF Portfolios. Ferri offers his own “Core Four” portfolio solution that includes an all-Vanguard line-up:
Total Stock Market ETF (VTI )
FTSE All-World ex-US ETF (VEU )
REIT ETF (VNQ)
Total Bond Market ETF (BND)
When buying index funds that cover smaller slices of the market, watch out for the difference between a fund’s performance and the index that the fund is supposed to track.
The performance-index gap isn’t a problem for ETFs tied to broad-market benchmarks according to Sam Mamudi in the article Not All Index Funds Are Built Alike. However, exchange traded funds that track more volatile sectors can experience tracking error.
For example, Mamudi points out that the iShares MSCI Emerging Markets Index ETF (EEM) and the Vanguard Emerging Markets ETF (VWO) are both linked to the same benchmark — the MSCI Emerging Markets Index — yet delivered different results in 2009 when the Vanguard fund outperformed the iShares fund.
Turns out that Vanguard has a trading advantage because it pools ETF assets with mutual fund assets. Another example where Vanguard has an edge – the Vanguard Total Bond Market ETF (BND).
2009 was a good year for Bond ETFs. Through November 2009, taxable-bond ETFs had net inflows of $32 billion, the most among major asset classes according to a recent WSJ article by John Spence.
Broad-based bond ETFs such as iShares Barclays Aggregate Bond Fund (AGG) and the Vanguard Total Bond Market ETF (BND) were popular choices among investors.
Emerging market ETFs were also popular choices in 2009. Two favorites among investors — the Vanguard MSCI Emerging Markets ETF (VWO) and iShares MSCI Emerging Markets Index Fund (EEM).
Bond ETF investors may be taking a haircut when their funds add or reduce shares.
According to Bond ETFs: A New Way to Buy High or Maybe Sell Low, the WSJ’s Tom Lauricella writes that, in the short history of bond ETFs, investors have tended to pay more than the underlying portfolio is worth.
The difference between price of an ETF and its net asset value (NAV) is driven by the bid-ask spread. The spread is important because new ETF shares are created when market makers buy bonds at the higher ask price and then exchange those bonds for ETF shares. At the same time, the NAV for those same shares is based on the lower bid price.
Lauricella notes that the Vanguard Total Bond Market ETF (BND) has closed above its NAV 98% of the time since the fund started trading.
A recent Morgan Stanley report concluded that the weighted average tracking error for ETFs in 2008 was 39 basis points or 0.39%.
In the blogpost ETFs stuck close to indexes despite 2008’s volatility, MarketWatch’s John Spence summarizes the findings from the report that looked at how well ETFs stayed close to their tracking indexes.
One ETF that delivered very low tracking error was the Vanguard Total Bond Market ETF (BND). Although the fund holds only 3,731 of the 9,168 securities in the index, the tracking error was only 5 basis points or 0.05%.
Funds that delivered higher tracking errors were hampered by diversification requirements. For example, Spence points out that the Vanguard Telecom Services ETF (VOX) had a big negative tracking error because it was underweight in AT&T.
The large telecom returned 28% in 2008 compared to the fund’s overall return of 10.5%, however, SEC rules prevented VOX from fully matching the index’s 50% weighting of AT&T.
For investors willing to look beyond cash for yield, bonds are the next step up the risk ladder. The WSJ’s Jonathan Burton explores how ETFs can play a role in his article Using ETFs for Bond Bets.
Building a diversified portfolio of individual bonds is hard and expensive for most investors, so funds are the better way to go. ETFs have an advantage over actively managed mutual funds due to their low cost, flexible trading and tax efficiency.
To get started in Bond ETFs, Burton points out that many advisors recommend iShares Barclays Aggregate Bond Fund (AGG) for exposure to a broad mix of bonds. A similar offering is the Vanguard Total Bond Market ETF (BND).
Other ETFs mentioned in the article:
Corporate – iBoxx Investment Grade Corporate Bond Fund (LQD), iBoxx High Yield Corporate Bond Fund (HYG)
Shorter term – iShares Barclays Intermediate Credit Bond (CIU), iShares MBS Bond Fund (MBB)
Munis - iShares S&P National Municipal Bond (MUB), Powershares Insured National Municipal Bond Portfolio (PZA), Market Vectors Long Municipal Index (MLN)
For a complete listing of fixed income ETFs, see the ETF Directory
Money Magazine’s undercover financial planner recently answered the question How to Make Money in ETFs (and how not to).
The undercover planner believes that financial advisers are not big fans of ETFs and regard them as a threat. With ETFs, individual investors can create a simple, low-cost portfolio that beats the pants off professionally designed plans. Why pay advisors 1.5% to 2% a year to do something that you could manage yourself?
The Mole recommends using ETFs that own the whole market at the lowest cost and have the greatest tax efficiency such as Vanguard Total Stock Market (VTI), Vanguard FTSE All-World Ex-U.S. (VEU) and Vanguard Total Bond (BND).
New York Times reporter Tara Siegel Bernard provides a primer on ETFs in her article Exchange-Traded Funds: What You Need to Know.
Bernard points out that many people like exchange-traded funds, or E.T.F.’s, for the same reasons they like index funds: they provide easy access to broad spheres of the market, while keeping costs and taxes low.
She recommends the Vanguard Total Stock Market ETF (VTI) and the Total Bond Market ETF (BND) as a prudent way to wade into investing waters with ETFs.
She also points out that investing in any fund with less than $50 million in assets is not advisable.
The New York Times Conrad De Aenlle published a story over the weekend on the current opportunity in corporate bonds.
In the article Corporate Bonds Offer Opportunity, Aenlle summarizes the view of some bond specialists who contend that prices are so low and yields so high that they are immune from anything short of disaster — and maybe even that, too.
Investment-grade corporate bonds, for example, yield close to 5 percentage points more than Treasuries. Just after the 2001 recession, the spread peaked at about 2.5 percentage points.
A standardized basket of high yield corporate bonds recently yielded 14 percentage points more than Treasuries, 4 percentage points more than in 2002 or during the 1991 recession.
Not all strategists see the current bond market in the same light. Aenlle notes that Martin J. Mauro, a strategist at Merrill Lynch, counsels investors to stick with Treasuries and debt issued by federal agencies.
The $9 billion Lehman Aggregate Bond Fund (AGG) holds investment grade U.S. Government bonds and investment grade corporate bonds and carries a 30-Day SEC Yield of 4.3%.
A very low cost option for bond market exposure is Vanguard’s Total Bond Market ETF (BND) which owns a wide spectrum of public, investment-grade, taxable, fixed income securities in the United States and yields 4.7% and an annual expense ratio of 0.11%.
The SPDR Lehman High Yield Bond ETF (JNK) yields 16.8% and owns high-yield corporate bonds using the middle rating of Moody’s, S&P, and Fitch, respectively, and have $600 million or more outstanding face value.
See the ETF Directory at ETF MarketPro for a complete listing of Fixed Income ETFs.
