July 3, 2007 INVESTING IN FUNDS: A QUARTERLY ANALYSIS . Exchange-Traded Funds
As ETFs Seek Niches, Risks Rise
Returns are often at the top of the performance rankings -- and the bottom
By DIYA GULLAPALLI July 3, 2007; Page R1
As exchange-traded funds have rocketed upward on the sales charts, far outpacing the sales growth of mutual funds, they also are showing up in disproportionate numbers on another set of charts: performance winners and losers. In a Lipper Inc. ranking of top- and bottom-performing funds for the first four months of this year, 18 of the 60 funds listed were ETFs -- 10 winners, and eight losers. That is an outsize showing, given that the stock mutual funds Lipper screens recently outnumbered the ETFs almost 15-to-1. In the fund tracker's "Leaders and Laggards" charts for a similar period four years ago, there were no ETFs. In simplest terms, ETFs are low-cost, index-based funds that trade on exchanges like shares of stock. Their burgeoning presence on these lists is the latest sign that, as ETFs have become one of the hottest investments around, some also are among the most volatile. Critics have warned in recent months that ETF companies' efforts to distinguish themselves with new products have led to offerings that are too narrowly focused for most small investors' purposes. Many ETFs are praised for their broad diversification of holdings, but with more than 500 offerings today, the inexperienced can be tempted to play tiny niches, a potentially dangerous tactic. Narrow focus can lead to more extreme returns, both good and bad. To the critics, ETFs' heavy showing on Lipper's performance charts indicates the most-specialized ETFs are starting to resemble the risk profiles of individual stocks more than mutual funds. And it suggests that ETFs and mutual funds have headed in separate directions. While newer ETFs are focused on subsectors as limited as dermatology and nanotechnology, many mutual-fund companies increasingly offer funds that allocate money across big sectors and "life-cycle" portfolios that help investors prepare for retirement or other long-term goals. The proliferation of ETFs may be "just a more cost-effective means of producing a bad investor experience," says Don Phillips, a managing director at fund researcher Morningstar Inc. ETF providers see it differently. "ETFs have presented a really positive shift in investing choices in that you now have a lot of access to a lot of different portions of the market from some really tremendous indexers," says Noel Archard, head of product development for the U.S. iShares business at Barclays Global Investors, a unit of Britain's Barclays PLC and one of the biggest indexing specialists. If smartly used, narrowly focused ETFs can plug holes in investors' portfolios in ways that conventional mutual funds can't, say financial advisers who use asset-allocation strategies. Since 1998, The Wall Street Journal has featured Lipper-produced Leaders and Laggards charts in its monthly funds sections, listing the best- and worst-performing stock funds based on total year-to-date returns (including reinvested dividends). Lipper has no minimum asset size or start-date requirement. The loose criteria long have made the lists an amalgamation of riskier sector funds, focused on areas Page 1 of 3
such as gold, oil and China. They also often have featured "leveraged" funds, which use financial derivatives to multiply the investment return. While no ETFs appeared in the chart covering the first five months of 2003, three were in the five-month chart for 2004 and five others appeared for 2005. Among the ETFs in those two years were iShares MSCI Austria and iShares Dow Jones U.S. Energy Sector in the top, and iShares MSCI Brazil in the bottom. Last year, six ETFs made the list for the five months through May. Among the Leaders: streetTRACKS Gold Shares, iShares Comex Gold Trust and Internet Infrastructure HOLDRS. Among the Laggards: Internet HOLDRS and Biotech HOLDRS. This year, the numbers jumped: Of about 4,850 mutual funds and 350 ETFs in the stock universe analyzed by Lipper, 13 ETFs made the two charts. This included six of the 30 top funds: iShares for Malaysia, Brazil and Latin America, and ETFs from other companies tracking metals and mining, international basic materials and midsize stocks. At the bottom: iShares Dow Jones U.S. Home Construction and leveraged offerings from ProShare Advisors LLC that bet against the market. For the quarter just ended, 15 of the 65 top stock funds and 13 of the bottom 65 were ETFs. Such outsize performance is expected, given that many U.S. stock indexes have recently hit highs, says Michael Sapir, chief executive of ProShare Advisors. About a dozen ProFunds mutual funds also are on the two lists. But many new ETFs also are squeezing into narrow spaces that mutual funds generally aren't. Van Eck Global's Market Vectors Steel ETF led the Leaders chart for the four months through April with a 27.9% return. The ETF, which came to market last October, follows the Amex Steel Index, which tracks about 35 U.S.-listed stocks and American depositary receipts of foreign companies. It has no U.S. mutual-fund counterpart. Neither do the iShares for Malaysia and Brazil, with 30.5% and 26.2% total returns for the five months through May 31. According to research in May by State Street Corp.'s State Street Global Advisors unit, more than half of the 507 ETFs it monitored fell into a sector or specialty category. Sector ETFs are proliferating so fast, the firm's researchers are "challenged to keep track of all the new products and place them in relevant categories," a State Street spokesman says. Often, mutual-fund sponsors hesitate to launch such niche products because it is tough to support trading, record keeping and other chores with a small asset base while keeping the expense ratio reasonable. ETFs have less trouble with these matters, partly because their structure allows them to limit costs in ways that mutual funds can't. In instances where there are mutual-fund counterparts to top- or bottom-performing ETFs, there often is a key difference: The ETF tends to be more concentrated. The iShares FTSE/Xinhua China 25 returned 55% in the 12 months through the end of May, compared with a 47% return for Eaton Vance Greater China Growth mutual fund. The iShares ETF holds about 25 securities, while the Eaton Vance fund holds about 65. Many winning ETFs hold no more than 60 stocks, compared with some winning mutual funds holding closer to 100 stocks, according to holdings data through May that the mutual funds and ETFs publicly report. "It's betting it all on black," says Matthew Hougan, editor of IndexUniverse.com, an index-research Web site. "ETFs are far more concentrated than mutual funds have ever been." Winning ETFs also generally have lower fees and less turnover of holdings than the mutual funds; management expenses and trading costs cut into investors' returns. Page 2 of 3
Another factor in winning performances during market upswings may be lack of a "cash drag," which is the hit to performance that mutual funds incur when they keep cash on hand, rather than putting every bit of money to work in stocks. ETFs tend to hold almost no cash because of their complex inner workings: ETF shares are created when securities brokerages or specialists assemble baskets of stocks that match an ETF's underlying index and exchange them with the fund for ETF shares that they either hold or sell to small investors. Those shares can be resold any number of times among investors on an exchange. When the brokerages opt to take ETF shares off the market, the fund hands them the ETF's underlying stocks, rather than cash, so there is no reason for the ETF itself to hold cash. Most ETFs typically hold less than 1% of their assets in cash while stock mutual funds typically have 3% to 5% of assets in cash, and the mutual funds that most narrowly missed the cutoff for this year's Leaders list through May 31 held up to 20% in cash, a review of the funds' filings shows. The 22.7% return of mutual fund RS Global Natural Resources for the ranking for the five months through May 31 didn't make the Leaders list, but co-manager Ken Settles says getting knocked off performance charts by ETFs doesn't bother him "at all." While ETFs have benefits, he says, "we would draw a distinction between speculating and investing." Unlike ETFs, the RS fund charges investors 1.5% of assets annually to send staff to Iceland, Canada and elsewhere to examine oil wells and aluminum smelters and meet with company managements; it typically holds about 40 stocks. Topping its performance were ETFs like PowerShares Dynamic Oil & Gas Services, which returned 25.6%. It charges 0.60% to track a proprietary index of 30 oil-and-gas stocks. Lagging behind ETFs in hot sectors is "what you would expect from a diversified approach," says Weston Wellington, a vice president at Dimensional Fund Advisors LP, which runs variations of index mutual funds based on computerized screening aimed at identifying stocks with certain risk and return metrics. DFA Emerging Markets Core Equity Portfolio's 49% return for the 12 months through May 31 wasn't good enough to make it a top-30 performer. ETFs on that period's list included iShares MSCI Mexico, up 75%, and iShares MSCI Brazil, up 65%.
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