Appraising ETFs with a Scorecard

The enormity of the Exchange-Traded Fund (ETF) industry – currently valued in excess of $1 trillion — reflects a growing popularity among investors.  Two big advantages of owning ETFs are the low-cost diversification of investments and the ease of trading ETF shares in the stock market.  The main concerns are investment risk and structural risk.  Since ETFs vary according to their advantages and disadvantages, the purpose of this article is to describe the appraisal of ETFs by use of the following example (click → ETF scorecard for program):

Scorecard preparation:

ETF selection.  Online screeners — such as Morningstar.com’s — are used to select one or more ETFs from a large database of available funds. The screening criteria vary among websites but typically include several attributes of performance, investment strategy, and market exposure. Online screeners also provide access to market quotes and fund documents.

ETF data.  Table 1 illustrates a scorecard for two ETFs that are labeled by their stock market trading symbols.  The data in Table 1 were obtained from fund documents (prospectus, annual report, fact sheet) that are available online in the fund’s website, financial services websites (e.g., www.morningstar.com), and/or the SEC website (http://www.sec.gov/edgar.shtml).

Scorecard interpretation:

Longevity is the time interval between commencement of ETF operations (“inception”) and the publication date of the ETF document.  Longer is better.  ETFs with at least 10 years of longevity offer the advantage of durable operations.

Net assets describe the wealth of the ETF.  More net assets are better.  In today’s market, funds with net assets exceeding $2 billion typically offer the advantages of name recognition and operational success.  “Net assets” is the monetary value of the portfolio when calculated as the difference between total assets and total liabilities.

Underlying assets are the portfolio’s primary class of investments used to determine the shareholder’s returns.  Commodities, currencies, and futures are generally more risky than stocks and bonds.

Portfolio composition identifies the portions of asset classes held by the ETF.  Portfoliosare governed by diversification rules published in the Investment Company Act of 1940 and the U.S. Tax Code9,10,11.  The diversification rules are designed to protect portfolios and shareholders from losses incurred by holding concentrated portfolios of securities.  Diversified portfolios are generally less risky than non-diversified portfolios.

Market region is the country or geographic region of markets for the fund’s investments (domestic, foreign, or global).  ‘Market’ refers to a homogeneous group of financial assets (e.g., stocks).  The risk and liquidity of investments can vary according to market (e.g., stocks) and region (e.g. Mongolia).

Market sector is a subgroup of the market with a common characteristic such as a type of business, industry, product, etc. (e.g., automobile manufacturing).  Some sectors are riskier than others by virtue of their market (e.g., futures) or sector (e.g., commodities).

Index is a measurement of the market value of the fund’s underlying assets.  The index is prepared and published by an independent financial firm.  Most ETFs use an index to execute and evaluate their investment strategy while the remaining few restrict their use of the index to evaluation of performance.  Beware of unfamiliar indices based on inconsistent or unclear methodology25.

Legal structure determines the scope of ETF operations4,8,12.  In the U.S. stock market, funds labeled as ETFs must hold at least 80% of the underlying assets in securities relevant to the fund’s name.  ETFs are structured either as an open-end investment company (OEIC) or unit investment trust (UIT) for the common goal of investing in a diverse collection of securities.  Fewer funds – often called exchange-traded vehicles (ETVs) — are structured as a limited partnership (LP)or grantor trust (GT) for exposing the investor to a concentrated portfolio of commodities, currencies, or securities.  The risk of a concentrated portfolio is that fund performance is exaggerated by the returns or losses of the largest holdings.

  • Unmanaged portfolio– The UIT and GT operate a fixed portfolio of securities — derivatives excluded — that replicate the composition of a market index.  The underlying assets are never rebalanced, never reinvested – (only distributed to shareholders after correction for expenses) –, and never loaned.  UITs have a renewable expiration date.
  • Managed portfolio– The OEIC and LP operate a professionally managed portfolio in which managers may rebalance assets according to investment strategy, invest in derivatives, reinvest portfolio earnings, distribute earnings to shareholders after correction for expenses, and lend portfolio assets.  The OEIC and LP may incur the risk of leverage by investing in derivatives and the risk of ‘failed trades’ by lending securities1.

Investment goal is the desired performance of the portfolio in relationship to the investment performance of the index.  Most ETFs seek to match the price and yield performances of the index before deducting the fund’s operating expenses.  Some ETFs seek to outperform (e.g., leveraged ETF) or underperform (e.g., inverse ETF) an index.  The investment goal determines the shareholder’s returns.  TIP: Use an interactive chart to informally compare the past performances of the portfolio, ETF shares, and index.

Investment strategy is the fund’s stated plan for achieving its investment goal.  The main strategies are passive, active, and leveragePassive management is the process of maintaining a portfolio that mirrors the index.  The prime methods of passive management are replication and sampling.

  • Replication- “(The) replicate index-based ETF holds every security in the target index and invests its assets proportionately in all the securities in the target index.” 27
  • Sampling- “(The) sample index-based ETF does not hold every security in the target index; instead the sponsor chooses a representative sample of securities in the target index in which to invest. Representative sampling is a practical solution for an ETF that has a target index with thousands of securities.” 27

Active management is an investment strategy designed to outperform the index.  Leverage is typically the riskiest strategy.  Leverage is the use of debt in the form of derivatives to achieve a desired rate of investment performance.

Risk & uncertainty are external factors that may cause a loss on investment.  Risk is predictable and uncertainty is not.  A comprehensive list of risk factors is discussed thoroughly in the ETF’s prospectus and annual report.  Only the most relevant factors need to be mentioned in the scorecard.

Structural risk is the possibility that one or more factors related to ETF structure could interfere with trading or generate losses.  I classify these factors as restricted redemption, trading risks, asset risks, and managerial risk.

Tax burden.  Taxation is a unique risk that threatens to diminish investment returns.  U.S. citizens must pay income tax on the investment earnings of an ETF’s portfolio and on their personal capital gains from trading ETF shares in the stock market.  The total tax burden consists of the income tax plus the tax accountant’s fee.  If the accountant charges an hourly fee, the tax burden will increase in proportion to total time spent on tax preparation.  Grantor trusts and Limited Partnerships may inflate the routine tax preparation fee according to extra time needed to prepare trust letters, K-1 forms, 990-T forms, unusual tax calculations, and out-of-state tax returns. The fund prospectus gives important tax information that is time-sensitive and should be confirmed by a professional tax advisor such as your accountant.

Two ways of reducing the tax burden are to invest in tax-free ETFs and hold ETFs in tax-deferred accounts (TDAs).  The underlying assets of tax-free ETFs are tax-free agency bonds.  The taxation of a RIC, grantor trust, and limited partnership can be deferred when held in a tax-deferred brokerage account.  However, TDAs don’t protect from the taxation of “unrelated business taxable income” earned by a limited partnership12,22.

Scorecard summary

The following statements illustrate a summary of the scorecard (Table 1) for purposes of comparison and decision:

  • SPY is a durable, wealthy fund that strives to match the performance of the broad U.S. stock market at the main risk of incurring losses from market volatility.
  • USO is a small commodity pool that tracks sweet-crude oil prices at high risk of increased tax burden coupled with the risk of investing in futures.

Conclusions

The internet provides ETF screeners that allow investors to select an ETF based on desired market exposure and investment performance.  Selected ETFs deserve further appraisal by use of a scorecard to examine the fund’s investment strategy, structural risk, and potential tax burden.   The screening criteria and scorecard summary can reveal expected outcomes and the need for risk management.

copyright © 2011 Douglas R. Knight, updated 2012

References

1.   BIS Working Papers No 343: Market structures and systemic sisks of Exchange-traded funds. Srichander Ramaswamy, Monetary and  EconomicDepartment of the Bank for International Settlements, April, 2011.  http://www.bis.org/publ/work343.pdf

2.   Exchange Traded Products- Education.  ETF & ETV Activity Flow.  ®2011 NYSE Euronext.  http://www.nyse.com/about/listed/1266318204137.html

3.   SEC Concept Release: Actively Managed Exchange-Traded Funds, SECURITIES AND EXCHANGE COMMISSION, 5/18/2004. http://www.sec.gov/rules/concept/ic-25258.htm

4.   Exchange Traded Products- Education.  ETFs.  ®2011 NYSE Euronext.  http://www.nyse.com/about/listed/1266318204096.html

5.   Exchange Traded Products- Education. Creation/Redemption process. ®2011 NYSE Euronext.  http://www.nyse.com/about/listed/1266405887198.html

6.   Mutual Funds. U.S. Securities and Exchange Commission. Modified 12/14/2010.  http://www.sec.gov/answers/mutfund.htm

6a.  Maxey, Daisey. “ETFs and Products hit $1 Trillion in U.S.”, page B17, Wall Street Journal, B17, 12/18/2010.

7.   ETF Education Center, ETFs vs. Mutual Funds. ©2011 ETFguide.com.  http://www.etfguide.com/mutualversusetf.htm

8.   Investment company registration and regulation package. U.S. Securities and Exchange Commission. Modified 4/2/2009.   http://www.sec.gov/divisions/investment/invcoreg121504.htm

9.   The Investment Company Act of 1940. Section 3. Definition of Investment Company.  Security Lawyer’s Deskbook,  The University of Cincinnati College of Law, © Copyright 1998-2011, University of Cincinnati,  ronald.jones@uc.edu.   http://taft.law.uc.edu/CCL/InvCoAct/sec3.html

10.  Internal Revenue Bulletin No. 2003-32, August 11, 2003. Section 851.-Definition of Regulated Investment Company.

11.  The Investment Company Act of 1940. Section 5. Subclassication of Management Companies. Security Lawyer’s Deskbook, The University of Cincinnati College of Law, © Copyright 1998-2011, University of Cincinnati,  ronald.jones@uc.edu.   http://taft.law.uc.edu/CCL/InvCoAct/sec5.html

12.  Little, Pat.  Is that an ETF? Research Note, Hammond Associates, September, 2010.

13.  SEC Looks Into Effect of ETFs on Market, Scott Patterson, Wall Street Journal, September 7, 2011.  http://online.wsj.com/article/SB10001424053111903648204576554770203689108.html?mod=ITP_moneyandinvesting_0

14.  Choking the Recovery: And Unrecognized Risks Of Future Market Disruptions. Harold Bradley and Robert E. Litan. Published Nov. 8, 2010, revised Nov. 12, 2010.  © 2010 by the Ewing Marion Kauffman Foundation. All rights reserved.

15.  Exchange-Traded Funds: Too much of a good thing. The  risks created by complicating a simple idea, June 23rd 2011, The Economist.  http://www.economist.com/node/18864254

16.  Circuit Breakers and Other Market Volatility Procedures.   U.S. Securities and Exchange Commission, Modified: 08/09/2011.  http://www.sec.gov/answers/circuit.htm

17.  Ari L. Weinberg.  Exchange Traded Funds: When ETFs are Lenders. Wall Street Journal, July 6, 2011.  http://online.wsj.com/article/SB10001424052702303823104576391573704929238.html?KEYWORDS=when+etfs+are+lenders

18.  Canaries in the Coal Mine. Systemic Risk for Financial Firms and Investors. March 2011. © 2011 by the Ewing Marion Kauffman Foundation.

19.  Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs).  Financial Stability Board, 12 April 2011.  http://www.financialstabilityboard.org/publications/r_110412b.pdf

20.  Exchange-traded funds: A good idea in danger of going bad. The reckless expansion of “synthetic” funds requires a few new rules, June 23rd 2011, The Economist.  http://www.economist.com/node/18867037?story_id=18867037

21.  Portfolio Turnover.  Richard Loth, Investopedia.com.  http://www.investopedia.com/university/quality-mutual-fund/chp7-fund-activity/portfolio-turnover.asp#axzz1XIp6eGp8

22.  Laura Saunders, Jason Zweig. Extreme Tax Frustration. Wall Street Journal, June 25-26, 2011.  http://online.wsj.com/article/SB10001424052702304231204576403674025064848.html?KEYWORDS=extreme+tax+frustration

23.  ETF Education Center, The history of exchange-traded funds.  ©2011 ETFguide.com.  http://www.etfguide.com/exchangetradedfunds.htm

24.  Publication 598 (03/2010), Tax on Unrelated Business Income of Exempt Organizations, revised: March 2010.  http://www.irs.gov/publications/p598/index.html

25.  Ferri, Richard A., CFA.  All About Index Funds, second edition.  McGraw Hill, 2007

26.  The “tax efficiency of fund is tied to turnover ratio”, Motley Fool, The
Columbus Dispatch, page D4, 3/20/2011.

27.  Investment Company Factbook, 50th Edition, A Review of Trends and Activity in the Investment Company Industry. Investment Company Institute, 2010.  www.icifactbook.org.

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