Sunday, October 7, 2012

Making Sense of the Growing ETF Landscape

Monday’s Wall Street Journal warned that a "a treacherous landscape of potential trading problems" harasses the world of ETFs. Most of these problems are associated with liquidity; some have it, some don't. Identifying the haves, and the have-nots, is prudent way to start looking at ETFs. But the task is daunting, at least in the beginning of your search, because of the sheer number of products to review.

Sifting through the potential list of choices takes more time with each passing month. There are more than 900 ETFs, according to Morningstar Principia, and the list keeps growing. That’s good news--lots of choices. It’s also bad news because you have to sort through the list in search of investor friendly products. There are also hundreds of index mutual funds to consider, if you’re so inclined. Most of these choices aren’t worth your time for reasons including high expense ratios, insufficient liquidity, high tracking error and poor overall design, to name a few.

But that’s just the beginning. Reviewing the fund candidates is no trivial task, although it’s all a sideshow to the primary task of designing and managing a multi-asset class portfolio.

Half the battle is simply paring the ever-growing list of index fund products by separating the wheat from the chaff. That takes time and vigilance, but the paring pays off if only by keeping your investments away from the dogs. Our short list of funds is about 200 products, comprised of index mutual funds, ETFs and ETNs that run across the major asset classes and several key subgroups. Keeping the list short by focusing on the high-quality funds doesn’t take a Ph.D., but it does require a constant focus on pruning, watching and reading the details of the fund literature.

The other side of the coin is monitoring the markets for clues about optimizing asset allocation. What's our philosophy here? Actually, we wrote a book on the topic: Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor, which is published this month by Bloomberg Press.

The shorter version of how we think: start by tracking the market portfolio, which we define as all the world’s major investable asset classes (stocks, bonds, REITs and commodities), each weighted by their respective market values. The asset allocation of this market portfolio is a robust starting point for considering your own investment portfolio. The basic question: How should you alter Mr. Market’s asset allocation to suit your own particular profile, based on risk tolerance, time horizon, investment goals, etc. In addition, we can intelligently rebalance the resulting asset mix. Also, there are opportunities for tactical asset allocation (i.e., making changes based on forward-looking analysis). This is less about "market timing" vs. prudently harnessing the insights dispensed by financial economics over the decades, particuarly since the 1980s.

What are the factors to consider? It's actually a long list, but it includes an array of variables including volatility and correlation trends, dividend yields, p/e ratios, yield curve analysis, return spreads, yield spreads, estimating equilibrium risk premia. And, of course, watching the business cycle for some insight on whether the wind is blowing in your favor, or not.

More and more choices are a good thing when it comes to investing, but there are no free lunches. As the world of index fund products expands, so too does the workload for staying up to date by sorting through the full menu. Indeed, most of the products available aren't worthy of consideration. That's not always obvious. Meanwhile, it's important to stay focused by keeping your eyes on the prize: earning a sufficient risk premium to fund your particular set of future liabilities.

The implied value proposition in the 21st century is that investing is easier and more efficient than ever. That's true in theory. In practice, however, the details are complicated. Liquidity is a critical issue, as the Journal article suggests. But that's just the tip of the strategic iceberg.

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