Some ETFs Don't Track Their Index Too Well

Investors like me who merely seek to replicate the returns of a broad index and not to time markets but merely passively track the index often use ETFs to do so. It's probably no surprise that ETFs vary considerably in how well they do the job of tracking the target index. The measure of the deviation from the index is tracking error.

Forbes' ETFs Behaving Badly article and accompanying 20 Best and 20 Worst slide shows describes results of a survey of 505 US-traded ETFs done by Morgan Stanley for 2008. In many of the worst cases the tracking error is several percentage points. The best have really tiny tracking errors.

Many of the worst trackers turned out to have out-performed or done better than the index in 2008. The article explains how some of those came about which gives me the sense that it's likely to keep happening. It's perhaps a nice accident that some results were better than the index in 2008 but in future years an uncontrolled or uncontrollable tracking error could well mean serious under-performance. Just give me the index please!

Most of both the best and worst lists are quite specialized ETFs. It's reassuring to see that among the best are Vanguard's Total US bond market ETF (BND) and iShares US TIPS Inflation-Indexed Bond Fund (TIP). A surprise is that some of the worst are several Vanguard offerings like their Energy Fund (VDE) and a Telecomms Fund (VOX) and an ETF heavyweight, iShares MSCI Emerging Markets Fund (EEM). There are also several bad country trackers, notably iShares' ETFs for Mexico (EWW) and Austria (EWO) and the SPDR S&P China fund (GXC).

The Benefits and Imperfections of Asset Class Investing

What's Wrong with Judging Investment Performance with an Index
One of my pet peeves is articles about investment performance based on the price variation of indexes such as the TSX, the Dow or the S&P 500. Unfortunately they do not reflect real world individual investor experience. Though it is possible to buy ETFs or mutual funds whose objective is to track an index, such things as trading costs / commissions, tracking error, bid-ask spreads and distributions can cause actual results to vary from the index.

Another thing I find annoying is that people often limit themselves to indexes for only two asset classes - stocks and bonds. We've all seen the classic 40% bonds, 60% stocks. There are a lot more asset classes out there with which to diversify, like real estate (REITs), real return bonds, foreign developed or emerging market equities (which introduce the issue of currency hedging), small and value cap tilts, commodities. Current theory says we should take advantage to maximize diversification and the ETFs are there to allow the average investor to do that, so why not model it?

Another issue of note is whether and when to rebalance a portfolio. Would a policy of reviewing the portfolio every December, and rebalancing if too much out of sync with target allocations, have done better than simply buying and holding?

Finally, the recent (on-going?) financial crisis and market crash provides a real high stress period in which to see how various realistic portfolios fared.

Assumptions: So, I've done some calculations in as realistic a way as possible. I started with $100,000 in May 2007 before the troubles really began and took it to the close last Friday, September 11, 2009. The portfolio is split 70% equity, 30% fixed income, with finer sub-divisions of both for the 4- and 16-asset portfolios. I used passive index ETFs available on US exchanges and the TSX.

The USD-CAD exchange rate I've used is based on the mid-market closing rate, which I've adjusted for the initial purchases by adding 1% to approximate the foreign exchange fee embedded in Canadian broker rates. At the Dec.17, 2008 rebalancing date, I have not adjusted for FX since almost all of the FX fee could be avoided by doing wash trades offered by most brokers and/or keeping the USD distributions in a USD account when received, as all brokers allow for non-registered accounts and some do for registered accounts. Also I have not deducted any US withholding tax from the US ETF distributions, which is ok for ETFs held in registered accounts but not in a TFSA or a non-reg account. So that assumption might slightly overstate returns depending on the account in which a portfolio is held.

As to rebalancing, I modeled none in Decmeber 2007 because the ETFs had not strayed far from their May target percentage allocations. Ths cash distributions were merely accumulated in the account. I ignored interest on the cash since it would have been too little to matter. ... all this stuff about my assumptions shows why so many people don't like taking the trouble to do realistic calculations - it's painstaking!

Results:

• big surprise, the simplest portfolio, consisting of only the iShares S&P/TSX 60 Index (XIU) and the iShares ScotiaCapital DEX Bond Index (XBB) fared best in every way!! It dropped the least to the review point of Dec.17, 2008 and has recovered almost fully (less than 1% below) to the starting value. That's why I've named it the "KISS Me Quick" portfolio - It has treated you well - who doesn't like a kiss!? It's KISS = Keep It Simple Stupid and it sure is quick to implement.
• big surprise again, the more diversified the portfolio, the worse the results! Huh, I though diversification was supposed to help, but whether or not the strategy was buy-and-hold or rebalancing, the fancy 16 asset portfolio did worst: it dropped the most and has receovered the least. That's why it's called the "Diversification Guru" - we all know what gurus are really worth.
• wow, rebalancing really worked well. In the short time since last December, all three rebalanced portfolios have outdone the buy-and-hold approach by anywhere from 7% to 9%.
• no surprise, diversification by holding fixed income is a lot better than just equities; if only XIU had been in the portfolio, there would have been a 31% drop in value, even including distributions. That's much worse than the 22% fall of even the worst portfolio, the 16-asset version. And XIU as of Sept.11th was still 14% below its initial value of May, 2007. The strong recovery of XIU has not made up the ground lost up to December. The reason is that no rebalancing occurred, as it could not with a single asset.

Why More Diversification Didn't Work

• real estate and foreign markets - some of the extra asset classes fell harder than Canada's; the UK's banks made up a bigger chunk of the FTSE index and they had just as much trouble as US banks
  
• currency shifts - up to last December, the CAD's big drop relative to USD as the flight to safety occurred cushioned some of the blow of drastically falling stock markets but since then the strength of CAD (check all the blue appreciation of the last 3 months at RatesFX) has limited the upside.

Further Thoughts:

• the future may not be like the past - this time and in this relatively short period, it was bonds, particularly government bonds, that provided the critical diversification benefit. Safety of principal was the issue. That may not be the case if inflation for instance, is the next big threat. In an uncertain world, different assets for different threats is still my best guess at what will allow me to survive if not thrive quite as much as the strategy which has worked best in retrospect.
  

UK Immigration Rules Ruin People's Lives in Order to "Protect" Them

Through a sad and bizarrely crazy new set of immigration rules, the WWB (World Wide Bureaucracy) has struck again in the UK as a happily and voluntarily married young Canadian-Welsh couple will be obliged to live apart for a couple of years due to regulations supposedly designed to protect young British women of Pakistani or Bangladeshi origin from being forced into marriage. The woman involved is not British (she's Canadian), she has no Pakistani, Bangladeshi or any remotely Asian roots by all appearances ... I know, I know, I'm revealing my deep prejudice by coming to that conclusion by looking at her name (Wallis), her white face, her red hair ... and both she and her husband vehemently deny any coercion to get married.

She's not especially young either, being 19 years old, and sounding rather mature in the BBC news interview found in the above link. It's interesting that UK law permits 16 and 17 year olds to get married with their parents' permission. Above that age, Brit teens can marry if they like. By the logic of the regulations which deny marriage visas to foreigners under 21, the implication is that pure Brit teens are superior to non-Brits.

This case leads one to wonder if the new regulations were cast in such an un-necessarily broad ill-fitting manner to adhere to political correctness and avoid singling out a particular country or ethnic group. The "for the greater good some have to suffer" explanation put forth by the Home Office is laughable. Since all of the cases cited in the What is a forced marriage? booklet of the Forced Marriage Unit website involved teens travelling to another country, maybe the government should simply have banned all foreign travel by British citizens under 21?

As a Canadian who, though considerably older than this couple, came to the UK through marriage to a British citizen and experienced frustrations dealing with the Home Office in getting the necessary visas, I have a great deal of sympathy for Adam and Rochelle. I really hope their problem gets sorted, though the bureaucratic stonewalling and circling of wagons to back up the idiotic Home Office regulations is all too evident in the BBC account.

Annuity Payouts Improving but All Over the Map

Annuity rates move more or less in tandem with interest rates - as interest rates fall, so do annuity payouts. Not long ago, the IFID centre posted a time series going back to 2000 showing sample annuity payouts and implied longevity yield, described as a measure of an annuity's return. It's a handy and welcome way to judge the trend and whether things are getting more advantageous for a retiree to turn a lump sum into an annuity. The recent trend seems to be upwards towards higher payouts e.g. a 65 year old male could get about $680 monthly income at the end of June (it's the latest data apparently) per $100,000 initial premium versus $650 or so last September. The highest it has been was about $740 in 2000-2001 so there is some way to go before rates get really attractive.

It is also worth noting that it is essential to shop around. Cannex has one freebie table of current annuity rates offered by the various providers showing payouts for a single life male with a 10-year guaranteed payout. There is a wide range - a 65 year old can get as little as $594 monthly from Standard Life to as much as $667 from Canada Life or Great_West Life, a 12% difference.

Book Review: Investing from the Top Down by Anthony Crescenzi

A bit strange this book is. On the one hand it has a great deal of explanation and links to sources on macro-economic indicators and trends, how they affect markets and how investors can use them to advantage. On the other hand, it steadfastly maintains that such an approach is simple and easy for the average investor.

I really doubt that somehow. How many investors are willing to take the time and trouble to regularly monitor and read no less than 40 top-down indicators? How many will be able to correctly remember all the inter-actions and implications to properly interpret the data therein in order to find the appropriate investment target sectors? How many will know where to find the investment target securities?

An example to illustrate the challenge: on pages 164-169, Crescenzi analyzes the then (June 2008 or thereabouts) subprime mortgage situation and begins with a comment that credit default swap indexes were priced for defaults on such mortgages to reach as high as 40%. Huh, how did he figure that out? If that is the basis for a judgment that the market at the time was over-reacting, we the investor would have to be able to estimate that too. But one would need to know what a credit default swap is, then know where to obtain the data, then to know what calculation to perform to estimate the 40%. And finally, of course, there is the bigger issue that instead of over-reacting, maybe the market at the time was under-reacting given the crash that resulted from September onwards.

I daresay the average investor will find it challenging, perhaps overwhelming. Crescenzi, as a top investment strategist (he recently got hired away by the famous PIMCO from the Miller Tabak, which is listed on the dust jacket as his employer), may find it easy from years of learning and observing and may even be very rich from carrying out his own recommendations. I think it does a disservice to himself and to his audience to pretend it is simple and quick. The get-rich-quick message isn't required and casts a shadow of suspicion that the whole approach is just a scam. He also harps on about how it is much easier than bottom-up value investing, an unnecessary distraction to the reader who just wants wants to know how to do it.

This is really a book for the committed active investor, the afficionado who is looking for another angle, another method or set of tools to find the winners. It will not appeal to those convinced that passive index investing is the surest, though slow, route to investing success.

To a degree, it will also interest those who like to read and understand their economic and financial world. I enjoyed finding many more informative and useful websites and sources of key data.

The book is available from Chapters and Amazon.

My rating: 3 out of 5 stars

Proposal for a New ETF: Shunned and Sin Stocks

There are ETFs for just about everything these days. Amongst the country, commodity, sector and bear/bull ETFs, there are Socially Responsible ETFs.

To cater to those who view the SRI funds as political correctness and who love to decry it, in the spirit of equal opportunity I would like to modestly propose the creation of another one that presents the opposite point of view - the Shunned and Sinner Index ETF. One has to admit, it has a certain ring to it, or more precisely, a TWANG - tobacco, weapons, alcohol, nuclear and gambling.

The S&S ETF investor need not sacrifice for his or her unpopular personal point of view. No indeed. In their paper, The Wages of Social Responsibility, found over at the Social Investment Forum (Ah, the world is full of ironies, isn't it. This very paper that won the 2008 Moskowitz Prize for Socially Responsible Investing confirms that you can make money by doing the opposite), researchers Meir Statman and Denys Glushkov found that "... we also find that ‘shunned’ stocks outperformed stocks in other industries". They cite another study by Harrison Hong and Marcin Kacperczyk called the Price of Sin that found "... that the realized returns of ‘sin’ stocks were higher than the returns of other stocks." These 198 baddies stocks include GE (weapons and nuclear), Coca Cola (alcohol ... so that's the secret ingredient!), Altria (tobacco and alcohol) and Harley Davidson (gambling ... really? riding a bike isn't that dangerous).

An S&S ETF would allow investors to add a Mean tilt to their portfolio to supplement the oft-noted Value and Small Cap tilts. It's time to jump in now, before the efficient market discovers the S&S effect and eliminates it through arbitrage.

We can all have our cake and eat it too though, since Meir and Glushkov also found that the SRI approach can do well by focusing on companies with good community and employee relations and high scores on environmental responsibility. Everyone wins, no one loses, now that's politically correct.

How about it, iShares, Powershares, Claymore isn't there an unexploited opportunity and a clientele to be served?

Why Jumping on the China, India, Russia Investing Bandwagon Might Not Work

Countries experiencing rapid economic growth like China, India and Russia should be a good place to get higher stock market returns than stolid slower-growing places like Europe, right? Oops, not so fast.

Apparently, it ain't so. There is no relationship between a country's high GDP growth and stock market returns, especially not in the long run and only weakly in the short run. In Economic Growth and Equity Returns from SSRN, professor Jay Ritter calculated that there was in fact a negative relationship between economic growth and stock returns in 16 major countries (including Canada and the USA) over the period 1900 to 2002 - this chart is taken from the paper.

Other people have found the same thing, focusing on the USA - Crestmont Research's It's Not the Economy has a decade by decade chart showing the unpredictable differences in the same or opposite directions. CXO Advisory in Update: GDP Growth and Stock Market Returns tried calculating leads and lags to see GDP predicted the US market or vice versa and found that didn't really explain much either. In Canada, CIBC's Economic Insights of August 25th has this scatter plot which again demonstrates the same point.

Ritter's explanation is that consumers and company managers get the benefit of GDP growth, not stockholders.

He also makes the dramatic statement that past stock returns are of no use in predicting future returns!

The main metric that does predict future returns according to Ritter is the smoothed earnings yield (taking a 10 year average of earnings to eliminate business cycle effects) i.e. Earnings / Price. "A low smoothed earnings yield does, however, predict low real stock price growth over the following ten years. In other words, P/E ratios revert towards the mean through price changes rather than earnings changes." The only caveats that could derail that relationship would be: if managers and employees take the profits due to shareholders (are shareholder rights well protected?) and; if some catastrophe like war, revolution, hyperinflation destroys the value of financial assets. Based on the numbers in 2004, Ritter said that real annual compounded stock returns would average 4.5% instead of the historical 7%. Crestmont's little blurb attached to their chart also says it's the P/E that matters.

Wish I had the data to do the calculation for today's markets. The Price part of the equation is down quite a bit, such that the E/P will be lower but is it enough to produce good future equity returns?

In any case, these studies suggest strongly that the assumption that China's rising economic success means assured investing success is wrong and likely to disappoint.