Thought I might see what the HO people think of this.

ETFs, what are they? Are they index funds, active funds, both or neither? I don't think they qualify as true index funds because they aren't cap weighted, but they aren't managed either, so are they neutral ground where active and passing investors can both be satisfied?

Another article from Index Universe. This one from Robert Arnott:

Indexing in Inefficient Markets 

Excerpt from the conclusion:

Yet, unlike active managers, the Fundamental Index strategy maintains the broad coverage, high capacity, and low fees reflecting the positives of index implementation.

So, it is clear that Mr. Arnott does believe ETFs are actively managed.

Paul 

 

It's funny that you posted Arnott's link today. I just finished reading it at IndexUniverse.com.

ETFs of whatever type are index-based in some manner... traditional, fundamental, quant, enhanced, whatever else is now out there. From what I have read, the bulk of ETF types seem to be index-based and passive. The way I see it, if the formula used to create the index and its components is passive (ie written once and applied as is forever with no changes), then the ETF is passive. If the formula is re-applied periodically to modify the index and its components, then it is enhanced yet still passive. I'm sure others will disagree with me, but I consider fundamental ETFs to be just another form of enhanced ETFs.

Check out this link to Seeking Alpha's explanation of fundamental sector ETFs. Even more importantly, y'all might be interested in following the links at the bottom under Further Reading. They provide some nice links to both the pro and con of fundamental indexing... JMO, but I think Accidental Consultant on the con side of the equation is an idiot. His attempt to support cap-weighted indexes vs fundamentally-weighted indexes is a total failure. His example using only 2 stocks encompassing the universe of an index is simplistic and self-defeating. His argument is weak and ineffective and only serves to weaken his own position (Rob Arnott's RAFI 1000 Fundamental Index -- Not An Index At All).

I am aware that they are trying to develop a more active ETF prototype --one whose managers do more than exercise an index formula by plugging in numbers. Are the fundamental ETFs it or are there other more complex ones still in the works? I thought that the "active" ETFs were supposed to be truly active --not just applying a single formula once in a while but truly actively managing it daily.

I don't understand what they're trying to accomplish. Why do they want to activate the ETFs? Wouldn't they then just be CEFs in sheep's clothing? It makes no sense to me.

Regards,

Susan

Susan,

It seems to me that actively managed ETF's (whatever that may actually be) might be more akin to quantitatively managed funds  like Bridgeway's or Bogle, Jr's funds rather than CEF's.  In roaming through google on this topic, it appears that the UK has long had actively managed ETF's but I couldn't find a definitive enough article to link.

Roberta 

I hate to say it, Roberta, but I disagree. If the quant funds by Bridgeway or Bogle Jr are traditional open-end funds like Hennessy's HFTFX, HDOGX, HFCVX and HFBFX, then you're comparing cherries to bananas. I don't know much about ---and am not aware of any--- quant ETFs. I'm sure they're out there. In my ignorance, it is quite possible that I AM familiar with a few and just don't realize it. Please provide some tickers for quant ETFs so we can recognize them for what they are and examine them.

It would also help if you can give the tickers for Bridgeway's and Bogle Jr's OEFs, too. Please provide the same if they have any ETFs or CEFs.

Of course, I am assuming that fundamental and enhanced ETFs are not defined as a type of quant fund --or vice versa. I don't know. I'm not an indexer. I like ETFs and indexed OEFs definitely have their uses.** I own several ETFs and have owned index-based funds like HFTFX and the PIMCO index-enhanced OEFs, but I'm really an active investor.

This is getting a little convoluted, isn't it? LOL!

I would describe ETFs and CEFs as mutual funds on wheels. Their shares trade intraday from minute to minute. In contrast, traditional open-end mutual funds (OEFs) recalculate their values only once daily. IMO, OEFs are either index-based or -enhanced or they are actively-managed. Quant OEFs are formula-based and yet have the human element. Indexers might consider them sullied by the human hand and, therefore, are active OEFs by their definifiton of "active". As a member of the active-management camp, I consider quant OEFs to be a type of index fund if the human element is infrequent. Only if the human influence is intrusive and is applied quite frequently would I consider it to be active (ie quarterly or monthly).

With ETFs and CEFs, I think it should be clear-cut. Either you're index-based or you're not. If you're index-based, you are passive. IMO, I really don't think we need quasi-indexed/quasi-active ETF/CEFs. I think the SEC should tell Mr PussyFoot wanting them to approve an "active" index ETF to grow up and just call his products enhanced-index or index-based CEFs.

Why muddy the waters, anyway? An ETF invests using a static formula. Changes in its holdings are infrequent and modifications in its formula would be rare. A CEF manages its investments. It can be index-based with an active human influence or it can be freely and actively-managed by its manager. If an investment product is 100% guided by a formula, it's an ETF. If it is mostly guided by a formula but has frequent human intervention, it's a CEF. Ergo, in my opinion, an actively-managed ETF is a CEF.

Regards,

Susan

P.S. for pkcrafter et al... I don't know if you noted this ** in my 3rd paragraph, but I hope this helps to explain why I subscribe to IndexUniverse.com --ETFs.

I just re-read my own post and it hit me!

Indexers beware! Mr PussyFoot (the investing industry) wants YOU. By calling their more actively-managed index-based investments ETFs, he's got your business. He thinks you would shy away from "active" investments like CEFs...

CEF = active, ETF = passive.  CEF.... bad. ETF.... good.

Ergo, they have to keep the ETF name and the pure indexing status it implies. Mr PussyFoot must think that your tiny minds (his opinion, not mine) will automatically accept the indexing aura of ETF.

Regards,

Susan

P.S. It is possible that this post will be duped. M* didn't accept my first one.

I always thought that one of the advantages of a ETF was the ability to add a creation unit.  How would anyone create a creation unit for an actively managed ETF?  The asset mix could very well be a moving target, one thing in the morning, but something completely different in the afternoon.
 
I have to agree with Susan.  If it is actively managed, then it should be called a CEF.

Gordon

[quote user="glallen"]I always thought that one of the advantages of a ETF was the ability to add a creation unit.  How would anyone create a creation unit for an actively managed ETF?  The asset mix could very well be a moving target, one thing in the morning, but something completely different in the afternoon.[/quote]

An actively managed ETF may decide to allow purchases and redemptions of creation units in cash using the next calculated (such as, end of day) NAV after the order has been received.

AlthoughETFs announce a basket of securities and cash to be exchanged for a creation unit each day before the markets open, during the day they may create or redeem creation units in exchange for a basket different than the published one.

Hi Susan,

Thank you for the link to additional information. Some of your views are so opposite from mine that it makes me smile. I am afraid I will have to once again sit in the idiot's corner because I can see accidental consultant's point.

First off, I believe that a true index must actually track the market or some segment of the market as it exists. That means it has to be cap-weighted because that is the way the stock market actually is.  It's that way because that's the way investors have invested their money.   

The largest stock in the market will get a lot more of an invested dollar than a small stock because the biggest stock is worth a lot more. But each stock will get the same percentage in proportion to it's value.  AC's example is somewhat simplistic, but it's generally accurate. If there are only two stocks, one giant and the other small, a true index fund will allocate almost all of a dollar to the giant stock. In a fundamental index, the smaller stock will get more of the dollar; therefore, the money invested in it is overweighted as measured against the consensus of all investor money. There may be nothing wrong in doing this, but it is a departure from the consensus.

.
Fundamental indexes are created indexes, and since they are not cap weighted they can't be true index funds. I don't think this is arguable, but I'll see what others have to say.I really don't know what came first, the fundamental index fund or the fundamental index. I suspect that the idea of a fund with a small and value tilt was envisioned first and then an index was created so it would have something to track. Even Vanguard has a designer fund and index created for it to track. It's the High Dividend Yield Index, VHDYX.

I tend to think of these passively managed ETFs as quant funds. And I think your perception of what they are and how they are marketed is right on. YES! I agree with you. : - )

 

  Paul

 

 

 

 

[quote user="rascfw"]

I hate to say it, Roberta, but I disagree. If the quant funds by Bridgeway or Bogle Jr are traditional open-end funds like Hennessy's HFTFX, HDOGX, HFCVX and HFBFX, then you're comparing cherries to bananas. I don't know much about ---and am not aware of any--- quant ETFs. I'm sure they're out there. In my ignorance, it is quite possible that I AM familiar with a few and just don't realize it. Please provide some tickers for quant ETFs so we can recognize them for what they are and examine them.

It would also help if you can give the tickers for Bridgeway's and Bogle Jr's OEFs, too. Please provide the same if they have any ETFs or CEFs.

Of course, I am assuming that fundamental and enhanced ETFs are not defined as a type of quant fund --or vice versa. I don't know. I'm not an indexer. I like ETFs and indexed OEFs definitely have their uses.** I own several ETFs and have owned index-based funds like HFTFX and the PIMCO index-enhanced OEFs, but I'm really an active investor.

This is getting a little convoluted, isn't it? LOL!

I would describe ETFs and CEFs as mutual funds on wheels. Their shares trade intraday from minute to minute. In contrast, traditional open-end mutual funds (OEFs) recalculate their values only once daily. IMO, OEFs are either index-based or -enhanced or they are actively-managed. Quant OEFs are formula-based and yet have the human element. Indexers might consider them sullied by the human hand and, therefore, are active OEFs by their definifiton of "active". As a member of the active-management camp, I consider quant OEFs to be a type of index fund if the human element is infrequent. Only if the human influence is intrusive and is applied quite frequently would I consider it to be active (ie quarterly or monthly).

With ETFs and CEFs, I think it should be clear-cut. Either you're index-based or you're not. If you're index-based, you are passive. IMO, I really don't think we need quasi-indexed/quasi-active ETF/CEFs. I think the SEC should tell Mr PussyFoot wanting them to approve an "active" index ETF to grow up and just call his products enhanced-index or index-based CEFs.

Why muddy the waters, anyway? An ETF invests using a static formula. Changes in its holdings are infrequent and modifications in its formula would be rare. A CEF manages its investments. It can be index-based with an active human influence or it can be freely and actively-managed by its manager. If an investment product is 100% guided by a formula, it's an ETF. If it is mostly guided by a formula but has frequent human intervention, it's a CEF. Ergo, in my opinion, an actively-managed ETF is a CEF.

Regards,

Susan

P.S. for pkcrafter et al... I don't know if you noted this ** in my 3rd paragraph, but I hope this helps to explain why I subscribe to IndexUniverse.com --ETFs.

[/quote]

 

http://tinyurl.com/66sf9x

Ok, pkcrafter, who did I insult this time? No, wait --I take it back. If you know who Accidental Consultant is, please don't tell me. I'd have to wipe egg off my face again. What can I say? As you know (unfortunately), I can be quite opinionated and I'm not shy about sharing my views.

Upon reflection, my "idiot" comment about AC was a little harsh. My bad. Then again, I fail to see how he/she could think that anyone would perceive a list of 2 stocks as a potential index. It isn't. If it was and you just cap-weighted the index as AC suggests, I'd discard the microcap stock and just buy the mega-cap stock outright.

AC should have taken an actual index like the S&P500, Russell 2000 or whatever and then demonstrated how applying the fundamental weighting would change the composition of what you'd own. You know, the dividend yield, sector/industry percentage breakdown, the beta (if calculable), etc. Better yet, why couldn't AC just compare SPY SPDR S&P500 ETF with RSP Rydex S&P Equal Weight and use these real-world investments to present his/her case?

I agree with you about fundamental indexes, Paul. I think that the concept of a fundamental index-based investment was hatched and a fundamental index was born from that concept. So long as the fundamental investment actually meets a real need, though, I see nothing wrong with that. It's this frivolous froo-froo actively-managed "ETF" baloney that really blows MY mind.

Do you see any possible benefits in owning a fundamental index-based investment (OEF, ETF or CEF)? Or do you prefer to restrict yourself to plain-vanilla index investments? If so, why? I'm not trying to be intrusive. I'm just trying to understand this from your perspective.

Regards,

Susan

P.S. Hallelujah! I'm glad to see that we have found common ground, Paul...

I tend to think of these passively managed ETFs as quant funds. And I think your perception of what they are and how they are marketed is right on. YES! I agree with you. : - )

The quant OEF's I was thinking of were BOGIX as Gregory noted and the BRUSX and BRAGX from Bridgeway.  To my mind, CEF's are actively managed and neither quants nor indexes.  I look at things like BLU, TY and ADX.  CEF's grew out of the investment trusts and b/c of the reimbursement model for the sellers have to sell at a constant discount except when they're hot and overpriced.

Roberta 

Hi  Everyone,

Here is a new Book "The ETF Book:All You Need to Know about Exchage Traded Funds" by Richard Ferri  

 

According to this book ,Using Index Strategy Box

ETFguide’s Index Strategy Boxes™ are organized into nine grid shapes and each shape represents a different index strategy.

The vertical axis categorizes index strategies into three broad security selection methods: passive, screened, and quantitative. The horizontal axis categorizes index strategies into three broad security weighting methods: market capitalization, fundamental, and fixed/equal weight.

Index Strategy Boxes™ enables investors to quickly identify and distinguish the differences between index security selection and weighting strategies. This user friendly tool is easily applied to equity, fixed income and commodity indexes. Check any ETF's classification at http://etfguide.com/fact_sheet.php

Did it help ? 

Thanks.

Manji 

 

Susan,

This is what you said that I thought was very insightful:

Indexers beware! Mr PussyFoot (the investing industry) wants YOU. By calling their more actively-managed index-based investments ETFs, he's got your business. He thinks you would shy away from "active" investments like CEFs...

CEF = active, ETF = passive.  CEF.... bad. ETF.... good.

Ergo, they have to keep the ETF name and the pure indexing status it implies. Mr PussyFoot must think that your tiny minds (his opinion, not mine) will automatically accept the indexing aura of ETF.

Maybe you are reading too much IU. You are beginning to think like an indexer.  : - )

I do think that some ETFs can prove to be useful in an index portfolio. For instance, some ETFs like Arnott's can provide a way to add a value and small tilt if positioned properly. Many other ETFs are just too far off the track to be useful to most investors.  I don't even like Jeremy Siegel's Wisdomtree funds too much as I see too much hype and promotion. I wonder if Jeremy is related to Bugsy?

Luckily, I'm not accidental consultant. PHEW! And I don't consider your remarks offensive. We might say you are a might passionate about your investing, but please keep in mind that when someone says index they may not actually be trying to convert you.

cheers,

 

Paul 

 

Hi Paul & Susan: I tend to agree with Susan's definition that IF some investment follows a simple list with weighting definitions, it is a passive investment. In that sense, Mr Arnott's fundamental index based funds are passive because they follow a list & a defined a weighting formula. The list may change periodically (like in a cap weighted fund, list also changes periodically). For cap weighted index based funds like SPY, the definition of cap weighting is inherent, but IMO that cap weighting does not restrict it as being the ONLY passive option. Paul & index fans seem to add this added requirement on top. Hope that helps ..... Anil

Anil wrote:
 For cap weighted index based funds like SPY, the definition of cap weighting is inherent, but IMO that cap weighting does not restrict it as being the ONLY passive option. Paul & index fans seem to add this added requirement on top.

I agree that cap weighted indexes are not the only passive option. All of the ETFs, except three new actively ones, are passively managed. However, if you want to accurately track the market or a segment of the market the requirement is a cap weighted index or cap weighted ETF.

 

Paul
 

ETF are a means to control capital gains and transparancy at a low cost, but you have to be selective of what you are trying to accomplish.  For foreign investing, sometimes, they can prove to be rewarding.  Country specific!  But if you are trying to create a portfolio only using ETF you will lose out.  Passive Vs selective stock selection in the key.  Large cap stocks no brainer.  Mid and Small cap sometimes, but usually you need a manager that has exstensive research.  Do not forget the commodities or real estate in devising a efficient frontier.  EFT's are not the end all in devising a portfolio.  You have to actively buy or sell for yourself!!!!

Let's use the S&P 500 as a model for a capitalization-weighted index.

.

The S&P 500 index was developed in the late 1950s. It superseded an earlier S&P index that had 90 stocks.

.

The change was made possible because of an increase in the computing power at the New York Stock Exchange (NYSE) and the American Stock Exchange (ASE). In the late 1950s, the NYSE and ASE computers became capable of tracking an index composed of 500 stocks throughout the day. The reason these computers could do this was because the index was capitalization-weighted: All the computers had to do was multiple the total outstanding shares for each stock by their current prices, sum the results, then divide that result by a divisor. Even the old IBM 360s that were prevalent at the time could do that as rapidly as the human operators could update the punch cards.

.

And so the capitalization-weighted index became a standard for indexing.

 

In the early 1970s Wells Fargo created a pool of stocks based on the S&P 500 index. Wells Fargo offered the pool (kind of like today's mutual funds) to institutional investors. Because the Wells Fargo pool was S&P 500 index based, it gave institutional investors an easy way to meet the "prudent man" and "legal list" criteria (and laws) of the time at a minimal cost. This further solidified capitalization-weighted indexing.

.

Jack Bogle picked up on Wells Fargo’s idea, and sold the concept to the general public. That planted the idea of capitalization-weighted indexing in the minds of average citizens/investors.

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Consider that, during the entire time that capitalization-weighted indexing has been sold as the “best” possible investment medium for both institutional and individual investors, all reputable business and finance schools have been teaching that another criteria actually determines the value (and ultimately the price) of stocks and other assets.

.

Starting with Graham & Dodd's Security Analysis in 1934, and James C. Bonbright's The Valuation of Property in 1937, every single reputable business and finance school has been teaching that free cash flow (i.e., ability of a business -- or any asset -- to provide a dividend or return to the owners) is what determines the value (and ultimately the price) of an asset.

.

Capitalization-weighted indexing and fundamental indexing are mutually exclusive: Either one believes that whatever stock or asset people are currently throwing the most money at is the stock or asset in which one should be invested (capitalization-weighted indexing); or one believes that in the long run free cash flow will determine the price of the stock or asset (free cash flow-based fundamental indexing).

.

Even though the idea that free cash flow (i.e., return to the owners of the asset) is an old, well-established valuation concept, converting that concept into an index is quite new. Needless to say, the capitalization-weighted indexing fraternity is fighting fundamental indexing tooth and nail.

.

I have no idea if the current fundamental indexes truly reflect the concept of free cash flow to the owners. However, I can say that anyone who disagrees with fundamental indexing (insofar as it represents free cash flow available to the owners) in general, is taking the position that what is being taught in every reputable business and finance school in the country (world?) since the 1930s is wrong.

 

Mike

I have no idea what happened to the formatting of my post. I had a blank line between paragraphs. I've tried to edit it three times to no avail. I hope you can read through the weird formatting Morningstar created and see my separate points.

 Mike

After applying Susan's excellent suggestion (see below) it looks much better!

Mike,

 

You are right on.  Fundametal metrics work most of the time(time Frame) Momentum trading short term.  PLASIDUABLE TIME FRAME FOREWARD LOOKING

I don't know what it is about this new software, but that sometimes happens to me, too.

Excellent, excellent post, Mike! I wish you'd write a book. This type of knowledge is acquired only if those who know share it with the rest of the world.

I have never really been that thrilled with cap-weighted indexes. Probably because it makes absolutely no sense to me. They're like a portfolio allocation gone amuck. How do you fix a portfolio allocation that's out of whack? By rebalancing it, by fixing the flat tire. It seems that that is what a fundamental index offers to the indexing world.

Now I'll show my total ignorance here, but I don't care. You don't learn if you don't ask. For Mike and Paul and anyone else who has something to share...

• Can you give examples of all of the different types of fundamental indexes now available to investors? Equal-weighted, dividend-oriented... what else?
• Who are the pioneers in offering fundamental indexes to investors? Powershares? iShares? Another possible, FirstTrust? WisdomTree and Rydex are more recent converts, I believe.
• Can you give us a link to an unbiased website or article that discusses the practical application of fundamental indexing more thoroughly?
• Is there a white paper that addresses the pros and cons of fundamental indexing?

It may sound hilarious, I also found it helpful to review the basics at Wikipedia.com.

Thanks, Mike --and thank you, too, Paul.

Regards,

Susan

P.S. I told you that I'd sound dumb, but how the heck do you learn anything if you don't just ASK?

Don't you just love this ad? I found it on the Research Affiliates website. I think a picture is worth 1,000 words but, unfortunately, it wouldn't let me copy'n paste it here.

Regards,

Susan

Mike; FYI

You are a little off on your computer history time line. The IBM 360 family of computers was first announced in 1964 and the first one to ship to a customer was in 1965. However, it is nice to see that someone besides me remembers those 80 column punched cards.

Gordon

Ohhhh, Mike, you are opening the ol' can-o-worms -- efficient markets.

I don't want to get into it, but you make is sound like the original tracking index was created because it was easiest. Actually Wells Fargo had a very hard time running that index. You can correct me if I'm wrong, but I think the index creators simply looked at the stock market profile and tried to copy it. The profile of the market is the result of where investors as a group have put their money. That's where the EMH comes in. If investors felt that the #100 stock is worth putting more money into, that stock would move up the list and the price would not make sense based on the fundamentals.

As you know, the EMH folks claim that the cap-weighted total stock market index is the most efficient way to invest.  I'm not going to claim that, and certainly there is a lot of validity in Grahams beliefs and many investors follow his ideas. However, those investors and fund managers buying on value are contributing to the overall market profile. But at the same time, so are the speculators. There is plently of historical evidence that value wins out about half the time and growth (driven mostly by speculation) wins half the time. Those who choose to invest in the total market just accept whatever the market does.

Most of the ETFs I've seen try to lean toward Graham's value ideas in one way or another, but they also increase the holdings in smaller stocks. When these things are done, the investor is implicitly saying that the market consensus about the value of a stock is wrong. 

Again, I'm not arguing that value investing is not a good way to invest, I'm just trying to explain.  There is also a lot of evidence that value stocks and small stocks provide a return premium over the market, so it would be reasonable to expect a fund or portfolio that invested this way to outperform the market in the long term. Indexers handle this by slice and dice which allows them to just add more value and more small cap funds. They also claim they can do this much cheaper than buying a fundamental index.

One thing we will find with many of the ETFs that are value and small tilted is that they have been created in a time period where value and especially small have been very productive. But small is volatile and outperformance is on, off. And it can be off for more than a few years. When that happens, a lot of ETFs are not going to look so attractive and the industry will put out growth tilted ETFs to capture investors money.   

Susan, I'm not fully up to speed on ETFs, but I must admit I do admire Rob Arnott's sensible approach. By the way, Arnott's personal family money is invested in index funds.

Far too many ETFs are simply trying to capture todays hot money and I don't even bother looking at them. And there is an awful lot of hype that wisdomtree keeps putting out which doesn't say much for content.

 

Paul