The Intelligent Investor (Rev Ed)
Benjamin Graham and Jason Zweig

“It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits.”

“Allocating at least 10% of your retirement assets to TIPS is intelligent.”

“The worse the future looks, the better it usually turns out to be.”

“The primary cause of failure is that investors pay too much attention to what the stock market is doing currently.”

“The key to rebalancing is having a predictable schedule”

“For most investors, intermediate bonds are the simplest choice, since they enable you to get out of the game of guessing what interest rates will do.”

“For most investors, bond funds beat individual bonds hands down.”

“If you had invested $1 in U.S. stocks in 1900 and spent all your dividends, your portfolio would have grown to $198 by 2000. But if you had reinvested all your dividends, your portfolio would have been worth $16,797.” (Stock indexes do not include dividends.)

“It is essential that (the intelligent investor) entrust himself only to firms of the highest reputation.”

If you find yourself trading more than twice a year–or spending more than an hour or two per month on your investments–then something has gone badly wrong.”

“If you started investing $100/month in September 1929, your money would have grown to $15,571 by August 1939. That’s the power of disciplined buying–even in the worst bear market of all time.”

“The knowledge of how little you can know about the future, coupled with the acceptance of your ignorance, is an investor’s most powerful weapon.”

“Alan Greenspan said on January 7, 1973: “It’s very rare that you can be as unqualifiedly bullish as you can now.” (1973 and 1974 turned out to be the worst years for the stock market since the Great Depression.)”

“A great company is not a great investment if you pay too much for the stock.”

The Intelligent Portfolio
Christopher Jones

“Sadly, our educational system has been woefully behind the curve in preparing people for the heavy new financial responsibilities of a self-directed investment world.”

“Be careful of how your advisor gets paid. Conflicts of interest can yield advice that is not in your best interest.”

“There are many ways to measure risk other than looking at just the volatility of returns.”

“A study of investor behavior by the research firm DALBAR found that market timers in stock mutual funds lost -3.29% per year on average relative to investors who pursued a consistent strategy.”

“Unlike a mutual fund, it is quite possible for a single stock to lose all its value by going bankrupt.”

“Never make the critical mistake of being too concentrated in your employer’s stock.”

“Fund expenses are like termites. They can quietly eat away at the returns of your investment without you even realizing there is a problem.”

“From the analysis of 22,472 mutual funds–only about one quarter of mutual funds were able to demonstrate performance that exceeded what you could achieve with a low-cost index fund.”

“Evaluate diversification at the household level, not at the individual account level.”

“If you own a home already, you probably have enough real estate in your household portfolio.”

“Asset allocation explains more than 90% of the variation in returns for most mutual funds.”

“You are virtually guaranteed to outperform more than two-thirds of the actively managed funds with low-cost index funds.”

“It is very expensive to guarantee that you will have a certain amount of money in the future, but if you can tolerate some uncertainty, you can likely fund your future goal with significantly less savings.”

“The only way to be more confident of reaching a financial goal is to invest more conservatively and save more.”

“All other things held equal, it will cost a woman more to fund her retirement than a man of the same age due to her longer expected lifespan.”

“As an investor, you want to be cautious about investing in a fund just prior to it making a distribution to shareholders.”

The Individual Guide to the Top Mutual Funds
American Association of Individual Investors

“The most important factor when diversifying a portfolio is selecting investments whose returns are not highly correlated.”

“Bond mutual funds are attractive to investors because they provide diversification and liquidity, which is not as readily attainable in direct bond investments.”

“The higher the turnover, the greater the brokerage costs incurred by the fund.”

“The market risk measure used for common stocks is beta; for bond funds, average maturity is used.”

“Dollar-cost averaging works especially well with more volatile portfolios.”

“Top Performance lists are dangerous.”

“The classic response of funds that focus on small stocks is to migrate investments to mid-cap and large stocks when they start to achieve a large asset base.”

“Don’t forget that almost all fund performance data is reported without adjusting for front-end or back-end loads.”

“One reason beyond low expense ratios that make index funds are tough to beat is that they are always 100% invested in the market.”

To be continued …. here.

Commissions have been one of the few drawbacks to ETFs because they can chew up accounts of investors who prefer to invest through dollar-cost averaging. This was once an area where mutual funds had an edge, but no more at Schwab and other brokerages who may follow suit (Preet wonders if this is what the Bank of Montreal — BMO — has in mind with its ETFs). So mutual-fund executives could be on the Maalox now. And so too might executives at ETF companies with no brokerage arms.

But how is it possible for Schwab to charge no commissions and MERs as low as 0.08%? In a previous post, I thought it would be possible for ETFs to get their MER costs down lower, even all the way to 0%, by using fees earned from lending out securities to cover operating costs. This seemed less fanciful a speculation when a few months later, as Preet noted in a blog post, some ETFs had emerged in Europe with 0% MERs.

So that would be my guess in this case. Schwab is diverting the revenues from its securities lending operations to cover off its operating costs. With sufficient volumes of business, they could still turn a profit while giving investors big breaks on fees.  This is what Tom Lydons of ETF Trends thinks it might be too.

Indeed, it’s conceivable, as competition heats up, for MERs on ETFs such as Schwab’s to move to the 0% mark. It may not happen overnight or not at all, but there is a potential. Also, one wonders if established ETF families like Barclays Global, which currently pocket 50% or more of the securities-lending fees for themselves, might now feel pressured to switch their cut toward lowering MERs. Could they even possibly pay investors to buy their ETFs — or otherwise reimburse their trading commissions?

I pointed out that several academic studies had found mutual-fund advisers added no value to the selection of funds (indeed, likely subtracted it). So why did ETFs need to be adjusted for trailer fees when doing comparisons with mutual funds? Reader John De Goey (a fee-only financial advisor) took this a little further. He noted:

“Call virtually any discount brokerage in Canada … you will find that they all require their investor clients to use A-Class funds. In other words, investors are obligated to pay the trailing commission on a product for advice that is neither received nor requested. This is scandalous! Imagine if Canadian Tire charged people for a muffler and installation if they simply bought a muffler! The Competition Bureau would step in.”

This arrangement further raises questions concerning the view that trailer fees are the cost of financial advice. In this context, it appears to be more part of the cost structure of the mutual fund company. No financial advice or service is provided to the buyer.

In the discussion of trailer fees in Part I, attention had also been drawn attention to a survey that found a minority of financial planners did financial plans for their clients – again raising questions about the value of services obtained through trailer fees. Since then I have come across a post by a financial advisor who paints an even bleaker picture. To quote:

“While many financial planners claim to do financial planning and provide holistic advice, very few actually provide comprehensive planning with written financial plans, as taught in the CFP courses.”

Product integrity

The ETF vs. mutual-fund debate often overlooks important side issues, notably the stability of the products. After an investor purchases a mutual fund or ETF, it may change in various ways. But the changes for ETFs appear to be on a much smaller scale compared to mutual funds. Examples of the changes affecting mutual funds  include:

• turnover in portfolio managers – many investors may buy into a fund because of a well-regarded manager only to see the star later jump ship for another fund, leaving unitholders faced with the decision to stay with a less skilled manager or redeem and pay a rear-end load fee as high as 5%

• changes in the manager’s investing style (style drift) – portfolio managers may stay put but then start trying investment approaches different from what unitholders expected, increasing, for example, the proportion of risky securities in an attempt to juice returns

• termination or merging of a fund with another fund – which again presents unitholders with a disruption in their investing plans

Tax efficiency

While some ETFs may distribute taxable capital gains to unitholders, the incidences are more the exception to rule. Mutual funds, on the other hand, tend to distribute capital gains as a rule rather than the exception. At least that is what the averages would seem to indicate: for example, David Swensen’s book Unconventional Success shows that the average annual distribution of S&P 500 index mutual funds was 1.8% of assets from 1993 to 2002, compared to 0.01% for the SPDR S&P 500 (SPY)

Flexibility

The more one can tailor an investment vehicle to their needs, the more one can maximize their utility; having extra options is a valuable trait to many investors. Some examples:

• ETFs can be bought and sold at a known price throughout the trading day while mutual funds are bought and sold at the price prevailing at the end of the day.

• ETFs can be purchased on margin, sold short, and combined with ETF options to create covered trades and other hedging strategies

Diversification

Mutual-fund defenders say Canadian equity ETFs i) expose investors to the risk of stocks growing to a large weighting in the index, (Nortel effect) and in the case of Canadian broad-market indexes, ii) leave investors weighted toward financial and resource stocks. Let’s deal with these two points in turn:

• as for the “Nortel effect,” Canadian ETFs are no longer exposed to such risk; the fundamental ETFs offered by Claymore in Canada are not market-cap weighted and ETF families using market-cap weighting now limit the weights of individual stocks so that none can have the influence Nortel once had.

• as for achieving a portfolio less weighted toward energy and financial stocks, that would seem to be an asset allocation choice perhaps better left to the individual investor (they can tailor exposures to their preferences better than an equity mutual fund can); ETF investors typically achieve their desired level of diversification through holding a portfolio of ETFs tracking a variety of asset classes such as small caps, U.S. stocks, and international stocks.

Performance

Mutual fund apologists say mutual funds: i) offer the potential to outperform the market, ii) show periods of outperformance, and iii) have relatively better performance in sectors like small caps and U.S. stocks. Let’s deal with these three points in turn.

• as for the potential to outperform indexes, some mutual funds may be able to do so (studies show less than 5% over the long run) — but identifying them ahead of time is hit and miss; odds are that the investor will end up an underperforming fund

• as for periods of outperformance, using more extensive time sampling and adjustments for survivorship and other biases, virtually all mutual-fund-performance studies published in peer-reviewed journals indicate “that mutual fund managers on average underperform their risk-adjusted benchmarks,” to quote Professor Richard Deaves in his book, What Kind of Investor are You? (Deaves own study of the Canadian stock market found that equity mutual funds on average fell short of their indexes by more than 1% a year over the period 1988 to 1998)

• as for relatively better performance in sectors like small caps and U.S. stocks, the odds of picking an outperforming fund may be higher but then again, it is hard to identify ahead of time which funds will do so (or at least avoid management changes, style drift, closure, etc.)

Cost of advice embedded in mutual funds:

 The mutual fund vs. ETF debate often overlooks the fact – as the MacKenzie Financial piece points out (and I have too) — that the cost of most mutual funds contains the cost of financial advice (i.e. trailer fees paid to financial advisors), so comparing the costs of ETFs to mutual funds is comparing apples to oranges. Fair enough. But are investors getting service commensurate to the fees? And, do advisers put their clients in the best funds or the funds that pay the best trailer fees?

•  A survey sponsored by the Financial Planners Standards Council (FPSC) showed only 40% of certified financial planners did financial plans for “most” of their clients in 2006, down from 53% in 2002

•  At least five studies from the academic community conclude financial advisers don’t add value to the selection of mutual funds – indeed, it appears they subtract value (a grey area is ancillary services like tax and estate planning)

Portfolio turnover costs and sales loads:

The mutual fund vs. ETF debate often focuses just on MERs and commissions to buy or sell ETFs – as MacKenzie Financial does. Other expenses to consider are portfolio turnover costs and front- or rear-end sales loads. The latter can add another 1.5% to the average annual MER of 2.5% in Canada for an equity mutual fund, bringing the total “all-in” annual cost to 4%

•  John Bogle in The Little Book of Common Sense Investing estimates the cost of portfolio turnover of the average equity mutual fund adds 1% in annual costs (cost of broker fees, bid-ask spreads, and market impact costs)

•  Front- or rear-end loads can add up to 5% to costs, which for a 10-year holding period, averages out to 0.5% annually (to use John Bogle’s figure); ETFs do have brokerage fees but for order sizes over $3,000, they generally average less than 1% to buy or sell

Bond and money market funds:

The mutual fund vs. ETF debate often just focuses on stocks funds – and so does the MacKenzie Financial article. There are also money market and bond funds. And they are “where mutual funds fees really hurt,” as Rob Carrick says in his book, How to Pay Less and Keep More for Yourself. Money market funds charge MERs that average half or more the interest earned, while bond funds MERs average close to 1.5% when yields currently range 2% to 4.5%. One could also add balanced mutual funds. In non-equity funds, the comparison of long run returns more clearly favor ETFs.

Heterogeneity in product classes and investors:

The mutual-fund vs. ETF debate tends to overlook the high level of heterogeneity in product classes and investors

•  Not all ETFs are good — for example, sector and leveraged ETFs may raise questions.

•  Not all mutual funds are bad – for example, mutual-fund families without marketing and advertising overheads can keep MERs low while providing advice through in-house reps; other useful mutual fund categories may be corporate class (tax advantages) and F-class (no trailer fees); closet-indexing mutual funds would definitely not be on the good list.

•  Since mutual funds reinvest dividends and allow regular deposits without commissions, they could be more cost effective for the small investor with regular, small amounts to contribute

•  Some investors don’t have the time or desire to manage their personal finances so would be not be deterred by extra costs

To be continued ….

• ETFs passively buy and hold the basket of stocks in an index, so there is low turnover in portfolios and hence low realization of capital gains
• ETFs don’t have to sell securities to redeem units (unitholders can simply sell their units on the stock exchange to other investors)
• redemption requests from authorized participants (who arbitrage differences in net asset value and market price) are met by transferring stocks (not a taxable transaction)
• ETFs can give the authorized participants stocks with the highest unrealized gains in their portfolio, thereby reducing the potential for distributing gains to unitholders

This greater tax efficiency is said to be one reason why ETF sales continued to grow during the bear market while mutual funds were experiencing heavy redemptions. Many mutual fund holders were facing hefty capital-gains distributions and decided to avoid them by selling their funds and buying ETFs tracking the same market.

Still, ETFs have been known on occasion to distribute capital gains to their unitholders. For example, the iShares CDN Tech Sector Index ETF (XIT) last year distributed a capital gain of $0.80 per unit, or about 20% of the price. What then are the risk factors? What ETFs are more likely to surprise unitholders with hefty capital-gains distributions? Here are some considerations:

1. ETFs tracking indexes with a lot of turnover have more potential for selling stocks with capital gains.

2. Newer ETFs pass along capital gains more than older ETFs because they tend to track smaller slices of the market and have fewer liquid stocks (so there is greater volatility in prices and thus greater potential for bigger and/or more frequent capital gains/losses).

3. Inverse and leveraged ETFs (particularly smaller ones) use derivatives (like options and swaps), which don’t lend themselves well to “in-kind” redemptions (so if a market maker delivers a block of units to the fund company, the company must sell some of their derivatives to raise cash to pay the market maker).

4. Some ETFs with substantial capital-gains distributions give their unitholders several days to sell before the date of record and thereby avoid the distributions (like Ryder’s).

5. Some ETFs with substantial capital-gains distributions don’t give their unitholders any time to sell before the date of record (like ProShares).

6. During bullish markets, ETFs will tend to have more capital-gains distributions because turnover in index escalates due to mergers, acquisitions and spin-offs – plus, indexes with caps on the size of individual stock holdings are often compelled to pare back positions when they bump up against their caps.

7. Established, broad-based ETFs tend to have very few distributions and fare much better than index mutual funds.

8. Changes in an ETF’s mandate and the movement of stocks between small, mid, and large cap strata can trigger distributions.

Sounds like fun! But bear in mind such competitions aren’t to be played the same way one should invest an actual amount of money. For one thing, you shouldn’t seek to own stocks for their short-run performance. It’s the long run where returns are less exposed to random fluctuations and lucky outcomes.

Nevertheless, Professor Moshe Milevsky won a Globe and Mail stock picking contest three years in a row and wrote a paper on how to win contests like these. What you do, he said, is pick from the most volatile investments.

This advice is somewhat qualified for those wanting to win the grand prize because it is based on risk-adjusted returns. But for the other prizes (see below), that is the way to go (and you still have a shot at the grand prize).

As well, the Prof would recommend, as I understand it, a contrary stance. Most participants will likely be assuming current trends continue, so it will be easier to differentiate your portfolio by going against the grain. 

Diversification is also a handicap to winning contests like these: the more narrowly focused the portfolio, the greater the likelihood of an extreme performance reading (up or down).

Putting things together, could the winning portfolio feature a prominently weighted Claymore NGX Canadian Natural Gas Index ETF? It has the volatility and is falling while everthing else is rising. But the oversupply problem in gas is quite severe and the timing could be off …

Contest details:

No purchase is required. Submissions have to be entered by Monday August 17th, 2009 at 9:30am ET. The prizes are:

• a grand prize of $1,000 cash (or a $1,500 donation to a Canadian registered charity of the winner’s choice) will be awarded to the competitor with the “best total risk adjusted performance”
• a “Wii Fit Bundle” (value of $453.99 Canadian) will be awarded to the competitor with the best total return performance
• an iTunes gift certificate, Starbucks gift card, or Claymore promotional merchandise (approximate retail value of $20) for those with the best weekly return performance.

To help with ETF picks, participants can use Claymore’s Portfolio Index Allocator Tool.

Risk budgeting is employed by “sophisticated pension plans seeking to maximize their potential returns.” Instead of using a fixed asset mix, they use “constant risk rebalancing” to manage asset allocations.

“Traditional money management often ignores the fact that markets are sometimes more risky than at other times,” notes Yamada. During the tech bubble, those investors guided by a fixed asset mix were trimming equity weights back to a preset allocation such as 60% stocks and 40% bonds. But those guided by risk budgeting would be cutting back on stocks even more and taking stock allocations below 60%.

PŮR’s risk budgeting approach uses volatility as an indicator to make “subtle shifts in the portfolio.” Volatility may be defined as the 252-day moving average of standard deviations of daily changes in the S&P 500 Index. The CBOE Volatility Index (VIX) may also be OK to use “in a pinch,” but has greater variation.

“Before the “tech wreck” the technology sector was 8% of the S&P 500 Index and at the peak it was over 30%! At the same time, the 252-day moving average of the S&P 500 volatility moved from about 12.5 to over 15,” says Yamada.

“When volatility, as defined above, is falling or stable, a more positive market is suggested. More importantly, when volatility is rising, assuming less portfolio risk is indicated.”

Adds Yamada: “We think timing the market is generally a ‘mugs’ game. It’s expensive and hard to do consistently. However, as a form of insuring a portfolio against big negative downdrafts, volatility is an interesting indicator.”

His firm is also investigating use of the ‘VIX ETFs’ (VXZ and VXX) in this context too.

You’ll find it on the website of PUR Investing Inc., a Canadian investment counseling firm that designs tailored ETF portfolios for investors. One of the principals is Mark Yamada, who has had over 30 years of investment experience as an analyst, portfolio manager and chief investment officer (at Manulife Financial, Sun Life Investment Management Co., Guardian Capital Advisors LP, etc.).

The screener, called PŮR CONSTRUCTS Screener, filters ETFs by five factors: 1) diversification, 2) cost, 3) liquidity, 4) tax efficiency, and 5) tracking error. It’s fairly easy to use: just move the cursors up or down on one of more of the five factors to see which are the best ETFs for your preferences.

The website also has other tools.

Q. Can you give readers a bit of a background on yourself?

A. I have approximately 25 years of experience in asset management – all of it in the realm of indexed and quantitative investing, including ETFs. I was with Barclays Global Investors Canada Limited for 14 years, joining them in their very early days to establish the investment side of the business. For the last four and a half years I served as President and CEO….

When BGI decided to move its investment management operations to San Francisco I elected to remain in Canada. I am extremely proud to be with BMO – the only bank that is taking a leadership role in Canada by offering ETFs to Canadian investors.

Q. Why another family of ETFs? 

A. BMO has a long and strong tradition in providing investment solutions for all of the client segments that we serve … we see BMO ETFs as another means of ensuring that our customers have access to an even broader range of solutions that meet their evolving investment and savings needs.

ETFs are consistent and resonate with BMO’s vision to “make money make sense” by providing products that are very transparent and simple to understand for the retail investor. At the same time ETFs can be the building blocks for comprehensive portfolio construction for sophisticated HNW and institutional customers ….

Competition is good for the industry – it will increase awareness and education regarding ETFs among clients and ultimately works to their benefit.

Q. How can BMO succeed in the ETF space in light of TD Bank’s experience a few years ago?

A. We will follow a two pronged strategy to ensure success:

Firstly, we intend to give investors comprehensive and efficient home-grown solutions for their ever evolving investment needs. With our four BMO ETFs that are already launched and the three more that are coming in July we are providing investors with a broad and robust initial offering. And we plan to add to these significantly in the coming months so that as investors need change we are always there for them. (TD only had four before it decided to pull back from market).

Secondly, BMO will put significant educational and sales support in ensuring that the marketplace and investors are fully aware of all the benefits that BMO ETFs bring to their portfolios. In this we will work to support investment advisors and end-clients alike.

Q. Where are the growth areas in the ETF industry?

A. ETFs are experiencing broad based growth – across asset classes and across geographies.

• World wide the growth has been incredible with assets increasing by 65% over the last three years.

• In Canada, the growth was 8% in 2008 to over $19B, which is remarkable given that the majority of market indexes plummeted more than 30% and ETF AUM was up $7.3B compared to net redemptions of $10.5B for mutual funds.

• This is a market that is forecasted to grow to $105B by 2016 in Canada and a product that our clients have expressed a need and desire for.

A lot of smart persons spend their working days conceptualizing and strategizing about lending out the securities that investment funds hold for their unit holders. How to do it better, how to do more, how to increase yield ….

To get an idea of who is involved and what they are talking about these days, check out the agenda of the security-lending conference to be held on June 15-16 in New York City.

There are also blogs on securities lending. Stock Lending Today is written by one of the consultants vying for a piece of the business. It’s a good reference for learning more about the industry and staying abreast with developments.

The industry is becoming increasingly organized. In April, a group of Canadian organizations with interests in securities lending announced the formation of “the Canadian Securities Lending Association (CASLA) to advocate on behalf of all securities-lending market participants in Canada.” And, as they say:

“CASLA seeks to enhance the public’s understanding of securities lending, encourage the adoption of best practices and work with regulators and other industry associations to ensure an efficient and secure marketplace.”

If industry members are the only ones making their voices heard in the public realm, then fund holders will likely continue to get what appears to be the short end of the stick.

1. BMO Dow Jones Canada Titans 60 Index ETF tracks the float-adjusted, market-cap-weighted Dow Jones Canada Titans 60 Index. The top ten stocks are the same as those in the iShares CDN Large-Cap 60 ETF, with slight variations in relative weights.

2. BMO Canadian Government Bond Index ETF tracks the Citigroup Canadian Government Bond Index. It has 28 holdings of Government of Canada bonds whereas the iShares CDN Government Bond Index ETF has 86 holdings of federal, provincial, municipal government bonds.

3. BMO Dow Jones Diamonds Index ETF tracks the Dow Jones Industrial Average, a “price-weighted” index. It has 30 holdings, representing the largest U.S. companies in a range of industries except transport and utilities. It hedged back into Canadian dollars. Barclays has the iShares CDN S&P 500 Index ETF.

4. BMO U.S. Equity Index ETF tracks the float-adjusted, market-cap-weighted Dow Jones U.S. Large-Cap Index hedged back into Canadian dollars. It has 251 holdings, representing the largest and most liquid of public companies in the United States. Barclays’ other ETF for U.S. stocks is the iShares CDN Russell 2000 Index.

In short, the main difference from Barclays’ ETFs appears to be: the BMO government-bond ETF is more conservative and the two U.S. equity ETFs provide exposure to different stocks (with one having a different weighting scheme that gives greater weight to higher priced stocks). Another observation: it’s possible that BMO’s two U.S. equity ETFs may have tracking errors of 1% to 1.5% annually on top of the MERs, similar to iShares U.S.-equity ETFs.

Rudy Luukko of Morningstar Canada notes: “Because of its large trading volume, however, the iShares ETF will enjoy the advantage of tighter bid-ask spreads than its upstart BMO competitor.”

Three other BMO ETFs are to be listed at a later date: BMO International Equity Index (ex-North America), BMO Emerging Markets Index, and BMO Global Infrastructure Index Dow. 

This is already the case, apparently. As reader FinanceProf mentions in the comments section of the June 2 post, Barclays takes 50% of the lending fees flowing from iShares portfolios, but the 50% left over for fund holders is still larger than the revenues Vanguard generates (after covering just its costs from securities lending).

In Vanguard’s case, the incentive of wanting to be the lowest cost supplier seems to be sufficient. Maybe fund holders should be happy with that scenario even though it may not generate as much revenue from securities lending. When lending agents are allowed to take a sizable cut of generated revenues, there is a risk they may push the envelope too far and lower lending standards (like mortgage lenders did in the run-up to the financial crisis of 2008). A few years ago, for example, borrowers of securities had to put up government bonds as collateral, but these days, riskier assets such as stocks and corporate bonds are also accepted.

Even if a fund were to take a large cut like Barclays does, there still is the question of how much of an incentive is enough to maximize revenues. Is 50% the “commission” that yields the optimal amount for fund holders? Couldn’t an unaffiliated agent, operating at arm’s length from iShares, generate the same amount of business with a smaller incentive?

One was how the lending fees are split between fund investors and fund managers. It appears many funds do not fully, or even partly, rebate the income to fund holders in the form of lower fees or higher returns — even though the securities are being held in trust for fund holders.

Zweig said T. Rowe Price Group and Vanguard Group fully rebate lending fees (after expenses) to fund holders. He named some smaller funds that don’t. The elephant in the room he did not mention in this regard is Barclays and its iShares family of ETFs (presently on the auction block).

They take 50% of the security-lending revenues, which are becoming quite large these days. Barclays’ accounts indicate that the British bank earned £389 million from the practice last year on all its funds under management (of which iShares represents about one-fifth).

Barclays gets a 50% cut because it’s specified in the contract that the board of directors at iShares gave them to manage the lending operations on behalf of unit holders. Couldn’t the board have found managers that would be willing to perform the lending function at a fraction of the fees charged by Barclays?

Indeed, this makes one wonder if the iShares board really is functioning in the interests of fund holders. If the lending function were transferred to an arm’s length party, wouldn’t it be possible to allot more of the lending fees to substantially lowering management expense ratios?

Actually, at present growth rates in securities lending, it’s not inconceivable that ETFs could some day be offered to investors without any management fees – and/or with better performance than the indexes they track. Image that: buying the iShares S&P 500 Index Fund (IVV) with a 0% MER and earning a net return that is a percentage or two greater than the S&P 500. What a concept.

I’ll have more to say on this topic in a column scheduled to appear this Thursday after 4PM (EST) on the home page of Canadian Business (and later, in the column archives). Other issues pertain to the use of the borrowed securities for short selling and the risks in lending securities.

Inverse ETFs use swaps and futures; swaps predominate in inverse ETFs because of their flexibility (don’t require standard deposits or times to expiration). But swaps are purchased over the counter from banks such as Goldman Sachs and Morgan Stanley — and thus come with counterparty risk. Many swaps are not subject to mark-to-market accounting and margin maintenance requirements.

Probably the most serious drawback of inverse ETFs is the significant tracking error due to the constant-leverage trap (arising from the inverse ETF’s objective of returning the opposite of the index on a daily basis). The table at the end of this post shows a representative cross section of tracking errors calculated by Elston and Choi for 2008.

In the table, DOG, an inverse ETF tracking the Dow Jones Industrial Average (DJIA), underperformed its implied return by over 3%. DXD, a double-inverse ETF for the DJIA, underperformed by 22%. However, the biggest misses were in the sector-based inverse ETFs as highlighted by the ETFs for real estate (SRS) and China (FXP). With their volatility, they recorded declines even though their implied return was over 85%.

Yet another disadvantage: inverse ETFs are unable to minimize the distribution of capital gains to the same extent other ETFs do, so investors with taxable accounts can experience a lower after-tax return.  Inverse ETFs don’t passively track baskets of stocks; they have to buy and sell derivatives daily. And in the U.S., the tax rate on short-term gains is higher than on long-term gains. In 2008, a group of leveraged inverse funds made capital-gain distributions ranging from 12% to 86% of their assets.

One advantage of inverse ETFs is avoidance of the practical problems associated with short selling. They are: i) the broker may not find the shares, ii) the broker has the right to terminate the short position anytime, iii) the accounting for short sales, especially for tax purposes, may “become distinctly more difficult or time consuming.”

Inverse ETFs enable short selling in registered retirement savings accounts. Many see this as another advantage. Others might not agree. Inverse ETFs are financial innovations that overcome regulatory prohibitions against short selling within retirement funds. Such regulations presumably exist to protect investors from taking excessive risks with savings that will be needed in old age.

In the conclusion to the paper, Elston and Choi suggest shorting the long versions of ETFs rather than going long on their inverse counterparts. This strategy could have even greater results when used in lieu of double-inverse ETFs for volatile sectors. There should be an extra boost from the tracking error. Of course, this strategy would have to be confined to taxable investment accounts (and one wonders if this would qualify the recommendation of Elston and Choi).

Preet Banerjee has a related post on shorting ETFs. 

When you are not too big to fail, you are … well, allowed to fail. The Federal Deposit Insurance Corp. closes your doors. So the list of failed regional banks keeps growing. According to the FDIC, there were three banks shuttered in 2007, another 25 in 2008, and 32 more in just the first 18 weeks of 2009.

As the list gets longer, warns the May 20 issue of Standard and Poor’s The Outlook, it could have negative consequences for investors in smaller banks — specifically, holders of exchange-traded funds such as the iShares Dow Jones US Regional Banks (IAT) and SPDR KBW Regional Banking (KRE).

The site has summaries of Canadian/U.S. market activity, quotes/charts, news feeds, research tools (e.g. stock screeners, calculators), and company rankings. Most of the site’s content consists of data collected from TMX Group’s trading exchanges or licensed material from other sources.

It also has a section on exchange traded funds (ETFs), which was recently expanded to become more like a portal. Sections cover education, ETF listings, news, and so on.

I can see myself coming back on occasion to TMXmoney.com to check the list of new ETFs, ETF market stats, and reference sections like the one on ETF options. What might get me to come back a little more regularly is if there was more unique content, such as a few blogs or articles on financial topics.

So far the decision to rebalance aggressively from 40%/60% to  60%/40%  stocks and bonds is paying off. But we shall see what ultimately unfolds as 2009 wears on.

The quarterly gain in the OMP reflects a 9% appreciation in the iShares S&P/TSX 60 Index Fund and a breakeven return on the iShares Canadian Bond Index Fund.

For more details on the OMP, check out the December 18 article on the last rebalancing. The OMP was created in early 2003 and has been rebalanced annually since. Based on just two exchange-traded funds, it follows the KISS principle when it comes to investing. The average annual gain since inception is close to 7.5%.

Blogger Canadian Financial DIY fears this may be the case – perhaps less so in the U.S. where there are several competing, low-cost offerings but more so in Canada where the choices are limited.

The sale appears to be the usual leveraged buyout. CVC Capital is putting up just $1.05 billion of the purchase price with Barclays itself providing $3.1 billion of debt financing to CVC Capital. Will CVC Capital now be squeezing iShares to wring out as much profit as possible to meet debt charges? Their website would have us believe that they won’t try and extract every cent:

“CVC focuses on building businesses over the long-term, typically holding investments for five years or more …. CVC believes that the effective ownership and management of a company creates benefits for all stakeholders, from employees to customers, suppliers to shareholders and the wider community …. “

The buyout aside, do Canadian investors in iShares have another thing to concern them?  On April 1, Barclays Global Investors Services Canada Limited resigned its membership in the Investment Industry Regulatory Organization of Canada, the Canadian regulator responsible for investor protection when it comes to overseeing investment dealers and investment funds.

Update: I’m told by Som Seif, CEO of Claymore Investments that “IIROC really doesn’t have any regulatory impact on us or iShares. They regulate market trading organizations. There is really no reason for iShares to be a member.”

Update 2: Barclays says: “Barclays Global Investors Services Canada Limited is anentity separate from Barclays Global Investors Canada Limited, the manager of the iShares Funds. BGISCL had no involvement in the management of the iShares funds and, therefore, would not have impact on the sale of iShares to CVC Capital Partners. BGISCL was the institutional transition management sevices business which is now being supported through our affiliates, and hence membership in IIROC was no longer required. Investors in the iShares Funds need not be concerned with, nor will they be affected by, this membership resignation.”

Further to this news, the bank announced in a statement put out today, March 30, that it would not be participating in HM Treasury’s Asset Protection Scheme. “In making our judgement about the Asset Protection Scheme, we have looked carefully at the economics of participation, and we have talked to many investors,” said John Varley, Group Chief Executive, Barclays. “This has led us to today’s decision.”

The bank confirmed that the sale of its iShares exchange-traded-funds division was progressing.