Inflation in the 21st Century

Thursday, March 24th, 2011

March 18, 2011

by dshort.com

My monthly update Inside the Consumer Price Index identifies the components of the Consumer Price Index, documents their relative weights, and uses line charts to show the cumulative percentage change of each since 2000.

In this post I’m using a bar chart to illustrate the relative change over the same time frame. The table below documents the current weights assigned by the Bureau of Labor Statistics (BLS) to the eight components of CPI. I’ve also included the weights of the two aggregate categories — Food (ex alcoholic beverages) and Energy — that are excluded from CPI to determine the Core CPI. (Note: CPI is sometimes referred to as “Headline CPI” to distinguish it from the Core variety.)

The bar chart below shows the relative change for each component and the two special aggregates. I’ve also added College Tuition & Fees, a subcomponent of Education and Communication, because of its significant impact on households with college expenses. Incidentally, the BLS assigns a mere 1.5% weight to this subcomponent of CPI. But for households planning for college expenses, the impact of inflation is dramatic.

Click for a larger image
The Inflation Controversy

The table and chart above help to explain why inflation is such a controversial topic. If your household mirrors the expense ratios of the CPI weightings, then the monthly CPI reports may seem reasonably accurate. However, households on tight budgets will be highly sensitive to the more volatile components of CPI — food and especially energy expenses. Also, for households with greater exposures to energy costs (especially gasoline), medical expenses, or college bills than the BLS weightings, the CPI data will definitely understate your experience.

Copyright © dshort.com

Tags: Alcoholic Beverages, Bureau Of Labor Statistics, College Bills, College Expenses, Components Of The Consumer Price Index, Consumer Price Index, Core Cpi, Cpi Data, Cpi Reports, Cumulative Percentage Change, energy, Energy Expenses, Expense Ratios, Headline Cpi, Index Documents, Line Charts, Relative Change, Relative Weights, Subcomponent, Tight Budgets, Volatile Components
Posted in Markets | Comments Off

ETFs Better Than Mutual Funds For Long-Term Investors

Sunday, June 13th, 2010

This article is a guest contribution by Matt Hougan, IndexUniverse.com.

John Bogle is wrong: Exchange-traded funds are actually the best available tool for long-term investors. Better, by far, than mutual funds.

I had this realization the other day when I was speaking about ETFs at a symposium organized by Vanguard. Anytime I put Vanguard and ETFs together, I’m reminded of the fact that Bogle, Vanguard’s founder, dislikes ETFs with a passion rarely seen in the indexing community.

A year ago, Bogle presented data at our annual Journal of Indexes board meeting showing that the average dollar invested in ETFs dramatically underperformed the ETF itself. In other words, investors had a tendency to buy high and sell low.

Bogle’s argument was built on imprecise data, but I’m not going to reopen that. For purposes of this blog, I’m less concerned with the experience of the average investor than the experience of investors who use ETFs correctly. And for those investors, there’s no question: ETFs aren’t just equivalent to mutual funds, they’re qualitatively better.

Usually, when people make this argument, they focus on the fact that ETFs are, by and large, cheaper than mutual funds. While true in general, it’s almost irrelevant. Some institutional mutual funds have lower expense ratios than any ETF. Also, ETF investors bear additional costs in terms of commissions and bid/ask spreads, which mutual fund investors don’t pay.

On costs alone, it’s a tossup.

Where ETFs truly excel—where they are definitively superior to mutual funds—is on fairness.

When you buy a mutual fund, you’re exposed to the actions of others. For instance, if you buy shares in the Growth Fund of America, and then half of the investors in the fund decide to redeem out of their positions, you will bear the brunt of the trading costs as the fund sells stocks to meet those redemptions. If any capital gains are incurred, you will pay those gains, even though you didn’t sell a share and had no intention of exiting your position.

If, on the other hand, no one sells, but another $10 billion in investor cash comes into the fund, you have to pay your share of the costs of putting that money to work: the commissions, the trading spreads, the market impact, etc.

With ETFs, the only thing that matters is you. Outside of a small number of bond funds and a few alternative asset products—such as Vanguard’s ETFs, which share classes of broader mutual funds— existing investors are completely shielded from the actions of others either entering or exiting the ETF. No paying for other people’s commissions, no paying for other people’s market impact and, by and large, no capital-gains distributions driven by the actions of others.

Your investment return and tax profile are driven by your actions, and that’s it.

This may seem like a minor detail, but if you’re investing for 10 or 20 years, those details add up.

I understand Bogle’s concerns about ETFs. Too many people trade them way too often, racking up big costs and they often shoot themselves in the foot trying to time the market.

But the beauty of the ETF structure is that if you’re a long-term investor, none of that matters. It’s just noise.

For the long-term investor, ETFs are the fairer investment, and they should generally deliver stronger after-tax returns.

The low, low costs don’t hurt either.

Copyright (c) IndexUniverse.com

Tags: Board Meeting, Brunt, Capital Gains, Commissions, ETF, ETFs, Exchange Traded Funds, Expense Ratios, Fairness, Hougan, Imprecise Data, Indexes, Indexuniverse, Institutional Mutual Funds, John Bogle, Mutual Fund Investors, Realization, Redemptions, T Pay, Term Investors, Vanguard
Posted in Bonds, ETFs, Markets | Comments Off

Ten Common Mistakes Every ETF Investor Should Avoid

Friday, April 23rd, 2010

Email this article | Print this article

This article is a guest contribution by Michael Johnston, ETF Database, etfdb.com.

ETFs have experienced widespread adoption from investors around the world in part because of their simplicity. Near total transparency, intraday trading, and a (generally) more straightforward tax situation all make ETFs appealing to everyone from buy-and-holders to active individual and institutional investors. While ETFs offer numerous advantages over traditional actively-managed mutual funds and individual stocks, they aren’t foolproof, and there are plenty of opportunities to make mistakes while investing in ETFs. Below, we profile ten common but easily avoidable mistakes made by ETF investors:

Mistake #1: Blindly Using Market Orders

The liquidity of ETFs ultimately depends on the liquidity of the underlying securities. So an investor looking to establish a big position in a thinly-traded ETF that invests in blue chip stocks would be able to do so at or very near to NAV. But that doesn’t mean that limit orders are unnecessary when trading ETFs, regardless of the apparent liquidity of a fund. Putting in a market order on a thinly-traded ETF may result in the order being executed at a big premium or discount before the Authorized Participant (the primary arbitrage mechanism in place to keep market prices near the NAV) is able to step in and create additional shares. Moreover, the readily available bid/ask numbers won’t always reflect the true depth of the market for an ETF, since some market participants are hesitant to show their entire hand. So using a limit order may allow investors to flush out additional buyers or sellers of a particular security. Regardless of the trading volume of an ETF, the use of market orders creates the potential to get burned and put yourself in an early hole.

Mistake #2: Ignoring Expense Ratios

ETFs have become so popular in part because of the competitive expense ratios charged relative to traditional actively-managed mutual funds. But the range of expense ratios charged by exchange-traded products is wide enough to drive a truck through, ranging from 7 basis points to well above 1.0% (see the cheapest and most expensive ETFs). Generally speaking, the more complex or granular the exposure, the higher the expense ratio. So comparing the fees charged by an S&P 500 ETF to those of an emerging markets ETF isn’t exactly fair. ETF selections shouldn’t be made on the basis of expenses alone, but fees should definitely be part of the equation. For more active traders with relatively short holding periods, the impact of a few basis points may be minimal. But for buy-and-holders, the “tyranny of compounded costs” can eat into bottom lines. While expense ratios for similar ETFs will generally be comparable, there are some surprisingly large gaps between nearly identical products. For investors looking to minimize expenses, the switch from mutual funds to ETFs is a good start. But for those who want to really cut costs, comparing expense ratios is the next step, and can create some surprisingly large savings (an easy 20 basis points in this example).

Mistake #3: Liquidity Screens

When narrowing the universe of nearly 1,000 ETFs down to find a particular fund, one of the first screens run by a lot of advisors and individual investors filters by liquidity. There are a lot of different rules of thumb thrown around for determining “sufficient” liquidity; some require average daily trading volume of 25,000 shares or $2 million in notional volume. The potential to get burned by running out a market order representing a significant portion of (or even a multiple of) daily volume is very real. But eliminating from consideration any ETF that doesn’t pass a “liquidity screen” can cut out some quality products that may be well-suited for accomplishing a certain goal. Again, investors must be careful about trading low-volume ETFs, but there are several cheap and easy ways to establish or liquidate a position without paying a huge spread. The use of limit orders goes a long way to narrow spreads for smaller trades. For larger orders, there a number of firms, such as Street One Financial and WallachBeth, that specialize in facilitating efficient trades in low-volume securities. Liquidity screens seem like a good way to avoid the potential pitfalls of getting stuck in an illiquid asset, but these dangers are often overblown. Cutting down the universe of potential ETFs based on assets or trading volume is potentially a much bigger mistake.

Mistake #4: Judging A Book By Its Cover

Generally, the name of an ETF gives investors a pretty good idea of the exposure offered. The S&P 500 SPDR (SPY) tracks exactly what you’d expect. But making assumptions about a risk/return profile based on an ETF’s nametag can –surprise, surprise–have some disastrous consequences. It’s frightening to imagine, but there is no shortage of horror stories of advisors who bought UNG for client portfolios thinking they were gaining exposure to spot natural gas prices. And there are those who think the underlying assets of USO are barrels of crude oil. It should go without saying that you can’t judge an ETF by its name, anecdotal evidence suggests that many investors and advisors do. Understanding the underlying holdings of an ETF is particularly important in the commodity space (see What Every Investor Should Know About Commodity ETFs). Be sure to take a quick look at the underlying holdings before purchasing an ETF. The assets that make up an ETF–and will determine its returns–won’t always be what you expect.

Mistake #5: Cap-Weighted Blinders

Investors are creatures of habit, and they tend to stick with what they know. The majority of equity ETFs available to U.S. investors are based on market cap-weighted indexes that determine the weighting given to an individual stock based on its market value. Familiarity with indexes like the S&P 500, Russell 1000, and S&P SmallCap 600 makes it easy to gravitate towards ETFs tracking these benchmarks and avoid unknowns like the Rydex S&P Equal Weight ETF (RSP). But there’s a lot of evidence suggesting that cap-weighting methodologies may suffer from certain flaws, not the least of which is their tendency to overweight overvalued components. Once a sector or size/style combination is selected, a lot of investors will default to a cap-weighted ETF option. But there are a number of interesting alternatives to cap-weighted exposure available through ETFs, including everything from equal weighting to allocation strategies based on top line revenue. Know the nuances of the underlying index, and don’t be afraid to take the road less traveled by pursuing some of the alternatives to cap-weighted ETFs (see Beyond SPY: Nine Alternatives To S&P 500 ETFs).

Mistake #6: Misjudging “International” ETFs

ETFs have been praised for bringing access to every corner of the world within the reach of U.S. investors. In some sense, they get far too much credit in this regard. While it is true that there are now ETFs targeting nearly every major market–both developed and emerging–the majority of these funds consist primarily of mega cap equities that might not necessarily provide pure exposure to the local economy. Because many of the world’s largest companies maintain a global customer base, they generally maintain only moderate exposure to the economy where they are traded. The iShares MSCI Spain Index Fund (EWP) is a good example of this phenomenon. Many of the major holdings–including the top two that make up 40% of assets–generate significant portions of their earnings from Brazil. So despite massive economic issues in Spain, EWP actually held up pretty well last year because of surging demand in Brazil (see What Every Investor Should Know About The Spain ETF). Be aware of the inherent limitations of some international ETFs. Investors looking for pure play exposure to a particular market may be better served through a small cap ETF (use the ETF screener to identify small cap international ETFs).

Mistake #7: Using ETFs In Lieu Of Stocks

ETFs were first marketed as an improvement to traditional mutual funds, but investors have also embraced them as an alternative to stocks. Once upon a time, investors bullish on the financial sector may have purchased Citi stock. Now they’re more likely to buy XLF, recognizing that the wrong call in the right sector is still a bad pick. But sometimes this preference for ETFs can get taken too far. If you’re bullish on the outlook for Apple after the launch of the iPad, the best way make that play isn’t through QQQQ or another tech ETF, but through Apple stock. ETFs will generally reduce risk by providing exposure to a diversified basket of securities, but risk is a two-way street. If you’re looking for a bigger up-side, individual stocks may be the way to go. Stocks may seem strangely old-fashioned as investment vehicles. There’s nothing wrong with moving them to the bottom shelf of your investment toolkit, but don’t throw them out altogether.

Mistake #8: False Sense Of Diversification

ETFs have become so popular because, like mutual funds, they offer immediate exposure to a diversified basket of securities. Investors who understand security-specific risk also grasp why an ETF made up of 1,000 individual stocks may offer reduced risk relative to picking a handful of stocks. But ETF investors, especially those with a preference for cap-weighted indexes, can easily get a false sense of diversification. Many ETFs have hundreds of holdings, but the use of a market cap weighting methodology results in heavy concentrations in a few big names. The Energy Select Sector SPDR (XLE) is a good example. This ETF offers exposure to the energy sector through 42 different stocks. But the largest, Exxon Mobil, makes up 17% of assets and the top ten account for more than 60% of holdings. It’s the same thing–albeit to a lesser extent–with broad-based ETFs like SPY. When looking at a potential ETF investment, there are a few good indications of the level of diversification. Number of holdings is a good starting point, but it’s helpful to also consider the weighting methodology and percentage of assets in the top ten holdings. Equal-weighted ETFs will avoid big concentrations in a few names, a problem that plagues some cap-weighted products.

Mistake #9: Ignoring New Products

A lot of advisors have their “go to” list of ETFs that they use when constructing portfolios for clients. There’s nothing wrong with going through the due diligence process to identify a preferred list–that’s one of the signs of a good financial advisor in fact. But letting your list of “go to” funds get stale can mean you’re missing . The ETF industry is still very young and is growing very quickly. Last year there were more than 100 new product launches, and we’re already above 60 so far in 2010 (see all the new ETF launches here). Not all of these new products are going to be useful for everyone; products have, in general, become more targeted and esoteric in recent years. But there are some interesting ideas coming out that offer a way to gain exposure to a previously inaccessible asset class (volatility ETNs from iPath) or a unique twist on popular products (small cap sector ETFs from PowerShares). If you’re not aware of all the ETFs that have been brought to market in recent months, it might be worth taking a look.

Mistake #10: Skipping Out On ETF Homework

This last one sounds simple and obvious, but it’s worth repeating yet again. ETFs are very simple in many ways, but somewhat complex in others. From understanding the unique tax treatment of GLD to how contango affects UNG to the differences between EEM and VWO, there are a lot of nuances that can have a significant impact on total returns. As we’ve seen by the total failure of some to understand how leveraged ETFs actually work, there are a lot of lazy investors out there who aren’t taking advantage of an abundance of educational resources on leveraged ETFs. There are a lot of great resources out there (see Top 50 Free ETF Tools And Resources). If you’re willing to do a little research and take a little time, you’ll be far less likely to make potentially costly investment mistakes (see our new ETF Library for a variety of educational reading). For more ETF insights, sign up for a free trial of ETF Edge. Disclosure: No positions at time of writing.

ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships. Read the full disclaimer here.



Tags: Adoption, Arbitrage, Avoidable Mistakes, Blue Chip Stocks, Brazil, Commodities, Email, Emerging Markets, energy, ETF, ETFs, Expense Ratios, Institutional Investors, Intraday Trading, Investing, Investor, Limit Order, liquidity, Market Participants, Michael Johnston, Mistake, Mutual Funds, Natural Gas, Natural Resources, Participant, Profile, Simplicity, Tax Situation, Transparency, True Depth
Posted in Brazil, Energy & Natural Resources, ETFs, Markets, Outlook, US Stocks | Comments Off