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The New Global ETF Investor - back to Contents >
Chapter 3:
What on Earth are ETF’s?
An ETF is a basket of securities that is bought and sold on an exchange like an individual stock. Similar to an index mutual fund, an ETF closely tracks a specific market index and represents ownership in a portfolio of securities that make up that index.
iShares are the largest family of ETFs and were created by Barclays which is one of the world’s largest banks and is a pioneer in indexing. iShares track indexes from providers such as Standard & Poor’s, Russell, MSCI, Nasdaq, Dow Jones, Goldman Sachs and Lehman Brothers.
iShares ETFs were launched in 2000 and now represent more than $100 billion in assets and a family of 101 ETFs. iShares have grown at an annualized rate of 98% during the past three years compared to minus 1% for bond and equity mutual funds. Furthermore, none of the iShares have distributed capital gains to investors during the past 3 years.
ETFs have been around for about a decade but have grown tremendously since iShares were introduced in 2000. According to the Investment Company Institute, ETF assets have grown form $36 billion in 2000 to more than $300 billion today. In 2005, the number of ETFs on the market grew from 151 to 201 with new families such as Powershares growing assets and launching new products at very rapid rate. Rydex has also introduced some great new ETFs and in March, 2006, State Street Global Advisors filed with the SEC for 17 new ETFs.
ETFs are not a new and untested investment tool. Rather, they have gone mainstream and are listed alongside, stocks, bonds and mutual funds everywhere you look.
Investor demands for flexibility, transparency, simplicity and efficiency are fueling this expansion. ETFs offer both individual and institutional investors broad advantages in the following areas: asset allocation and diversification, lower expense ratios, better tax efficiency and impressive trading flexibility.
A Remarkable Asset Allocation Tool
Numerous studies have shown that investor returns are more than 90% due to assets allocation than individual stock picking. The most important task facing you and your advisor is deciding what asset classes to invest in and in what proportion to increase the likelihood of achieving your goals.
There are dozens of asset classes ranging from large, mid-cap and small-cap, growth and value, international, specific sectors like financial services and a variety of regional and international classes. Experienced investors have learned that having a variety of asset classes in your portfolio will cushion the risk that a downturn in asset class will seriously affect your portfolio.
iShares offer you a comprehensive choice of 101 funds to fit the asset classes of your choice in building a diversified portfolio. Here is a snapshot of the remarkable breadth of iShares funds:
- 21 countries from Australia to South Africa
- Large-Cap from Russell 1000 to S&P Global 100
- Mid-Cap from Value to Growth
- Regional from S&P Europe 350 to S&P Latin America 40
- Fixed Income from Lehman 1-3 year Treasury to Lehman Aggregate
- Small-Cap from the Russell 2000 to Nasdaq Biotechnology
- Sector from Dow Jones U.S. Healthcare to U.S. Financial Services
- Global from S&P Global Healthcare to S&P Global Energy
You may be taken aback by the grand and global scope of iShares. This is precisely why we have chosen to rely on it as our primary investment tool in building core global portfolios. We will discuss asset allocation strategies for your portfolio in depth in Chapter Four.
Significantly Lower Expense Ratios
Expense ratios for iShares and other ETFs tend to be significantly lower than those of actively managed mutual funds and oftentimes lower than index funds. This can affect the fund’s performance and its effect is compounded over time.
Here are a few examples that illustrate the iShare difference. In a 2003 analysis, Morningstar came up with the following comparison of expense ratios:
Morningstar Fund
Category |
Average
Active Fund |
Average
Index Fund |
iShare
Fund |
US Taxable Bond |
1.1 0% |
.45% |
.15% |
Large Cap Value |
1.45% |
.75% |
.20% |
Small Cap Blend |
1.67% |
.68% |
.20% |
Sector Fund |
1.81% |
.99% |
.60% |
Keep in mind that iShares need to be purchased on an exchange, and therefore you will pay brokerage commission. These commissions could be as low as $5 a trade if you use an online discount broker.
The Tax Efficiency You Need
Most investors do not pay much attention to tax consequences when making investments. Smart investors evaluate their investments on an after-tax basis and iShares offer you more control over your taxable capital gains. With traditional actively managed mutual funds, you are at the mercy of other shareholders and sell decisions by fund managers. In addition, you may have been surprised to receive sizable capital gains distribution in a mutual fund you own even if that fund has lost value.
If a fund manager decides to sell certain stocks or if redemptions force a fund manager to raise cash, you will pay the resulting capital gains on the transaction proportionate to your investment in the mutual fund. As mentioned earlier, if this stock has been a holding in the fund for ten years and has tripled in price, you will receive this capital gains distribution even if you have been in the fund for only one month. Fund managers are obligated to distribute these gains on an annual basis.
Shareholders of iShares are insulated from other shareholder activity because they buy and sell from each other on an exchange – not with the fund itself. You also decide when to sell an iShare and therefore, are in control of when you will incur capital gains. Finally, in general, actively traded mutual funds will tend to generate more capital gains since there will likely be more frequent buying and selling of securities. This is one important reason why actively managed funds have such a hard time beating indexes on an after-tax basis.
The Trading Flexibility of a Stock
Your iShares are funds but like stocks, you can buy them and sell them with a degree of flexibility that a traditional mutual fund cannot match. Here are some of the features of iShares that highlight their trading flexibility.
- You can own an entire market, a country, a region, a sector, or an asset class in a single transaction.
- Unlike mutual funds, you can buy and sell iShares throughout the trading day.
- To better manage risk, you can place stop and/or limit orders on iShare transactions. Try that with your mutual fund or mutual index fund.
- With iShares there is no investment minimum and a round lot purchase is not necessary.
- There are options available on some iShares and you can buy/sell short in margin accounts.
- Like stocks, dividends paid in an iShare fund can be re-invested immediately.
Now that we have covered the advantages of iShares, we will next turn to a description of some of your investment options. A complete list of iShares is included as an appendix. When describing your iShare fund options, we are really describing the underlying index that they track. Try not to be overwhelmed by all the choices. As you will see, indexing is not just the S&P 500 anymore. We will simplify matters and discuss the different strategies and what blend of these options might be right for you in the next chapter.
- United States Market iShares
- Global iShares
- United States Market Specialty iShares
- International iShares
- Country Specific iShares
- Fixed Income iShares
United States Market iShares
The Russell 3000 Index
The Russell 3000 Index consists of the 3,000 largest-capitalization stocks in the US. Weighing of stocks in the index is by capitalization, meaning the stocks with higher capitalization (stock price x number of shares outstanding) will carry more weight in the index. The Russell 3000 represents about 90% of total US market capitalization.
The Russell 3000 is made up of the Russell 1000 which is the 1000 largest capitalization stocks and the Russell 2000 which represents the largest 2000 small cap stocks. In addition, the Russell 1000 has a sub-index called the Russell Mid-cap that represents companies considered midsize with a market capitalization between $1.5 billion and $10 billion.
In addition, each of these indexes has sub-indexes which comprise stocks in the index which are more growth or value-oriented. This is done by ranking companies in the index by their growth rates and their price to book value.
iShares Russell 3000 Index Fund
iShares Russell 3000 Growth Index Fund
iShares Russell 3000 Value Index Fund
iShares Russell 1000 Index Fund
iShares Russell 1000 Growth Index Fund
iShares Russell 1000 Value Index Fund
iShares Russell Midcap Index Fund
iShares Russell Midcap Growth Index Fund
iShares Russell Midcap Value Index Fund
iShares Russell 2000 Index Fund
iShares Russell 2000 Growth Index Fund
iShares Russell 2000 Value Index Fund
The S&P 1500 Index
The S&P 1500 Index comprises the weighted sum of the large-cap S&P 500, the S&P MidCap 400 and the S&P 600 SmallCap indexes. Like the Russell 3000, the S&P 1500 comprises about 90% of total US market capitalization. The three indexes that make up the S&P 1500 all have their growth and value components. Foreign stocks are not excluded from the index.
Companies for the index are chosen for their market size, liquidity and industry representation. S&P Midcap 400 companies start with minimum market cap of about $200 million, a maximum of $11 billion and an average of about $2 billion. Half of the companies in the index have a market capitalization over $1.7 billion.
iShares S&P 500 Index Fund
iShares S&P 500/BARRA Growth Index Fund
iShares S&P 500/BARRA Value Index Fund
iShares S&P Midcap 400 Index Fund
iShares S&P Midcap 400 BARRA/Growth Index Fund
iShares S&P Midcap 400 BARRA/Value Index Fund
iShares S&P Smallcap 600 Index Fund
iShares S&P Smallcap 600/BARRA Growth Index Fund
iShares S&P Smallcap 600/BARRA Value Index Fund
Dow Jones US Total Market Index
The relatively new Dow Jones US Total Market index represents the top 95% of the capitalization of the US stock market. It contains about 1,600 stocks and is adjusted quarterly.
This index is float adjusted meaning, outstanding shares which are held by insiders and do not trade are excluded from the index. It also excludes foreign stocks and some thinly traded stocks. The top 70% of the Dow Jones’s universe of securities makes up the large-cap index and the next 20% makes up the mid-cap index. The small-cap index consists of the next 5% of stocks that are selected based on a combination of capitalization and turnover.
The Dow Jones family of indexes also offers you indexes representing the different sectors and industries that make up the US economy. This allows you the opportunity to take advantage of the cyclical nature of the economy and overweight certain sectors you believe offer more opportunity than others. This strategy is referred to as “sector rotation” and will be discussed in detail in the next chapter.
iShares Dow Jones US Total Market Index Fund
iShares Dow Jones US Basic Materials Sector Index Fund
iShares Dow Jones US Consumer Cyclical Sector Index fund
iShares Dow Jones US Non-Cyclical Sector Index fund
iShares Dow Jones US Energy Sector Index Fund
iShares Dow Jones US Financial Sector Index Fund
iShares Dow Jones US Financial Services Sector Index Fund
iShares Dow Jones US Healthcare Sector Index Fund
iShares Dow Jones US Industrial Sector Index Fund
iShares Dow Jones US Real Estate Index Fund
iShares Dow Jones US Technology Sector Index Fund
iShares Dow Jones US Telecommunications Sector Index Fund
iShares Dow Jones US Utilities Sector Index Fund
iShares Dow Jones Select Dividend Index Fund
Given the changes in tax laws regarding dividend taxation, this recently launched iShare fund deserves special attention. This index contains a diversified basket of 50 of the highest yielding dividend companies in the Dow Jones US Total Market Index. One condition is that the companies selected for the index must have a positive historical five-year dividend-per-share growth rate. The index is rebalanced each year and a company’s weight in the index is based on its indicated annual dividend.
Global iShare Funds
iShares S&P 100 Global Index Fund
Global iShare funds consist of American companies as well as companies that are domiciled outside the United States. The S&P Global 100 Index measures the performance of 100 large multinational companies that are active throughout the world and have a minimum market capitalization of $5 billion. These are very large companies with a global reach and have an average market capitalization of 60 billion. About 58% of the companies in the index are American followed by the United Kingdom with 12% and France Switzerland and Japan with about 5%.
Another group of global iShares funds are global sector funds that represent parts of the S&P Global 1200 Index. The US represents about 50% of most of these iShare funds with the exception of the telecommunications and technology fund where American companies have a 75% weighting.
iShares S&P Global Energy Sector Index Fund
iShares S&P Global Financial Sector Index Fund
iShares S&P Global Healthcare Sector Index Fund
iShares S&P Global Technology Sector Index Fund
iShares S&P Global Telecommunications Sector Index Fund
US Specialty iShare Funds
As if you didn’t already have enough choices, iShares offers you specialty funds.
iShares Nasdaq Biotechnology Index Fund
iShares Cohen & Steers Realty Majors Index Fund
iShares Goldman Sachs Natural Resources Index Fund
iShares Goldman Sachs Networking Index Fund
iShares Semiconductor Index Fund
iShares Goldman Sachs Software Index Fund
iShares Goldman Sachs Technology Index Fund
To give you a feel for this group, here are some basic information on the Natural Resources and the Biotechnology iShare funds. The iShares Goldman Sachs Natural Resources Index Fund is heavily tilted to oil with about 75% of its market capitalization related to companies in oil and oil services. The balance is in metals & mining, paper and forest and natural gas. There are 115 companies in the index with an average market cap of $6 billion.
The iShares Nasdaq Biotechnology Fund contains companies primarily engaged or involved in biomedical research. The largest company in the index is Amgen and the index contains 75 companies with an average market cap of $2.9 billion. Like the Natural Resources Fund, its expense ratio is 50 basis points or 0.5%.
International iShare Funds
International iShare index funds track Morgan Stanley Capital International (MSCI) indexes and are comprised entirely of companies domiciled outside the US. We will take a brief look at the regional international iShare index funds and list the country specific funds.
iShares MSCI EAFE Index Fund
This is by far the most followed international index covering 21 developed countries in the regions of Europe, Australia and the Far East. Investors might expect that they are getting even exposure throughout these regions but actually almost 60% of the holdings are in the United Kingdom, Japan and France. Likewise, the index sector breakdown indicates that 55% of the capitalization of the index represents financial and consumer companies. Surprisingly, there is only a 3% exposure to technology.
iShares MSCI Emerging Markets Index Fund
The opportunity in emerging market countries is significant. The 20 countries and roughly 700 companies composing this iShare account for 20% of global GDP. The index’s regional breakdown is Asia at (54%), Latin America at (19%) and Europe, Africa and Middle East (27%). In terms of countries South Africa, South Korea and Taiwan comprise about 45% of the index.
iShares S&P Europe 350 Index Fund
This index is a subset of the S&P Global 1200 Index and covers about 70% of European market capitalization. The 350 companies that make up the index are chosen based on size, liquidity and distribution over 10 different market sectors.
iShares MSCI EMU Index Fund
This fund tracks the performance of countries that are members of the European Monetary Union (EMU). The United Kingdom is not yet a member of the EMU and therefore, is not part of the index. This iShare currently has 275 holdings and France, Germany and the Netherlands comprise 65% of the index.
iShares S&P Latin America 40 Index Fund
This fund tracks the performance of 40 companies located in Mexico, Brazil, Chile and, to a much lesser extent, Argentina, Mexico and Brazil together make up more than 80% of the index.
iShares MSCI Pacific Ex-Japan Index Fund
This iShare seeks to track the performance of the Australian, Hong Kong, New Zealand and Singapore equity markets. Australia currently accounts for 60% of the holdings and Hong Kong about 20%.
Country Specific Funds
There are currently iShares for the following countries.
| Australia |
Germany |
Netherlands |
Austria |
| Hong Kong |
Singapore |
Belgium |
Italy |
| South Africa |
Brazil |
Japan |
South Korea |
| Canada |
Malaysia |
Spain |
France |
| Mexico |
Sweden |
Switzerland |
Taiwan |
| China |
United Kingdom |
|
|
Fixed Income iShares
Fixed Income iShares offer you many of the same advantages as Equity iShares. These advantages include no minimum investment, instant diversification and the ability to quickly and conveniently buy a basket of bonds in one trade, getting broad exposure to the fixed income market.
Furthermore, you gain trading flexibility and lower costs. Each Fixed Income iShares are designed to track a specific fixed income index. Dividends are distributed monthly consistent with bond mutual funds.
iShares Lehman Aggregate Bond Fund
The Lehman Aggregate Bond Fund Index spans the US investment grade fixed-rate bond market to include Treasuries, Agencies and Credit and Mortgage-backed Securities. It consists of about 7,000 securities.
iShares Lehman 1-3 Year Treasury Bond Fund
iShares Lehman 7-10 Year Treasury Bond Fund
iShares Lehman 20+ Year Treasury Bond Fund
The Lehman series of US Treasury Indexes are a market capitalization weighted index, rebalanced monthly and designed to represent public obligations of the US Treasury that have a remaining maturity of between 1 and 3 years, 7-10 years and greater than 20 years.
iShares GS $ Investop Corporate Bond Fund
This index fund consists of 100 bonds, rebalanced monthly and designed to provide balanced representation of the US dollar investment grade corporate market through some of the most liquid corporate bonds available. All 100 bonds in the basket are equally par-weighted.
iShares Lehman TIPS Bond Fund
This index tracks inflation-protected public obligations of the US Treasury commonly referred to as “TIPS”. TIPS are income-generating instruments whose interest and principal payments are adjusted for inflation.
Other ETF Options
The first ETF was established in 1993 when the American Stock Exchange established the first ETF to track the S&P 500 index. It was soon dubbed the “Spider” and was followed by “Diamonds” which tracked the Dow Jones Industrial Average, and “Cubes” which track the NASDAQ 100.
Other ETF options include:
HOLDRS introduced by Merrill Lynch in 1998
Vanguard Family of ETFs
Rydex Family of ETFs
ProFunds Family of ETFs which has filed with the SEC to launch leveraged ETFs
BLDRs family of ETFs sponsored by the Bank of New York and based on their ADR indexes
ETF Innovations
Indexing is not the S&P 500 anymore. There are now more than 200 ETFs on the market. Here are a few of the most innovative.
Exchange-traded funds are essentially index funds that trade like a stock. All ETFs track a specific index and offer investors the advantages of lower costs, tax efficiency and some degree of diversification. When I started Chartwell in 2002 to specialize in ETFs, little did I imagine the current variety of ETFs allowing investors the opportunity to use them to invest in areas such as water, biotech, precious metals and foreign currencies.
Rydex recently introduced the Euro Currency Trust (FXE) ETF which tracks the price of the Euro and last May brought to the market the Rydex Russell Top 50 (XLG) which tracks a market-cap weighted index of the 50 largest mega-caps in the Russell 3000. These two ETFs build on its breakthrough Rydex S&P Equal Weight ETF that tracks the S&P 500 but weights each company equally rather than by the size.
It has outperformed the S&P 500 index by a handsome margin.
The largest family of ETFs is iShares and of particular interest to me is their country specific ETFs which track 22 foreign markets such as Australia (EWA), Brazil (EWZ) Switzerland (EWL) and Taiwan (EWT). iShares ETFs also cover a broad number of sectors, the Morningstar style boxes and are all market-cap weighted.
A new breed of ETFs is the Powershares family. Rather than follow traditional market-cap weighting theory, Powershares build indexes based on intelligent models. In short order, it has rolled out a flurry of forward-looking ETFs. Chartwell has built a New Venture ETF Portfolio around Powershares with exposure to Nanotechnology (PXN), Biotechnology (PBE), Water (PHO), Clean Energy (PBW), Aerospace & Defense (PPA) and Media (PBS). The Chartwell New Venture ETF Portfolio is already up over 7% this year.
Looking for a simpler and broader approach to gain global diversification? Try the BLDRS family of ETFs based on the Bank of New York ADR Index. You have four choices: an ETF tracking 50 ADRs in emerging markets (ADRE), one tracking 100 ADRs in developed markets (ADRD), a third tracking 100 ADRs in Europe (ADRU) and last, but not least, one containing 50 Asian based ADRs (ADRA).
But there is a drawback to this explosion of choice. How should an investor pick and choose the right ETFs to meet their investment objectives?
You need to blend your ETFs with a portfolio approach rather than randomly selecting ETFs that capture your eye. First, separate your core conservative portfolio from your growth portfolios. With the core conservative portfolio, your top priority is capital preservation and growth is a secondary consideration. Your growth portfolios are more speculative with capital growth as the primary goal.
Next, you need positions in your portfolios that are likely to offset each other as unexpected events and market movements become a reality. This is not accomplished with different sectors ETFs or a mix of small cap, mid cap and large cap ETFs. Rather the goal is to have some investments that are on both sides of risks.
For example, if the US dollar declines, have some investments in precious metals or denominated in other currencies such as Switzerland or Australia or Singapore ETFs. If inflation heats up have some investments that hedge this risk such as timber, gold or Treasury inflation protected bonds (TIPs). If political events or policies in one country take a turn for the worst, it is helpful to have investments in other well developed countries to offset any loss of value.
You get the idea, spread your risk and avoid having too much exposure to one ETF. You have the tools, now get going building a portfolio that is the envy of your friends and colleagues.
Examples of ETFs in Action
Let’s now take a look under the hood of several ETFs to learn more about where they might fit into your portfolio.
ETF Insight: Rydex S&P 500 Equal Weight Index Fund (RSP)
While we believe in the benefits of index fund investing, sometimes the preoccupation with weighting companies within an index by their market capitalization is not always helpful.
Let’s look inside the hood of the most popular index, the S&P 500.
Many investors believe they are getting broad exposure over 500 leading American companies. This is far from the truth.
- The top 10 companies in the index represent more than 22% of the index’s value.
- The top 50 companies in the index represent about 60% of the index’s value.
- The top 250 companies in the index represent about 90% of the index’s value.
- The domination of these larger companies in the index can swamp performance of mid-cap companies. Let’s look at the period from March 200o to September 2002 when the S&P 500 index fell 44%. Surprisingly, during this period, 300 of the smallest companies in the index actually rose in value and the smallest 200 companies rose 36%.
In other words, while the whole index of 500 companies fell 44%, 300 companies in the index rose and 200 companies rose 36%.
Rather than weigh each company by its market cap, this Rydex ETF weighs each of them equally. This eliminates the possibility that a small group of companies can dominate the overall performance of the index.
We have allocated a 10% position in this ETF for our Core Conservative Portfolio. The expense ratio is .40%. For further information and a prospectus on the Rydex S&P 500 Equal Weight ETF, please call 800-820-0888.
ETF Insight: iShares Lehman 20 Year+ Treasury Bond Fund (TLT)
It is smart to have some fixed income allocations in your portfolio to add some income and to buffer your portfolio’s value from declines in equity markets.
You have three options: buy a specific bond, buy a bond mutual fund, or buy an ETF bond fund.
The benefit of a specific bond is that you know precisely your return if you hold the bond until maturity. A bond mutual fund gives you much greater diversification with the downside of higher fees. In addition, a bond mutual fund will normally have capital gain distributions as the fund manager buys and sells holdings based on fund flows and predictions of interest rate movements.
This is a very simple and cost-efficient way to diversify your portfolio. This ETF approximates the total return of the long-term U.S. Treasury market and specifically tracks the Lehman Brothers 20+ Year Treasury Index. Its expense ratio is only 0.15%.
Currently, this ETF contains 16 different long-term Treasury bonds with an average maturity of just over 23 years and a weighted average coupon of 6.18%. Interest payments are paid monthly and bonds are sold and replaced as they approach maturity.
We decided on longer maturities because while we expect short-term rates to continue to increase, our view is that long-term rates will be fairly stable and may decline.
ETF Insight: iShares S&P Global 100 Index Fund (IOO)
One method of global investing is to concentrate on US large multinational companies that do business throughout the world. The advantage is that these large companies have solid track records and have been around a long time. Since they operate globally and in different currencies they offer some diversification and capture some of the earnings and growth potential of international markets.
However studies done by academics have shown that American multinational tend to trade with the overall stock market and not according to the markets they do business in. For example, even if a US company does 50% of their business in Japan, their stock price will largely be independent of the Japanese stock market.
Therefore it makes sense to include some foreign multinationals in your portfolio and the iShares S&P Global 100 ETF (IOO) is a cost effective way to do so. This ETF tracks a basket of 100 leading multinational companies with an average market capitalization of $69 billion.
It offers good diversification with US companies at about 55%, the UK with 12%, France at 6%, Switzerland, Germany and Japan with 5%. It is largely US and European oriented since this is where the largest multinationals are based. The annual expense ratio is only 0.4%.
In terms of sectors, this ETF also offers good diversification with about 20% in financials, 16% in information technology, 14% in healthcare, 13% in consumer products and 12% in energy.
The performance of the Global 100 ETF has been a bit disappointing this year but it appears that large companies are coming into favor again. For example, the largest 10 companies in the S&P 500 are up 4% this year more than double the increase in the overall index.
In 2003, this ETF was up 30.5% and so far this year it is down 0.9%. We have a 10% position in the Chartwell Global Opportunity model portfolio.
ETF Insight: iShares MSCI Emerging Markets Index Fund (EEM)
Launched in April, 2003, the iShares MSCI Emerging Markets Index Fund has both advantages and disadvantages.
Advantages
- Convenience: with one trade buy 243 companies spread across 20 different emerging market countries
- Cost Effective and Tax Efficient: annual expenses of .75% versus 2.00 % plus for most emerging market mutual funds
Disadvantages
- Concentration of Risk: Investors don’t normally realize how concentrated their positions may be. For example, over 50% of the fund’s exposure is to five countries: South Korea (16.5%), South Africa (14.7%), Taiwan (11.4%), China (9.5%) and Brazil (8.7%).
In addition, one company, Samsung Electronics accounts for 7.5% of the fund’s total investments. Overall, the telecom and semiconductor industry accounts for 30% of the fund’s total exposure. Most investors don’t have a clue about these concentrations and their potential consequences.
- Lack of Flexibility: The companies in the ETF are weighed by market capitalization. Therefore, the larger the market capitalization of the company, the higher its percentage weighting in the total fund. You can’t pick and choose among the 20 different countries and customize a portfolio.
This is the major reason why this ETF is not presently in any of our portfolios. We choose to selectively pick countries and decide what allocation is appropriate for each model portfolio.
For example, you may wish to add the South Korea iShare to your growth portfolio but at a level of 5% rather than the 16.5% in the Emerging Market ETF. On the other hand, you may think of adding a 5% allocation to the Malaysia iShare even though Malaysia’s weighting in the Emerging Markets ETF is only 0.32%!
ETF Insight: iShares FTSE/Xianhua China 25
This new ETF tracks the FTSE/Xianhua China 25 index which is comprised of 25 of the largest and most liquid China names. FTSE is a UK based index company and Xianhua is a China based media company.
All of the 25 stocks contained in the index trade on the Hong Kong Stock Exchange. Some of them are incorporated in mainland China (H shares) and some of them are incorporated in Hong Kong (red chips). The total market capitalization of the index is $170 billion. The broadest Xinhua China index includes 1,355 listed companies with a total market cap of $550 billion.
To put this in perspective, the average market capitalization for a company in the S &P Global 100 index is $70 billion. Again, that’s for one company.
We welcome this new tool to invest in China but hasten to point out the following important issues:
- The China iShare provides good exposure to three key sectors of China: energy (20%), telecom (19%) and industrial (18%). This concentration can be viewed as a plus or a minus depending on your perspective. For example, some smart investors are placing a bigger bet on China’s consumer markets.
- It seems that the China iShare is a much purer China play than the Hong Kong iShare which is a bit more of a proxy on the China story. The Hong Kong iShare has more emphasis on Hong Kong real estate (33%), utilities (17%) and banking (16%).
- The annual operating expenses of the China iShare are from 50% to 70% lower than other alternatives out there including actively managed Asia and greater China region funds.
- Be aware of the high concentration involved in the China iShare. The top five companies represent 40% of the index.
This ETF is rather like a rifle approach rather than a shotgun approach to investing in the China story. Rather than a core investment tool, it should probably be used as a complement to a broader vehicle.
Another Useful Tool: Closed-End Funds
ETFs are great investment tools but there are still many areas they do not cover. This is especially true in the area of country specific funds. Another useful investment tool to have in your quiver are closed-end funds (CEFs).
Closed-end funds are mutual funds that trade like a stock. Like a traditional mutual fund, they are actively managed. The key difference between a mutual fund (open) and a closed-end fund is their capital structure. CEFs have been around since the 1920s.
With a traditional mutual fund, investors can buy or sell (redeem) their shares at any time and for the Net Asset Value (NAV). In other words, the amount of money in the fund will fluctuate daily.
With a closed-end fund, once the fund is launched through a public offering, the number of shares remains fixed. The fund then trades on an exchange like a stock and its price is determined by supply and demand.
Interestingly, the share price of a closed-end fund (CEF) usually differs somewhat from the underlying Net Asset Value of the fund. It may trade at a premium (above) or a discount (below) the NAV based on investor sentiment and expectations.
The fact that money is not flowing in and out of a CEF on a daily basis gives its managers some advantages. They know exactly how much capital they have to work with and can be patient and wait for bargains. It also means that they are not forced to sell stocks to come up with cash for redemptions leading to tax problems for investors.
Here are some other advantages of CEFs:
- CEFs are total return products. They offer growth through distributions and appreciation and can distribute capital gains on a quarterly basis.
- The ability to purchase CEFs at a discount to NAV may lead to better returns.
- CEFs have no 12B-1 fees or trailing commissions. They do not need large and expensive marketing programs and fund managers can concentrate on their job.
- With CEFs, investors can time buy/sell decisions and the ability to complete a transaction at any time the markets are open.
- CEFs often times have lower turnover rates and on average lower expense rations relative to mutual funds.
- CEFs fees are more transparent than mutual funds and they do not impose minimum purchases.
CEFs are particularly suited for investing in specialty areas such as real estate, venture capital or emerging market countries. Managers are never forced to sell in tough times to meet redemptions and are not inundated with too much cash to invest when prices are to high. There are over 500 CEFs available to investors.
The following are the major segments and market shares of CEFs:
Municipal bond funds |
54% |
Taxable bond funds |
17% |
International equity funds |
12% |
U.S. equity funds |
9% |
International bond funds |
8% |
Chartwell especially uses CEFs for international bond or equity positions. This is especially true for “single country” investing. There are currently more than 80 single country funds oftentimes in markets with more volatility and less liquidity.
The following countries do not have ETF/iShares coverage but do offer investors the option of closed-end funds:
Argentina |
Russia |
Denmark |
New Zealand |
Israel |
Indonesia |
Poland |
Ireland |
Czech Republic |
Thailand |
India |
Philippines |
Peru |
Colombia |
Venezuela |
Hungary |
Ecuador |
Panama |
Chile |
Turkey |
The Next Step: Strategy
This completes our overview of the array of ETFs and CEFs available to help you build a global portfolio. Now, we turn to laying out several strategies and themes to help you organize and blend your ETFs investments to fit your financial situation and goals.
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