Tag Archives: indexing

Index Mix & Match? I think not! (05/08/2014)

Last time we looked at Broad Market index options. If you thought that was confusing, wait till we look at the landscape for ETFs based on company size. Let’s say you want to overweight mid and small cap because you have learned that they outperform large caps over the long run (albeit with increased risk). Besides, you want to be able to see the underlying portfolio blocks and rebalance between categories.

CRSP (Vanguard’s index provider) has done a great job describing various ways to split the market into size groups. Basically, you can slice the total market into either Two-Tier: Large + Small or Three-Tier: Large + Mid + Small. Of course ever-obliging ETF providers responded to investor demand by offering midcap options for even two-tier indexes. This and the sheer number of market cap ETFs created a confusing mess that we’ll attempt to decipher below.

Introducing the Field

Exhibit 1 shows available index funds with important characteristics to compare them. I described the metrics in the Broad Market Index post but also added Annual Turnover % as a proxy for tax-efficiency and other hidden costs. Naturally, broad index funds have the lowest turnover while small and midcap ones make a lot of portfolio changes due to fluid nature of those categories. I also calculated the stats for a sample combination of large & small indexes for each family. This way you can compare the resulting portfolio to the corresponding total market fund.

Exhibit 1 – Major Family Index Offerings by Market Cap

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Exhibit 2 puts the same line-up into visual form to see how they jive together. It is built to scale based on a number of holdings in each ETF (3,500 being the highest – so we have 35 “notches” of 100 stocks each). One caveat is that the number of companies in the fund doesn’t reflect its true diversification. For example, ITOT’s 1,500 holdings is only 40% of VTI’s 3,700 stocks yet it covers approximately 90% of the U.S. market capitalization.

Exhibit 2 – Market Cap Combinations

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Now, let’s review the line-up for each family.

Vanguard – CRSP US Total Market Index

Vanguard fields four market cap funds. CRSP describes this combined logic on their website:

The combined-size approach constructs indexes that function effectively in both building block scenarios. For the two-tier approach, an investor can combine CRSP Large + CRSP Small, or if a three-tier approach is preferred, the investor can use CRSP Mega + CRSP Mid + CRSP Small.

The one potential point of caution: If investors combine CRSP Large + CRSP Mid + CRSP Small, they have an overweight position in mid-cap stocks since large is already made up of Mega + Mid.

This point in bold is very important. I have seen this combination in quite a few portfolios. Let’s say if your goal was to overweight smaller companies and you allocated 60% to large, 25% to mid and 15% to small cap Vanguard funds. The resulting portfolio would double up on midcaps and actually be 55% large, 37% mid and only 8% small.

Note that Vanguard’s high turnover ratio has to do with them switching from MSCI to CRSP benchmark in 2013 and it should be lower in the future.

Schwab – Dow Jones U.S. Broad Stock Market Index

This is a solid offering, but once again you have to be careful with midcap component (Exhibit 2). It actually overlaps both large and small funds and is not necessary to create a total market portfolio. At my firm we typically use 75% SCHX / 25% SCHA for domestic equity – it’s very cheap (5 basis points for the combo), funds are very sensibly constructed and there are no transaction costs at Schwab.

iShares – Russell Index

Despite being the most expensive option, this is another popular stable of funds with great market coverage. Midcap fund is once more superfluous and completely overlaps with Russell 1000. Unique to this line-up, Russell offers a micro-cap option if you are interested in the very smallest public companies out there. Be careful though as IWC has a high expense ratio and can run into liquidity issues with some of their holdings.

Vanguard – S&P Index

This is an elegant two-fund solution that covers the TOTAL stock market with the highest number of holding in our combinations. It’s also quite cheap and has very low turnover.

iShares – S&P Index

S&P index scheme is probably the best-known to the general investing public. It’s a clean three-tier option and is a decent choice despite the relatively low number of holdings. Interestingly, turnover is much lower here as the indexes membership is managed by committee and not quantitative rules. Also note that SPDR has competing offering with SPY, MDY and SLY but not a total market option.

 Mix & Match – DON’T DO IT

You wouldn’t believe how many times I have seen real-life portfolios that mix funds from different providers in an attempt to cobble together “total market” exposure. People look at the fund names and assume that large, mid and small funds are exactly that and are interchangeable. Exhibit 3 shows couple examples of this creative splicing. Clearly there are lots of gaps and overlaps!

Exhibit 3 – Examples of Creative Splicing

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Source: Index provider websites, PlanByNumbers

The second example is a very common one – after all SPDR S&P 500 (SPY) and iShares Russell 2000 (IWM) are synonymous with large and small cap stocks, respectively. In fact, among all ETFs they are number one (112 million shares per day) and number three (48 million) by average trading volume (EEM is number two in case you were wondering). So let’s take a quick look at the results of combining these two instead of using Russell 1000 and Russell 2000 together (Exhibit 4). You would miss out on a number of well-known names such as Las Vegas Sands, Tesla and LinkedIn (although you might be happy to be out of TSLA today (5/8/14) as the stock is down about 10% on earnings). Moreover, the top names in S&P 500 would be overweighed relative to Russell 1000.

Exhibit 4 – Mixing SPY and IWM

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Takeaways

1)      Know if your index uses two or three tiers so you don’t overlap categories

2)      Do not mix index providers, pick one and stick with it

3)      Pay attention to expense ratios of your fund combination, number of holdings and turnover

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Indexing U.S. Stocks – Broad Market Exposure (04/16/2014)

Along with the rise in overall passive investing on the rise (Exhibit 1), domestic equity space has seen a large increase in indexing. I decided to do a series of posts looking at various index options. I will start with a deep(-ish) dive into the available broad market index funds. By the way, S&P 500 is NOT a broad market index – it’s a managed index of 500 large companies and excludes over 2,500 other stocks available in broader indices. And don’t even get me started on Dow 30 as a market benchmark!

Exhibit 1

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Let’s say you have read many articles on Morningstar, Vanguard and lots of other sites that convinced you that indexing your domestic stocks is a way to go (trust me, it is). You decided to replace your actively-managed funds with a broad market index and be done with it. So what is the best option to use and why?

Exhibit 2 shows most of the major ways to buy the entire U.S. stock market in one fund. There are several sub-sections in the spreadsheet. Major ETFs represent large funds tracking four main indices. Other ETFs are shown for reference, they wouldn’t be my first choices. Interestingly, iShares has FOUR different broad market ETFs tracking different indices. Seems a bit overdone to me, but that’s why I’m not an important fund company executive. Also, there are two other Russell 3000 funds from SPDR and Vanguard, but iShares version remains the biggest one despite having higher expense ratio.

I also showed a couple of major open-ended mutual funds that represent the total stock market. VTSAX is a different share class of VTI (note that AUM for VTI represents ETF share class only). Just to be thorough, I also included two funds from Dimensional Fund Advisors. They are not index funds per se – they use custom benchmarks that overweigh small cap and value stocks based on academic research. I might do a separate DFA post at some point, but this article will focus on funds that track actual commercial indices.

Exhibit 2 – Major Index Fund Metrics

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Below is a brief overview of the metrics relevant to index fund selection:

Assets Under Management (AUM) – Typically, higher AUM reflects an established fund that attracted a lot of assets with low fees and solid management (Yes, managing index funds DOES require large amount of expertise).

Expense Ratio – This one is pretty simple – lower is better!

Average Volume – ETFs (as opposed to mutual funds) are traded intraday, so you want to pay attention to how liquid they are. Personally, I wouldn’t use market orders on anything that trades less than 100,000 shares a day (200,000 just to be safe with all those high-frequency traders – 60 Minutes anyone?).

Years Since Launch – Shows an established fund, although new funds are not necessarily bad – Schwab products are solid choices

Benchmark Index – Note that fund companies listed above maintain arm’s-length relationships with index providers. They license the right to use the index name and track its holdings.

There are five primary U.S. index providers represented. Standard & Poors is a well-known index shop as is Dow Jones. Interestingly, these two formed a joint venture in 2010 and their indices are part of the same business now.

The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market.

MSCI is a provider more known for its International indices. Moreover, MSCI USA is really a large cap index as opposed to the broad market as it has no exposure to small stocks.

CRSP is affiliated with the Booth School of Business at the University of Chicago. Historically, they were geared towards academic community instead of commercial index products. But that all changed when Vanguard (the largest index shop) switched their domestic funds to CRSP in 2013. In fact, Vanguard changed their index providers several times recently: “Dow Jones U.S. Total Stock Market Index (formerly known as the Dow Jones Wilshire 5000 Index) through April 22, 2005; MSCI US Broad Market Index through June 2, 2013; and CRSP US Total Market Index thereafter.”

From investor’s perspective, the actual underlying index is not too important as long as it’s broad enough, but some index providers charge high fees that lead to higher fund expense ratios (see Vanguard’s VTI vs VTHR).

Now let’s take a look at some portfolio composition metrics and historical returns for these funds (Exhibit 3).

Exhibit 3 – Index Fund Composition and Returns

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Number of Holdings – In a broad market index you want as many positions as possible, while still remaining practical to manage. Thus VTI and IWV are great choices and EUSA not so much.

Another thing to note is index sampling – i.e. holding “representative” securities that get the returns “close enough” to the underlying index. For example, THRK’s benchmark is composed of 3000 companies, but the fund has only 2,512 holdings. Similarly, SCHB has 2,000 holding vs 2,500 in its benchmark. Sampling, if done well, keeps costs low by reducing the fund’s transactions.

Composition by Market Cap – related to last datapoint. You DO want significant exposure to small and micro caps since they tend to outperform larger companies over time. The top three major ETFs are very comparable in this metric.

Historical Return – For index funds, this is largely a function of low expense ratio. But index tracked, management experience, trading costs and other variable play significant roles.

Summary

After reviewing the metrics above, Vanguard’s VTI is a clear winner with Schwab a close (albeit less established) second:

Expense ratio – check (although its 1 basis point higher than Schwab).

AUM – by far the largest asset base, all those people can’t be that stupid

Volume – over 3 million shares a day, unless you are trading billions of dollars you won’t move the spread

Time in existence – the fund has been around for almost 13 years and Vanguard has been managed indexed funds since 1970s.

Index Tracked – CRSP is a very broad unmanaged index with reasonable licensing fees

Number of holdings – by far the largest number of companies in our sample

Small & Micro caps – related to last datapoint, VTI has a largest exposure to smallest companies (aside from DFA that is)

Historical Performance – best index fund returns over all timeframes (again DFA is better but with quite a bit more risk). Largely due to very low expenses, but the performance advantage holds even after adjusting for expense ratios.

How Come I Don’t Have Any… Tesla, Netflix or Facebook?

One of the most frustrating common questions financial advisors get from clients is “Why didn’t you buy that XYZ hot stock for my account?”  People watch the hype on CNBC or read financial press and get all excited about Elon Musk (Tesla) or Twitter IPO.  By the time these companies become household names in many cases the big run is largely over and the volatility goes through the roof.

I prefer to invest in domestic stocks through index ETFs as opposed to actively-managed funds.  There are many reasons for this including lower expense ratios, persistence of performance and style drift.  I won’t get into the detail of that here, but one of the “side effects” of investing in index funds is that you DO end up owning every stock in the market, including the hot performers.

Let’s make a few assumptions and see what a typical investor might own in their index portfolio.  For this example, we will take a total of $1,000,000 invested in a 60/40 portfolio.  Let’s assume 2/3 of equity allocation is invested in domestic stocks and that it’s split 70/30 between large and small cap ETFs (Exhibit 1).

Exhibit 1 – Equity Ownership of Sample Portfolio

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I typically use Schwab ETFs in client portfolios because they have the lowest expense ratios and are free to trade in Schwab accounts (which happens to be our custodian).  The analysis of resulting domestic stock portion is shown in Exhibit 2.  The 70/30 split has expense ratio of 5 basis points, about 2,500 holdings, 58% large cap stocks and is slightly tilted towards growth stocks (per Morningstar classification).  The numbers for U.S. Broad Market ETF are also shown for reference.

Exhibit 2 – Characteristics of Combined ETF Holdings

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Now let’s pick 10 hot stocks that get a lot of attention due to their performance and media popularity (subjectively selected by me).  With our $400,000 position in domestic stocks, here is what we own: $250 of TSLA, almost $400 of NFLX and $1,700 of FB (Exhibit 3).  We even have $56 worth of Twitter or one entire share.  TWTR went public on November 7, 2013 and was added to SCHX on December 23.

Exhibit 3 – Ownership of Popular Stocks in Schwab ETFs

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Exhibit 4 shows the top performers among U.S. stocks with market cap over two billion dollars.  You can see in my prior post reviewing 2013 that the best areas to invest in lately have been Solar, Biotech, and Social Media/Internet.  Out of 20 big gainers only four are well-followed names from Exhibit 3 (highlighted in grey).  The rest are small companies heavily concentrated in biotech and technology areas.  A year ago, how many of you could have picked Intercept Pharmaceuticals, Rite Aid or MGIC Investment to be big winners?  I know I couldn’t!  In the interest of full disclosure, by indexing you also own the biggest losers in the market, such as a nice bouquet of gold and coal miners that have lost 30-60% in the past year.  The upshot of that is that yesterday’s losers often become tomorrow’s darlings and vice versa.

Exhibit 4 – Ownership of Top Performing Stocks

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The “Bottom 99%” Note

The beauty of this approach is that you don’t need a million-dollar portfolio to own any and all stocks.  Index investing is a very democratic and [almost] anyone can open a Charles Schwab account with a minimum deposit of $1,000.  After that you can buy Schwab ETFs with ZERO commission in one-share increments (about $50).  (Note: I am not promoting Charles Schwab in particular, just using them as example since we are looking at their ETFs).

Exhibit 5 shows the exposure for the same portfolio as above but with only $10,000 overall investment.  Google (GOOG) is a twelve hundred dollar stock, but you can still own 0.044 shares worth $52.70.  Similarly, you would own 56 cents worth of Twitter stock giving you a tiny ownership in the [potentially] next big thing!

Exhibit 5 – $10,000 Portfolio Example

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