Exchange-traded fund investors know better than to ignore the cost of a particular investment in a portfolio. Most gravitate to ETFs for tax efficiency and low annual management fees relative to mutual funds. Let’s explore one natural benefit to the ETF structure that makes it tax efficient.

ETF Structure Affect Tax Liabilities

Exchange-traded funds are designed as trusts, most commonly under the Investment Company Act of 1940, which allows this particular structure of a fund. As a grantor trust, the exchange-traded fund is essentially its own being – an investment company. Buying and selling the ETF, then, is just like buying or selling any other company.

But what makes this open-ended structure unique is the creation and redemption process. Open-ended funds allow for “authorized participants” (mostly major investment banks or hedge funds) to trade assets for new shares, or shares for part of the portfolio’s assets. For example, a hedge fund could offer up a portfolio of S&P500 companies in exchange for shares in the SPDR S&P500 Index ETF (SPY). The hedge fund gives the ETF the appropriate amounts of stock for SPY shares, and the ETF company gives the hedge fund an appropriate amount of SPY shares for their stock.

The opposite of this transaction is the redemption process, whereby investors can trade SPY shares for a large block of all the shares in the S&P500 index.

The Awesome Tax Efficiency of ETFs

This system of creation and redemption allows investors to skip on a majority of their capital gains tax. By virtue of the creation and redemption process, exchange-traded fund administrators can “hide” capital gains that would otherwise be passed on to investors.

Let’s use an example to demonstrate how this works. Suppose State Street Global Advisors, which is the issuer of the popular SPY ETF, has holdings in every stock in the S&P500 index to back its fund. The fund naturally holds some shares at a gain, some at a loss, and from top to bottom the fund has shares acquired at a different cost.

In the S&P500 index is Apple, which SSGA naturally owns in the ETF portfolio. State Street did not acquire all these shares at the same time. It might have two different blocks with a cost basis of $650, and $500, while the current share price might be $600.

In the redemption process, State Street can make redemptions in which it delivers stock in exchange for SPY shares. State Street can deliver the shares with a cost basis of $650 to the investor asking for redemption. This transaction essentially provides for a capital loss of $50 per share, since the current share price is $600, neutering some of the unrealized gains on the stock acquired at a cost basis of $500. Paying out the redemption with shares at a $500 cost basis would create a capital gain of $100, given that the current value of Apple shares is $600 each.

ETFs vs. Mutual Funds on Tax Efficiency

Mutual funds cannot compete with ETFs when it comes to tax efficiency (over virtually anything else – see the data showing Mutual Funds are Dead). Just look to all the stories of mutual funds falling in value yet passing on large capital gains tax bills to investors.

It is tax law that makes ETFs more efficient than mutual funds. Note the difference in tax treatment between the two funds:

• When mutual funds redeem investors’ capital, the transaction is done in cash – shares are sold and the cash is delivered to an investor.
• When ETFs make redemptions, the ETF delivers shares as an exchange. (This is known as an exchange in-kind, where stock in an ETF is exchanged for stock in the underlying assets making up the index.) Exchanging assets is not a taxable event.

The result is that ETFs can essentially “hide” most of their capital gains tax burden. Mutual funds largely have to pass on this tax burden due to the difference between selling securities and exchanging securities.

ETFs Are Not Perfect!

Exchange-traded funds are not entirely tax-free. Not all of the capital gains in any given ETF can be disposed of via the creation and redemption process. However, because the creation and redemption process is integral to the operation of an open-ended exchange-traded fund, high volumes of creation and redemption do allow for the fund to operate without passing on any capital gains tax directly.

A Bloomberg study made obvious the extreme differences in capital gains taxation between exchange-traded fund structures and mutual fund structures. The study found that in the period of August 2000-2001, exchange-traded funds based on popular indexes passed on an average capital gains tax burden of 0.31% of the ETF’s value compared to 5.87% for mutual funds.

Remember, these are the exact same funds tracking the exact same indexes. The only difference is the structure and tax consequences of selling stock compared to exchanging stock.

In this case, a $100,000 investment spread evenly in every index would result in only $310 in capital gains distributions for the year 2000-2001. Mutual funds, by contrast, passed on capital gains distributions of $5,870.

There are many misconceptions about what ETFs are designed to do and what they deliver.  For instance, all leveraged ETFs go to zero and investors are perennially frustrated when they think a 3X ETF should actually triple the return of an index (which they don’t over time!).

Disclosure: the author does not hold any of the securities listed in the article above.

©2012 ETF Base. All Rights Reserved.

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Exchange-traded fund investors know better than to ignore the cost of a particular investment in a portfolio. Most gravitate to ETFs for tax efficiency and low annual management fees relative to mutual funds. Let’s explore one natural benefit to the ETF structure that makes it tax efficient.

ETF Structure Affect Tax Liabilities

Exchange-traded funds are designed as trusts, most commonly under the Investment Company Act of 1940, which allows this particular structure of a fund. As a grantor trust, the exchange-traded fund is essentially its own being – an investment company. Buying and selling the ETF, then, is just like buying or selling any other company.

But what makes this open-ended structure unique is the creation and redemption process. Open-ended funds allow for “authorized participants” (mostly major investment banks or hedge funds) to trade assets for new shares, or shares for part of the portfolio’s assets. For example, a hedge fund could offer up a portfolio of S&P500 companies in exchange for shares in the SPDR S&P500 Index ETF (SPY). The hedge fund gives the ETF the appropriate amounts of stock for SPY shares, and the ETF company gives the hedge fund an appropriate amount of SPY shares for their stock.

The opposite of this transaction is the redemption process, whereby investors can trade SPY shares for a large block of all the shares in the S&P500 index.

The Awesome Tax Efficiency of ETFs

This system of creation and redemption allows investors to skip on a majority of their capital gains tax. By virtue of the creation and redemption process, exchange-traded fund administrators can “hide” capital gains that would otherwise be passed on to investors.

Let’s use an example to demonstrate how this works. Suppose State Street Global Advisors, which is the issuer of the popular SPY ETF, has holdings in every stock in the S&P500 index to back its fund. The fund naturally holds some shares at a gain, some at a loss, and from top to bottom the fund has shares acquired at a different cost.

In the S&P500 index is Apple, which SSGA naturally owns in the ETF portfolio. State Street did not acquire all these shares at the same time. It might have two different blocks with a cost basis of $650, and $500, while the current share price might be $600.

In the redemption process, State Street can make redemptions in which it delivers stock in exchange for SPY shares. State Street can deliver the shares with a cost basis of $650 to the investor asking for redemption. This transaction essentially provides for a capital loss of $50 per share, since the current share price is $600, neutering some of the unrealized gains on the stock acquired at a cost basis of $500. Paying out the redemption with shares at a $500 cost basis would create a capital gain of $100, given that the current value of Apple shares is $600 each.

ETFs vs. Mutual Funds on Tax Efficiency

Mutual funds cannot compete with ETFs when it comes to tax efficiency (over virtually anything else – see the data showing Mutual Funds are Dead). Just look to all the stories of mutual funds falling in value yet passing on large capital gains tax bills to investors.

It is tax law that makes ETFs more efficient than mutual funds. Note the difference in tax treatment between the two funds:

• When mutual funds redeem investors’ capital, the transaction is done in cash – shares are sold and the cash is delivered to an investor.
• When ETFs make redemptions, the ETF delivers shares as an exchange. (This is known as an exchange in-kind, where stock in an ETF is exchanged for stock in the underlying assets making up the index.) Exchanging assets is not a taxable event.

The result is that ETFs can essentially “hide” most of their capital gains tax burden. Mutual funds largely have to pass on this tax burden due to the difference between selling securities and exchanging securities.

ETFs Are Not Perfect!

Exchange-traded funds are not entirely tax-free. Not all of the capital gains in any given ETF can be disposed of via the creation and redemption process. However, because the creation and redemption process is integral to the operation of an open-ended exchange-traded fund, high volumes of creation and redemption do allow for the fund to operate without passing on any capital gains tax directly.

A Bloomberg study made obvious the extreme differences in capital gains taxation between exchange-traded fund structures and mutual fund structures. The study found that in the period of August 2000-2001, exchange-traded funds based on popular indexes passed on an average capital gains tax burden of 0.31% of the ETF’s value compared to 5.87% for mutual funds.

Remember, these are the exact same funds tracking the exact same indexes. The only difference is the structure and tax consequences of selling stock compared to exchanging stock.

In this case, a $100,000 investment spread evenly in every index would result in only $310 in capital gains distributions for the year 2000-2001. Mutual funds, by contrast, passed on capital gains distributions of $5,870.

There are many misconceptions about what ETFs are designed to do and what they deliver.  For instance, all leveraged ETFs go to zero and investors are perennially frustrated when they think a 3X ETF should actually triple the return of an index (which they don’t over time!).

Disclosure: the author does not hold any of the securities listed in the article above.

©2012 ETF Base. All Rights Reserved.

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Every alternative has its costs. Exchange-traded funds make investing less expensive, arguably less thoughtful, and certainly much less profitable for the investment management industry. From the perspective of an individual investor, these are all very good things.

We often miss what the popularity of indexing tends to hide.

Separating the Index from the Investment

BusinessInsider ran a recent story on the subject of earnings in the S&P500 index. The writer found that without Apple (AAPL), the S&P500 index as a whole would report zero earnings growth in 2012. The tech industry as a whole has become such a massive part of the S&P500 index that Apple essentially decides the direction for the whole market.

And technology isn’t really all that hot outside of Apple’s single growth story. The same author notes that the technology sector will show lower earnings in 2012 than it did in 2011, despite high flying individual companies like Apple.

It’s incredible to think that a single-stock in a 500 company index could have this much effect on total returns. Investing in the S&P500 index for the first few months of 2012 is a lot like purchasing a few shares of Apple for your own portfolio and keeping the rest in cash. Without Apple’s massive earnings growth and incredible returns in the common equity, investors have little to cheer for. Earnings are flat, and appreciation is little with the exception of a single firm in a single industry – Apple.  Apple’s Dividend is notable this year, as are some analysts finally calling for a slowdown (in a sea of $1 Trillion valuation calls), and margins may be compressed by absurd complaints about worker conditions assembling Apple products, but whether this single stock can continue to carry the entire index remains to be seen.

The Last Internet Bubble

Apple’s dominance is a serious market event. The last time the S&P500 index derived 10% of its 3-month returns from a single company was in 2000. The first time was one year earlier in 1999. It was then that major indexes and the few ETF offerings on the market began to input position limits into their investment qualification tests. Today, no stock can make up more than 5% of the S&P500 index, although holdings are usually held to a much smaller part of the portfolio due to a market cap weighting.

Apple is an anomaly. It’s crushed through two index limitations that were designed to thwart a stock like Apple from distorting the value of the index. Few companies are large enough to hit the ceiling on diversification rules within the ETF. Being the largest company on American exchanges, Apple destroys this lingering qualification.

The rare feat is that Apple is also fast-growing. Few companies can sustain growth in the single-digits while maintaining a market cap greater than a billion dollars. Apple has maintained massive double digit growth all the way to $600 billion in market cap.

Re-Thinking the Indices

In light of Apple’s growth explosion and distortion of the S&P500 index (SPY), is it time to think about equal-weight indexes over the market cap weighted S&P500 index?  Some examples of equal-weighted ETFs include the Guggenheim S&P 500 Equal Weight ETF (RSP) and the newly launched Direxion NASDAQ-100® Equal Weighted Index Shares (QQQE).  As you might imagine, SPY has outperformed RSP over the prior year period, with a 4% gain for RSP vs. a flat return on SPY.  However, over the prior 5-Year period, RSP outperforms with a 2.5% gain vs. a loss of 4.2% for SPY.  Bear in mind though, that RSP has a higher expense ratio at 0.4%.  One method to employ if unsure of Apple’s future contributions to index returns could be to go equal-weight in large part, with an out of the money Apple option to avoid missing another 100% move.  But then again, markets are efficient, right?

Are investors really diversified if it is the single largest holding and largest stock on the market that is keeping earnings growth afloat?

Disclosure: No position in any ETFs covered in this article.

©2012 ETF Base. All Rights Reserved.

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Here are some ETF stories in the news this past week:

• Emerging-Market Bonds Quench a Yield Thirst (NY Times)
• Are Dividend ETFs the Best for Income? (Chicago Tribune)
• How ETFs Fit with 401(k)s (Barron’s)
• Van Eck Junk Bond ETF Coming (NASDAQ)
• ETF Statistics for March (ETF Daily News)
• Horizons ETFs Launches Canada’s First Inverse Volatility ETF (ETF Screener)

Thanks to the following outlets for featuring content from ETFBase:

• Self-Directed Investing Carnival
• Totally Money Carnival
• Carnival of Financial Camaraderie
• Carnival of Personal Finance
• Carnival of Passive Investing
• Totally Money
• Carnival of Wealth

©2012 ETF Base. All Rights Reserved.

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Let’s breakdown the best and worst performing exchange-traded funds in March 2012, while highlighting the best three leveraged and unleveraged funds.

Top Leveraged ETFs in March 2012

1. VelocityShares Daily Inverse VIX Short Term ETN (XIV) 36.94% – This inverse fund tracking double the daily change in the short-term VIX index ran away from the pack in March. Playing the VIX – the volatility index – is a popular bet this year as the markets trudge higher. However, the VIX continues to move lower, mostly due to on-again off-again positions from retail investors in one of the most illiquid futures contracts. ETFs seeking to provide accurate tracking to investors are now the largest players in the VIX future market.
2. Direxion Daily Financial Bull 3X Shares (FAS) 19.3% – This triple-leveraged fund tracking the Russell 100 Financial Services Index finds no reason to take a breather. Healthy bank balance sheets, excellent stress test results, and near daily advances in share prices for top financial firms through March allowed this fund to ride the wave to the top. Year-to-date, the FAS fund rewarded investors with a 68% return. Investors should be sure not to forget that all leveraged funds eventually go to zero – this fund lost 52.66% of its value in 2011.
3. Direxion Daily Tech Bull 3x Shs (TYH) 15.77% – This triple-leveraged fund tracks three times the daily move in the Russell 1000 Technology Index. Good earnings, free cash flow growth, and awesome performance by a key holding – Apple (AAPL), which appears to be immune even to a barrage of ridiculous criticism from the mainstream media – makes this market-cap weighted fund the third best performer in March. Again, much like the FAS fund in the number 2 position, this fund benefitted from consistent days of advances in tech stocks, which makes for lucky compounding as leverage is reset daily.

Unleveraged, Straight ETFs

1. iShares Dow Jones US Financial Services (IYG) 8.5% – Financial services are unbelievably hot on Wall Street. Tracking the biggest financial services companies involved any financial sub-industry, from equities to real estate makes this fund a great proxy for broader market exposure. When the markets are up, financial services companies naturally benefit from a rising tide – and better fee-based revenues.  With the economy improving, most firms doing OK on the recent Stress Tests and more volume coming from products like 401(k) annuities, refinancing activity and limited exposure to Europe, US Financials were oversold since the crisis and are now returning to full value.
2. SPDR KBW Bank (KBE) 7.5% – The KBE fund tracks the S&P Banks Select Industry Index, an index comprised of companies involved primarily in traditional banking services. Such companies are typically overweight traditional assets like car loans and home mortgages and lighter on equities or financial management services. The fund’s excellent performance in March is not at all surprising, given that recent economic indicators point to an improving economy and improving personal balance sheets.
3. SPDR KBW Regional Banking (KRE) 5.88% – For those who want exposure to the smaller banking stocks, the KRE ETF is a perfect choice. The fund tracks the S&P Regional Banks Select Industry Index, which holds many of the same funds as KBE’s benchmark, with most major banks excluded from the list. The fund holds positions in smaller banks, which have regional exposure and typically smaller balance sheets. The four largest stocks in this fund are mostly “unknown” – Synovus Financial Corp (SNV), Popular Inc (BPOP), Regions Financial Corporation (RF), and SunTrust Banks Inc (STI) – which should be proof enough this fund is highly concentrated into the plain-vanilla and mostly-local S&L banking institution.

Disclosure: the author holds no positions in any of the funds or stocks listed above.

©2012 ETF Base. All Rights Reserved.

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Only blind investors have missed the on-going boom in online stocks. The year-ended 2011 brought a slew of new tech IPOs, and it is expected that the dot com juggernaut, Facebook, will IPO later in 2012.

So how can investors play the internet sector? We’ll take a look at the Dow Jones Internet Index Fund (FDN) and compare it to a few other dot com exchange-traded funds.

Dow Jones Internet Fund (FDN)

The Dow Jones Internet Index Fund (FDN) is an exchange-traded fund issued and administered by First Trust, a growing independent issuer. The fund seeks to track the Dow Jones Internet Index, while selecting only U.S. securities for its portfolio.

Do note that restricting ownership to wholly U.S. firms disallows popular dot com companies trading as American Depositary Receipts on U.S, markets. Foreign ADRs in the tech sector tend to be Chinese firms, which, depending on your perspective on Chinese accounting issues, might not be a preferred asset in your portfolio.

Fund Methodology and Weighting

The fund is market-cap weighted, with individual securities limited no more than 10% of the portfolio. Given that technology and internet companies have come to dominate market-cap weighted indexes, a 10% restriction on individual holdings is a necessity for real diversification. Market cap is float-adjusted and then normalized by trading volume to ensure the fund avoids front-running in lower-volume stock issues.

The fund rebalances and considers new holdings quarterly, on the third Friday (typically options expiration days) of March, June, September, and December. Rebalancing the fund quarterly allows it to move into new IPOs and tech firms earlier than rival funds, many of which rebalance annually.

Key Holdings

The Dow Jones Internet Index Fund (FDN) is undiversified, holding only 41 securities in a single specific sector: online business. The fund’s largest holdings include Google (9.09%), Amazon (7.44%), eBay (5.86%), Priceline (PCLN) 5.53%, and Yahoo (4.48%).

FDN rival, the InvescoPowershares NASDAQ Internet Portfolio ETF (PNQI) is very different. Rebalancing annually, investing into ADRs, and limiting holdings to 8% of the fund creates a completely different dynamic. Priceline, eBay, Amazon, Baidu, and Google make up between 7-8.5% of the PNQI portfolio individually. The fund holds more securities, having 64 different holdings with 80% of the portfolio invested domestically and 20% in international businesses.

Fees and Expenses

Management fees are neither high nor low for the Dow Jones Internet Index Fund, with fees and expenses of .60% of assets each year. InvescoPowershares’ PNQI is priced at the same 60 basis points annually.

The new Global X Social Media Index ETF (SOCL) is 5 basis points more costly than FDN or PNQI, costing investors .65% annually. Technology ETFs tend to be more specialized and therefore more costly than other indexing alternatives; as a category, tech funds collect .52% of assets as fees each year.

Fund Performance Comparison

Performance is one of the best ways to compare funds in any given category. The First Trust FDN fund is one of the oldest technology funds, which makes it difficult to compare returns to newer alternatives. We’ll include PNQI as well as the iShares Dow Jones Technology Fund (IYW), which tracks the technology sector as a whole.

3-year performance
FDN – 158.23%
PNQI – 182.07%
IYW – 121.05%

5-year performance
FDN – 57.45%
IYW – 43.70%

The PNQI fund has an edge over the FDN ETF in the most recent 3-year period. This can be attributed mostly to foreign exposure, which has propelled the PNQI to better returns with successful ADRs like Baidu. Additionally, the dollar has weakened substantially in the 3-year period from 2009-2012, giving additional lift to ADRs and firms which earn their income in non-dollar currencies.

Not surprisingly, both internet funds – FDN and PNQI – have outperformed the general technology sector. The internet sector enjoys faster growth than traditional technology companies.

I charted the performance of the ETFs above since the inception of the newest fund, the PNQI ETF:

The returns above do not include dividends. However, investors in the funds above should expect total return to be a result of share performance. Tech firms are notorious for paying the smallest dividend possible, if any, although Apple now pays a dividend. Technology firms are most likely to pay a dividend large enough only to satisfy mutual fund requirements, which often require holdings to pay at least some kind of dividend, even if only a penny per year, per share.

Bottomline

The FDN ETF is an excellent fund for investors who would prefer to keep their investments local. Dollar devaluation and international exposure that fueled the PNQI fund to higher 3-year returns is unlikely a permanent fixture in the market.

International exposure through PNQI is attractive for investors who believe the best growth in technology will be in the emerging markets. One could make the case, however, that most large cap internet firms are inherently multi-national (Google, for example, derives advertising revenues in over a hundred foreign markets), and that investors only increase their risk by investing in firms operating in nations with less stringent accounting requirements, and fewer protections for private property. Dilution of equity to favored investors is common in emerging markets. In particular, Chinese firms have historically allowed for vast share count dilution with closed sales to preferred investors.

At any rate, investors are unlikely to be disappointed with growth in the technology sector.  Investors must be cognizant of the compartmentalization of various new tech themes like the Cloud Computing ETF and the Social Media ETF and contrast the holdings in each compared to a fund like FDN. Tech companies managed earnings growth well in excess of the broad market during the 2008 financial crisis, and continue to lead most every sector in the market, excluding highly-levered oil and mining stocks. Consistently high growth, excellent free cash flow, and potential for rapid scaling are hallmarks of the modern internet technology company.

Disclosure: The author holds no positions in any of the above funds.

©2012 ETF Base. All Rights Reserved.

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Buybacks are back in play. Looking to boost shareholder value, a number of companies have announced share repurchase agreements to buy back shares on the open market. Betting on one’s own company is usually a safe bet for executives, one which increases the earnings per share for a firm, and allows for a very good return on invested capital.

For stockholders, buybacks also push off a tax liability into the future. Theoretically, a dividend payment is inferior to share repurchases because of the tax liability paid by investors. Share repurchases increase shareholder’s ownership of a firm without taxes.

Buyback Achievers ETF (PKW)

The PowerShares Buyback Achievers ETF seeks to find companies buying back stock in much the same way some investors seek out dividend-paying firms. The rules-based ETF operates very simply on a few basic rules:

1. Included companies have to be incorporated in the United States
2. Each firm must trade on US exchanges
3. Firms must buy back 5% or more of their common stock in the trailing 12-month period

The requirements fuel higher turnover than other funds. Companies that repurchase 5% of their equity each year are quite rare – few can afford such a repurchase strategy for very long. More likely, companies meet criteria only for one or two years before cash outlays for share repurchase are scuttled as cash on hand is diminished.

Investment Methodology & Weighting

Any stocks meeting the three criteria above are put into the Buyback Achievers portfolio. Investments are market cap weighted, and capped at 5% of the portfolio.

The fund holds some 291 different firms, far more than one might expect given the very selective requirements for total share repurchases.

Personally, I like the fund’s inclusion requirements combined with the market cap weighting. Limiting the fund to companies that repurchase more than 5% of their common stock means it avoids firms that buy back shares solely to cover up stock option compensation to insiders. Also, the market cap weighting virtually ensures the fund is never taken by corporate diluters, who would find it very difficult to steal billions of dollars in shares by diluting the stock.

The 5% threshold is a bar set high enough that no stock will “accidentally” find itself as a position in the index. For a company to repurchase 5% of its equity, corporate leaders would have to view their company as a good wager at the current share price.

Industry Weight

Major holdings include consumer cyclicals (25.1%), technology (18.54%), health care (15.78%), industrials (11.65%), and consumer defensive stocks (8.33%). The heavy weighting of the fund to cyclical stocks makes this a fund for a turnaround.

Fees and Expenses

The fund carries a .7% annual expense ratio, which is higher than most market-cap weighted funds (Here are the 5 lowest cost ETFs). However, its small size and intriguing strategy make it inherently less cost-effective than large funds. Turnover and research costs undoubtedly add to the costs of managing this particular ETF.

Fund Performance

At the end of the day, it all comes down to total return. Here are the 5-year returns for PKW, as well as two other popular exchange-traded funds:

• PowerShares Buyback Achievers ETF (PKW): 23.42%
• SPDR S&P 500 ETF (SPY): 11.77%
• SPDR S&P500 Dividend ETF (SDY): 11.59%

Interestingly, the PKW ETF has bested both the S&P500 index as well as the S&P500 Dividend Index, which currently holds the 62 highest-yielding S&P500 components (more types of High Yield ETFs). As share repurchases are often compared to the alternative, dividends, it is interesting to see a buyback fund perform twice as well over the 5-year period as one of the most popular dividend ETFs.  This is especially vexing since dividends provide half the total market return over long periods of time and yet, PKW’s buyback strategy exceeds even the dividend payers in SDY.

See the chart below, which compares the price of the funds over time:

Be sure to note that this performance chart above does not include dividends. We can conclude from the share price performance that total returns from the buyback fund are almost exclusively from appreciation in the fund NAV. This only confirms the view that most companies cannot sustain both a high dividend yield and 5% repurchases of common stock every year.

There are a few reasons why total returns for PKW outpace both the SPY and SDY ETFs:

1. Exposure – The PKW fund is unlikely to invest heavily in financial firms. While financial firms were among the largest buyers of their own equity before the financial crisis, few banks ever repurchased more than 5% of their equity in any given year. This fund is unlikely to hold major banks in the future, given that repurchases are now governed by the Federal Reserve’s stress test results. At the time of writing, the PKW fund held only 8.22% of its assets in financial services firms, compared to 13% for the S&P500 index.  If seeking a combination of financials and extremely high yield, check out Preferred Stock ETFs.
2. Leverage – Companies that repurchase shares increase their operating leverage by decreasing their cash position to buy back stock on the open market. In a recovery, companies that consistently repurchase shares will perform better than average. However, in down markets, companies that repurchase share are unlikely to outperform.
3. Timing – The 5-year period is very forgiving to the PKW ETF. In 2009, at the bottom of the market, the fund held companies that were most active in doubling down their bets on their own equity. Anyone who purchased shares in 2009 should have done quite well in the following years. Likewise, the 3 year period from 2006 to 2009 sent the PKW index falling faster than the S&P500 index as fund holdings were purchasing shares at prices in excess of the value on the market – essentially wasting money on falling stock.

Bottom Line

This is a fund that I would expect to outperform a broad market index such as the S&P500 index over the longest of investment horizons. The methodology favors firms that are most confident about future earnings power. The exit strategy is also clearly defined, as the fund sells positions once the buyout bank balance runs too thin to sustain purchases. Repurchase agreements often send stock prices soaring as companies repurchase shares on the open market.

Disclosure: The author holds no positions in any of the above funds.

©2012 ETF Base. All Rights Reserved.

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Here are some interesting ETF news items out this week:

• Schwab jumping into the actively managed ETF fray (source)
• The High Costs of High Yield ETFs (Barron’s)
• The Apple Effect on ETFs (ETF Daily News)
• Diamond ETF in the Works? (Barron’s)
• Human Rights Index Fund – Not a good idea (Marketwatch)

Outlets that graciously featured my content recently for both High Yield Edge and ETF Base:

• Carnival of Passive Investing
• Carnival of Financial Planning
• Self-Directed Investing for Retirement Carnival
• Carnival of Wealth
• Carnival of Personal Finance
• Best of Money Carnival
• Carnival of Financial Comraderie
• Totally Money Carnival
• Carnival of Personal Finance

©2012 ETF Base. All Rights Reserved.

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Exchange-traded funds have commoditized broad allocation strategies. As exchange-traded funds require only a modest amount of overhead and competition intensifies, fund fees plunge with each passing day.

The Lowest Cost ETFs

Below are the five least expensive exchange-traded funds:

1. Focus Morningstar Large Cap Index ETF (FLG) – This FocusShares fund based on the Morningstar Large Cap Index tracks 265 total holdings, but market cap weighting means it has as much as 25% of the fund invested in the largest 10 companies in the index. All large-cap and all US-based, you won’t find much difference in this fund compared to other market-cap weighted funds based on the S&P500 index. However, with fewer holdings, the fund has far more exposure to the largest firms than does the broader S&P500 index.  The expense ratio is .05%.
2. Focus Morningstar US Market Index ETF (FMU) – Market capitalization weighted, this fund seeks to cover 97% of the large caps available on the market. The fund trades with a low .05% annual expense to investors, but low volume means that investors have not yet taken to low fee funds exclusively. The underlying index maintains exposure to 1674 holdings, an impressive diversification level given the low cost of ownership. The underlying index is a product of Morningstar, but the fund is managed by the smaller ETF issuer FocusShares.
3. S&P 500 ETF (VOO) – A Vanguard exchange-traded fund, and a popular choice among so-called Bogleheads, the VOO ETF tracks the S&P500 index as designed. Market cap weighted to track the 500 stocks in the S&P500 index, Vanguard charges only .06% per year to manage the fund. Economies of scale earned through Vanguard’s extensive mutual fund business and patented fund structure ensures that Vanguard will always be one of the companies with the lowest fees.
4. U.S. Broad Market ETF (SCHB) – Charles Schwab is new to exchange-traded funds fearing that the fund structure would eat into its higher-end fund and brokerage model. The company launched one of its first funds, the SCHB ETF, based on the Dow Jones U.S. Broad Stock Market Total Return Index, a float adjusted and market cap weighted index. SCHB costs investors a meager .06% per year to own in their portfolios. The fund holds positions in 1575 different companies.
5. Total Stock Market Index ETF (VTI) – Another Vanguard finds its way to the lowest cost ETF list with an annual expense of .07% per year. The Total Stock Market is just as it sounds – the index tracks at least 99.5% of all stocks on the market by market cap. The fund goes so far to dig into smaller stocks, including those traded on the smaller American Stock Exchange platform as well as equities traded over-the-counter. The VTI ETF holds a whopping 3326 securities.

A Trend in Lower Costs

The trend is quite clear; the lowest cost ETFs are almost always centered around massive, diversified portfolios invested in companies on domestic exchanges. Investors looking for long-term retirement planning options would do quite well investing in any of the above lowest cost ETFs to displace their stock holdings.  In fact, here are several ways to trade ETFs for free or even trade free above and beyond just ETFs for opening an IRA account.

Investors seeking balance with bond and fixed-income ETFs will have to pay a premium. PIMCO’s 1-3 Year US Treasury Index Fund ETF (TUZ) is the least expensive bond fund at .09% per year. The second lowest cost bond fund is the SCHZ ETF, a Charles Schwab tracking the aggregate investment grade bond universe with a price tag of .10% per year. Bond funds seem to be most populous in the .15% fee range, where many different, specialized bond funds begin to find a competitive balance between lower costs and less liquid fixed-income markets.  Investors seeking high yield ETFs will tend to pay more due to lower volumes and higher bid-ask spreads.

At any rate, the reality is quite clear: any investor can find a cheaper mutual fund option with ETFs.

Disclosure: No positions in any ETFs covered in this article.

©2012 ETF Base. All Rights Reserved.

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The following is a guest post on mortgage strategies while rates are at generational lows:

It’s tough to ignore what’s going on with mortgage rates around the world right now. With Central Banks committed to keeping their lending rates low, mortgage rates, at least in most developed nations, continue to hover at generational lows.  There are a few things I’ve looked into to see how I can capitalize on the situation.  Primarily, checking out a mortgage calculator and thinking about various avenues to exploit the situation is the first step.

• New Home Purchase – This is a major commitment and anchors you to a particular locale, but if you have steady employment and want to escape the recurring payments to a landlord, this is the obvious next step.  Why continue to pay the mortgage for a landlord permanently if you’re going to stay in the same spot for an extended period of time?  If you’re recognizing that housing could remain flat or even decline further, but think offsetting your expenses with equity build is worthwhile, now’s an optimal time!
• Refi – With rates low as long as they have been, many people in a position to refinance already have.  In some cases though, people haven’t had the finances or credit to do so, so they continue to pay higher rates.  With various government programs helping to loosen credit requirements and fees, or even the consideration of borrowing to do so, it might just make sense over the long-term, especially if your current rates are high.
• Rental Real Estate – If you have the capital available, it’s virtually always a good time to get into rental real estate.  Whether it’s starting small with buy to let mortgages or even going larger with a partner or group, the benefits range from diversification away from other asset classes to the benefit of leverage.  The downsides do of course include risk of loss, and any “investment property” should have a very long time horizon as it’s about as illiquid as it gets from an investment standpoint, but if you’re in it for the long-term, it’s certainly worthy of consideration.
• REITs – If none of these options are available to you given the larger capital and credit requirements, it might be worthwhile checking out the various real estate investment trusts and associated ETFs.

©2012 ETF Base. All Rights Reserved.

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