Ask The Pro: October 2009
Each month, Michael Johnston, ETF Database’s Senior Analyst, answers questions on the mind of ETF investors around the world. If you have a question for our ETF Pro, submit to mailbag@etfdb.com.
Question: Right now my two main bond holdings are AGG and TIP (yeah, I’m paranoid). I’m worried that I’m overweight in “riskless” bond classes since AGG holds so many government bonds. I don’t want my bond allocation to have much risk, but on the other hand, I want to hit the “sweet spot” between risk and return (according to Graham, that means high grade corporate bonds). Should I sell AGG and put the proceeds into LQD? Is there another option? And why aren’t there more high-grade, non-governmental bond ETFs?
Pro: You’re right that the bond section of your portfolio is very heavy in debt issued by the U.S. government and its agencies. But calling these assets “riskless” might be a bit optimistic. The iShares Aggregate Bond Fund (AGG) allocates about 25% of its holdings to Treasuries, 17% to FNMA, 17% to FHLMC, 4% to GNMA, and 10% to U.S. agencies. While securities issued by GNMA are backed by the full faith and credit of the U.S. government, those issued by FNMA and FHLMC are not.
But to get to the meat of your question: it seems to me that you don’t have nearly the exposure to investment grade fixed income securities that you desire. Only about 20% of AGG’s holdings are in investment grade corporate bonds, which means that only about 10% of your total fixed income exposure is to this sector. For an investor who subscribes to the Ben Graham school of thought, this is far too low. You’re already heavily exposed to Treasuries through TIP, so I don’t see the need to double down by adding another bond ETF heavy on risk-free securities. Shifting your holdings in AGG to LQD will better equip you to achieve your investment goals.
I wish I had a better answer for your second question. It really is astonishing how few fixed income ETFs are available given the importance of bonds in any well diversified portfolio. The options for investors looking for pure play corporate bond ETFs are extremely limited (basically just LQD), and the options for junk bonds aren’t much better (JNK, HYG, and PHB).
But I think that is going to change. When the ETF industry began to take off several years ago, investors were skeptical of including fixed income securities within the exchange-traded structure, fearing that liquidity issues and other structural flaws would limit their efficiency. iShares (and others) have since proven that this is not the case – fixed income ETFs offer many of the same advantages as equity funds. We’ve seen a number of well known players (Pimco and Vanguard come to mind) expand their bond ETF offerings in recent months. While these new launches have focused primarily on Treasury funds, I would expect that a wave of both diversified and targeted corporate bond ETFs isn’t far behind.
Question: I am 50 years old, in the highest tax bracket, and looking for income preservation. But I also hate Uncle Sam’s hands in my deep pockets. So my question is this: will fixed-income ETFs be as tax efficient as equity ETFs?
Pro: The tax efficiencies of ETFs are a result of the manner in which they are structured. First off, most ETFs are indexed, meaning that they generally experience lower turnover than actively managed mutual funds. Second, investors generally buy and sell ETFs to other investors, not to the ETF issuer or trust, meaning that the ETF doesn’t have to sell securities when an investor wants to liquidate his or her proceeds. No sale means no capital gains taxes to pass along to investors.
ETF shares can also be created and redeemed in a tax efficient manner. Large investors known as Authorized Participants exchange a basket of securities that mirrors the fund’s holdings for shares in the ETF (to redeem shares, the process works in reverse). Since these transactions are considered in-kind exchanges (as opposed to outright sales) for tax purposes, capital gains taxes are generally avoided when new shares are created.
No on to your specific question. The tax efficiency of ETFs doesn’t discriminate between asset classes. The system described above will work just as well for bonds as it does for equities. Properly managed bond ETFs can avoid incurring capital gains taxes when shares are created and redeemed.
It’s important to keep in mind that the ETF structure doesn’t eliminate capital gains, it simply defers them. When you sell the ETF, you may incur capital gains on any price appreciation. And any dividend payments received from a fixed income will be taxed in much the same manner as if you owned the bonds directly. But these taxes are under your control.
It sounds as if you have a relatively high ability to take risk, but your willingness to take it on is on the low side. If you haven’t done so already, you should consider allocating a portion of your portfolio to a municipal bond ETF (click here for a complete list). Debt included within these ETFs issued by various municipalities across the U.S. (ETFs focusing exclusively on New York and California are also available), and the proceeds are tax-free for most investors. For investors in a high tax bracket, the taxable equivalent of the yields generated by municipal bonds can be quite appealing.
By investing in municipal bond ETFs, not only do you get Uncle Sam’s hands out of your pockets, you get yours into his.
Question: I consider myself to be financially savvy, and generally have a pretty good grasp for the appropriate asset allocations (I’m more of a buy-and-holder, but can’t resist the temptation to occasionally engage in some tactical asset allocation). But there are multiple ETFs offering exposure to each asset classes (for example, large cap equities). How do you decide between ETFs that on the surface seem to be nearly identical?
Pro: As the ETF industry has expanded, certain corners of the market (particularly the equity ETF market) have become saturated with products offering exposure to similar asset classes and styles. Once I’ve homed in on a sector or region that I believe is poised for outperformance, I generally consider four factors when selecting a particular ETF: expenses, liquidity, beta, and depth of holdings.
When weighing the merits of relatively similar ETFs, the first metric I consider is the expense ratio. ETFs have become so popular in part because of their lower costs relative to actively-managed mutual funds. But the expense ratios for ETFs are far from homogeneous, ranging from .09% for a handful of funds (such as IVV and SPY) to 1.5% for actively-managed ETFs that implement more complex investment strategies (such as DENT).
So for example, if I was considering an investment in short term Treasuries, I would be inclined to purchase TUZ over SHY. These ETFs track the same benchmark, but TUZ has an expense ratio 6 basis points lower than SHY. This might not sound like much, but the effects of compounding over time can become material. Expense ratios are included on the ticker pages of each of the 870+ funds in our database (here’s TUZ and SHY as examples).
But there’s a lot more to consider beyond simple expense ratios.
When choosing between two or more similar ETFs, investors should also consider the liquidity of the funds. The savings from lower management expenses can be easily offset by large bid/ask spreads on ETFs with relatively low trading volumes. In general, the greater the average trading volume for an ETF, the easier it will be to sell shares at or near net asset value.
That isn’t to say that you should avoid ETFs with low daily trading volumes. Just be smart about how you get into and out of positions of these funds. Limit orders are a very powerful thing.
It may sound strange to those accustomed to active management, but an ETF that outperforms its benchmark by a wide margin is a very poor product. Whereas actively-managed mutual funds seek to outperform a benchmark, most ETFs seek to match the performance of an underlying index. But not all ETFs will track their target benchmark exactly. The closer an ETF tracks its benchmark, better the fund. ETFs with high tracking errors may suffer from inefficient management, significant rebalancing costs, and poor representative sampling techniques.
The final factor I would consider is depth of holdings. Some ETFs hold thousand of individual securities, while others may hold as few as two (e.g., BHH). For most investors, the more diversified the exposure the better.
So for example, if I was trying to gain exposure to the Chinese equity markets, I would be inclined to invest in GXC, which has about 130 individual components, over FXI, which has only 25.
Disclosure: No positions at time of writing.
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