Diamonds, spiders, webs and cubes gain favor.
by Douglas A. Lambrecht, CIMC 11/10/1999
If you listen closely you can almost hear the prescient rumbling sound of earthquake-magnitude changes building…forces that may shake the very foundation of the U.S. securities, mutual fund and investment management industry while providing a virtual avalanche of benefits to individual investors. These powerful ground-swell shifts have been at work for some time now, yet they are subtle enough that most investors and managers have been largely oblivious to them. Although gaining momentum, these changes have little to do with technology, the brave new economy or the Internet. They do, however, have everything to do with investor’s interests in achieving market-tracking performance with improved control over cost efficiency.
Many would quickly agree that changes are long overdue. To them they will be welcome. But for some industry participants they’ll surely signal a death knell. Still operating under dinosaur concepts including a transaction orientation and high commissions, old-school brokerage firms will be the first to experience the shake up. Then the mutual fund industry, plagued with under performance, yet charging stubbornly high fees, and therefore ripe for innovation, will be hit. Investment managers will be next. More than ever before, the bylaw of the coming new age of investing will be to innovate or be threatened with extinction.
Many investors feel that changes in the industry are long overdue.
The last two decades, with back-to-back record-breaking returns, have greatly increased the popularity of investing while also improving investor education. Asset allocation, once a core strategy talked about primarily by consultants with their institutional clients, has moved mainstream. Now, selecting both managers and mutual funds on the basis of investment style, capitalization or sector concentration has become commonplace. Concurrent with this increased investing awareness has come competitive pressure to bring down costs.
Some changes have already hit the financial services industry. The Internet is making the instantaneous availability of information ubiquitous. Extended trading hours and the day-trading phenomena are factors. The recent fall of the Glass-Stegal act allowing banks to easily enter the brokerage business, although played down by the media, was a big event. Even the traditional exchanges are being challenged by electronic commerce networks (ECN’s) offering investors efficient trading alternatives. Technological advances are now fueling previously unheard-of efficiencies, forcing transaction charges lower, and benefiting individual and institutional investors alike.
While the changes the industry has already experienced are collectively enormous, soft indications portend even more dramatic changes ahead…ushering in a brave new era in investing with even lower costs, greater control over asset allocation, reduced overall portfolio risk and hopefully, superior performance. Heralding the trend has been the growing popularity of index investing, which now accounts for nearly one fourth of all new money entering the market. With that cork safely out of the bottle, investors are beginning to discover kissing cousins to index funds: exchange-traded funds (ETF’s).
ETF’s are quietly emerging as an outgrowth of the proliferation of domestic and foreign market indices and the compelling idea of investing directly in them.
ETF's are curious hybrid-type investments, which trade like stocks, but offer all the advantages of funds. First there were the Spiders, introduced in 1993 to track the S&P 500 index and its sectors. Then came the Diamonds, proxies for tracking the widely watched Dow Jones Industrial Average. In 1998 Barclays introduced seventeen country-basket instruments based upon MSCI indices called WEBS, that trade on the AMEX. Then NASDAQ got in the game with their very successful technology-tracking Cubes. Now, despite relatively low marketing exposure, ETF’s have gained a foothold and are estimated to account for over 25 billion in assets, doubling since 1998 and fast gaining momentum.
More ETF’s are on the way. Barclays Global Investors, the second largest investment firm in the world with 700 billion in assets, will soon introduce a line of fifty new units, dubbed iShares, that will closely track nearly every conceivable micro-segment of the U.S. stock market. With their ultra-low management fees (less than 20 basis points), stock-like liquidity (allowing for intra-day trading), and better tax-efficiency than mutual fund counterparts, these new vehicles may represent a serious threat to the complacent, high-fee fund industry, certainly to any fund that has under performed (most of them).
Although not actively managed, ETF’s offer most of the benefits of mutual funds and then some.
They may, in fact, be the best bargain for investors since John Bogle launched the Vanguard 500 Index fund in 1976. Like their mutual fund cousins, ETF’s offer instant diversification. Several will track indices that no funds currently cover, allowing investors and their advisers to fine-tune asset allocation strategies. Because ETF's are priced, bought and sold based upon tick-by-tick price changes like stocks, as opposed to most mutual fund’s end of day trading and pricing, they will allow for greater trend-trading agility. Since they are basically modeled as closed-end unit trusts, ETF’s are not required to declare annual capital gains, so they can be more tax-efficient. But, unlike closed-end mutual funds, ETF’s are designed to trade at their NAV instead of a discount or premium, making them less volatile.
Some may argue that we have no need for new investment vehicles, but this writer opines that ETF’s represent very healthy competition and that individual investors will be the primary benificiaries. While it may take a while for the full extent of benefits to be felt, the die is being cast and these changes most certainly will occur. The cost of owning stocks has already fallen. The cost of owning a diversified basket of investments will be the next to fall.
At the end of the year, what matters to savvy investors is what remains in their pockets, after taxes, after fees, on a risk adjusted basis. Using asset allocation and mutual funds individual investors have been able to invest like institutions albeit at a higher fees. Now, with nearly instantaneous access to information and exchange-traded funds, the playing field is being further leveled. Hurrah!
Douglas A. Lambrecht, a Certified Investment Management Consultant, is Managing Director of Investment Resource Group, LLC, a Hilton Head, SC based registered investment adviser providing fee-based strategic investment advice and portfolio management. The author’s opinions expressed herein do not necessarily reflect those of Charles Schwab and Co., Inc.
Ó Copyright 1999, 2000 – Douglas A. Lambrecht, CIMC, Hilton Head Island, SC – all rights reserved
