Friday 26 October 2012

Socially Responsible Investing: Trends and ETF Track Records

When we first explored back in 2009 the idea of vetting investments based on ethical criteria, the ETFs created to implement the idea were relatively new and there was no real track record to say whether investment returns were the same, better, or worse than the broad market index funds. Was the idea just a fad that would pass in the face of other concerns like jobs and the economy after the 2008 credit crisis and its aftermath?

There is a collection of terms describing facets of the concern many people have - corporate social responsibility, ethics, governance, sustainable development, green or environmental responsibility. If we are to judge by how often these ideas receive mention in the worldwide press as tracked by Trends in Sustainability's Online Analysis Tool, which was used to generate the charts below, the multi-decade upwards trend of Sustainability suggests an important impetus for investors to consider.

Sustainability idea rising in importance for decades
Key sustainability issues - climate change (environmental), human rights (social), corruption (governance)

No big move to ESG/SRI as an investment trend for individuals
The explosion of ETFs in just about every direction has not yet reached the ESG/SRI slant. There is still only one Canadian ETF - the iShares Jantzi Social Index® Fund (TSX: XEN) - which five years after its launch has gathered a puny $17 million in assets. In the USA, there is only a handful of such ETFs (see ETFdb's screener result for SRI) with about $360 million in total assets, a small amount for the US market.

Apparently, institutional investors have been much more active in pursuing SRI investing according to this European report.

A high degree of overlap between ESG/SRI ETF holdings and non-SRI counterparts
Perhaps it is encouraging to know that the Jantzi index developers Sustainanalytics judge that so many large Canadian companies meet their SRI criteria. The result is that three quarters of XEN's holdings are also in the standard dominant cap-weighted Canadian equity ETF, the iShares S&P/TSX 60 Index Fund (TSX: XIU). XEN's holdings that are not part of XIU amount to only 2.67% of the fund's total assets.

The overlap between the US-oriented funds
is even higher at 80 to 85% with the iShares Core S&P 500 tracker (NYSE: IVV). In fact, the stocks the stocks are mostly deliberately chosen from amongst those in the mainstream large-cap US market index. The overlap is by design.
Result: a close tracking of the market performance of the mainstream ETFs by the ESG/SRI ETFs
The high degree of overlap seems to be more powerful in determining returns than the influence of stocks in the mainstream index that the ESG/SRI ETFs leave out. Indeed the KLD FactSheet explicitly says the aim is for the ETF to show the same risk and return characteristics as its mainstream kin.

XEN bounces along in close alignment with XIU as seen in this screen capture from BMO Investorline's ETF Compare Tool (available only to BMOIL's clients). Moreover, the annualized total return over the past five years is very close: XEN at -0.99% vs XIU's -0.40%. That is just about the difference between the XEN Management Expense Ratio (MER) at 0.55% and XIU's at 0.18%. The small annual difference adds up in the long run. Over five years, XEN's cumulative total return is -3.89% vs XIU's -2.37%

KLD and DSI follows IVV quite closely. Even NASI, despite about 10% of its holdings being Canadian stocks, follows the IVV's contours, though its more recent startup produces the higher starting point of its line in the chart below. Higher MERs on the ESG/SRI funds at 0.50% likely account for most of the slight annualized under-performance. That annual difference has added up. Over the past 5 years, KLD returned 1.33%, DSI 1.91% while IVV returned 4.07%.

EAFE / Developed Countries
The same close tracking shows up with the Pax MSCI EAFE ESG Index ETF (NYSE: EAPS). Over the year since its launch it has earned 6.08% while the standard cap-weight equivalent Vanguard's MSCI EAFE ETF (NYSE: VEA) returned 5.67%. It remains to be seen whether more years under the belt will see VEA pull ahead - its MER is only 0.12% vs EAPS' higher 0.55%.

Bottom Line
The above returns results jive with the bulk of academic research, such as summarized in the 2007 paper Does Socially Responsible Investing Hurt Investment Returns? (answer = no) from Phillips, Hager and North or Meir Statman and Denys Glushkov's 2009 The Wages of Social Responsibility on Miller/Howard Investment Inc's website (answer = the advantage of picking stocks with high SRI scores is more or less offset by the disadvantage of SRI's shunning "bad" companies).

Such academic studies did not factor in costs, such as the MER. The biggest issue is the higher MERs at 0.5+% of the ESG/SRI funds while the mainstream broad market large cap funds have MERs of 0.1% or less. That seems to be creating longer-term rising cumulative under-performance. If so, whether SRI/ESG ETFs are worth it is an individual investor decision.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday 19 October 2012

Pros and Cons of Managed Futures ETFs

What's not to like about an investment that delivers returns like the dark blue in the chart below taken from Frequently Asked Questions About Managed Futures at the CME Group website? Through thick and thin of the last 30 years, the dark blue line has gone ever upward with downward blips that are almost imperceptible compared to the 2001 Dotcom bubble crash and the 2088 Credit crisis.
The Barclay CTA Index line in the above chart represents an average of tracked results of Commodity Trading Advisors, professional investors who carry out Managed Futures strategies. Until recently such strategies have been the exclusive domain of large institutional investors such as pension funds and hedge funds.

In the past year or so, the expanding ETF industry has latched onto the idea to launch several Managed Futures ETFs, first in 2011 in the USA and then this year in Canada - the iShares Managed Futures Index Fund (TSX: CMF) and the Horizons Auspice Managed Futures Index ETF (TSX: HMF).

What are Managed Futures?
Managed Futures use futures contracts traded on exchanges such as the CME, NYNEX and others to build portfolios with exposure to a diverse range of:
  • agricultural commodities (e.g. grain, corn, soybeans, cotton), 
  • metals (e.g. gold, silver, copper), 
  • energy products (e.g. crude oil heating oil, gasoline and natural gas), 
  • currencies (e.g. the Canadian dollar, the US dollar, Japanese Yen, Euro) and
  • interest rates (e.g. US Treasury 5-Year or 10-Year or 30-Year bonds)
The key feature of Managed Futures is their active management strategies, which generally (though not always as CME points out) follow price trends in the market. When prices are going up, the strategies invest long and if prices are going down, they sell short. Thus, a Managed Futures ETF's holdings might be long crude oil futures one month and short the next. The overall portfolio will usually be a mix of long and short positions, as can be seen in our comparison table below of the two Canadian ETFs in the category. The aim is to make money whether markets are rising or falling, unlike traditional index ETFs that hold only long positions and make money when markets are good but lose in downward times.

  • Non-correlated with mainstream equity and bond returns - A portfolio with various non-correlated types of assets can attain lower volatility and better returns as the following marketing chart from Horizons shows for the back-testing done on its new ETF's index in combination with Canadian and US equity holdings. A different Managed Futures index, the popular Barclays BTOP 50, shows similar low or negative correlation with equities and bonds in data spanning 1987 to 2011 (cited in Lintner Revisited: A Quantitative Analysis of Managed Futures in an Institutional Portfolio)
  • Managed Futures have gone up especially when things are really bad in equities - Perhaps the most striking and attractive performance feature (see table below from the Lintner Revisited paper), at least in the past and through the index, is that the worst downward market quarters for equities were marked by upward moves in the Barclays BTOP 50! 
  • Past performance is not necessarily indicative of future results - This frequently encountered warning, which we conveniently copied right from the same Lintner paper, tells us to look closely at possible limitations. The table shows that in several bad equity quarters, the BTOP 50 also lost ground, albeit less. Every crisis is different. Some types of conditions are bad for trend followers - rapid price reversals, or the sudden onset of high volatility. The rules of thumb for the intuitive traders or the complicated mathematical formulas that detect the trends, may stop working. Most of the CTAs, and certainly the new ETFs, have based their investing rules on algorithms derived from past price movements that may not work in the future.
  • Indices may be touting what worked and ignore what failed - Michael Zhuang of the Investment Fiduciary blog levels a couple of criticisms along those lines in Managed commodities can counter volatility…NOT, as does investment author William J. Bernstein in On Stuff.
  • An Index is not investable and the ETF may not be able to track the Index - There are two problems. First, the indices we have cited are averages of many CTA strategies so an ETF cannot replicate what those averages show. And as we see in our comparison of HMF and CMF, different versions of trend following can produce dramatically different results. The second issue is that ETFs have costs (MER, trading, accounting, bid-ask spread, tracking error) which can severely undermine returns the investor actually receives. At times when markets don't have strong trends, constantly reversing direction, there may be not much return to offset the costs, which don't stop.
  • Returns come in larger but infrequent lumps and may be years in waiting - The Lintner Revisited paper says an investor should expect strong returns only over periods of three years or more. Many may lose patience and bail out when seeing lack of gains over a couple of years.
The Canadian Managed Future ETFs
  • Holdings - As we noted above, the two Canadian-traded ETFs have quite different portfolios. Less than half the holdings are the same. The iShares offering CMF includes a number of US equity futures while HMF has none. For one holding, heating oil, CMF is short, judging that the price trend is down, while HMF is long, detecting an upward trend. This illustrates again that strategies do not converge and obviously returns of the two ETFs will be quite apart as well.
  • Results so far - It is thus not surprising to see this chart from Google Finance. CMF and HMF haven't moved at all alike and neither is much like the TSX equity index either. Contrary to the intention that they should make money in good times and bad, both so far have lost value.

  • Fund Costs - CMF and HMF are not cheap for ETFs, though they may be in comparison to managed futures hedge funds which typically charge 2% MER plus 20% of any returns over a target benchmark. Both CMF and HMF have a 0.95% base MER, on top of which the ETFs get charged a 0.45% fee to pay the counterparty which is involved in the actual implementation (a tricky swap structure described in the Investment Strategy section of each ETF's Prospectus, which is available through Sedar's search for investment page). CMF also has an approximate 0.15% fee to pay for the hedging of returns back to the Canadian dollar. Its total fees are thus 1.55%, to which get added other return-reducing costs of unknown magnitude like trading commissions, index-licensing, legal and and accounting. HMF has the currency hedging too but does not state a cost for the service.
Bottom Line
Are these a must-have for every investor? It's hard to say. The crisis countering performance is quite attractive and the world is surely not done with financial crises but the implementation results in actual products have not been proven.

Further Reading:

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday 12 October 2012

High-Dividend Value-Priced European ADR Stocks

A few weeks back we looked at the depressed European equity markets and saw fundamental indicators of enticing pricing. Our review suggested a few ETFs that could be used to buy a basket of those stocks. The alternative of buying individual stocks we examine today, since it is possible to buy shares in European companies in that continent of peace and tranquility (according to the Nobel committee at least) through a security called an American Depositary Receipt (ADR).

What is an ADR?
An ADR is created when a bank buys the stock of a company in its native home market and holds or deposits the shares against which it issues the ADR which is traded freely on US exchanges. Since we Canadian investors can easily trade in US securities, we can buy and sell ADRs too. has a short primer on ADRs and the main bank issuer of ADRS, the BNY Mellon, has a section of its website called DR University that provides more detailed explanation.

Finding the European ADRs
What we would like to find is the difficult combination of high(er) dividend yield in a solid, consistently profitable company that is also reasonably priced. In the interest of building a diversified portfolio, we'll also look for companies in sectors less well represented in Canada and avoid the financials, energy companies and mining companies that dominate the Canadian market.

1) High dividend yield in European companies - The best free source we have found is TopYields. It lists European high-yielders amongst its other listings for every developed market (including Canada). There are individual country listings as well as a top-30 grouping for Europe. All are large to giant companies and many if not most sell their products or services throughout the globe, i.e. an indication of greater stability and success. Along with the current dividend yield, TopYields shows the current Payout Ratio (the percent of Net Income being paid out), which gives a preliminary indication of solidity. If the company is paying more than it earns, that casts some doubt on the sustainability of the dividend, or if it negative, that means the company has incurred a loss. It is also useful to see the Price-Earnings ratio (P/E) - if it is too high, such as 20+, the company is not cheaply priced. Below a P/E of 10, as for some of our results below, the price is definitely getting into cheap territory.

2) Check if the company has an ADR traded in the USA - Go to the BNY Mellon DR Directory page and either search for the name under the alphabetical listing or simply type it into the search box at the top right. Note that not all companies have an ADR. Once found, the company info will include the stock trading symbol.

Assess the company as an investment
Two sites with a lot of useful data on stocks are ADVFN and Morningstar. Type in the stock symbol to get the file on each company. Ratios, multi-year trends and graphs all help build a numerical story about the company. Links to each company's website will lead to investor pages with annual reports and other information to learn about the company and its prospects or troubles.

Sample of stocks that appear promising
Though the picture is not complete, we managed to find without too much trouble fourteen attractive companies across diverse sectors and countries, shown in the table below. All have had net profits in every one of the past five years, a good sign in a region that has suffered economically much more than Canada, though the continuing profitability often reflects their worldwide reach too. Dividend yields of 3+% in what look to be healthy companies will appeal to many investors. There are no doubt more stocks with similar characteristics - we did not go through the whole universe of European ADRs. Given the depressed state of European markets these days, there are likely many more attractive opportunities for the discerning investor to consider buying.
It won't be too long till Christmas. Maybe it's time to do some early shopping for stock bargains.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday 5 October 2012

Vanguard Index Change and Navigating The ETF Maze for Global Equities

This past week, Vanguard announced that it was changing its index provider from MSCI to FTSE on several of its ETFs that hold equities of many countries around the world. The investor might ask, "So what, why should I care?" Here are a few reasons, apart from the fact that Vanguard is a leviathan in the ETF world and is a popular option for passive index investors seeking US and global equity funds:

1) Potential MER reductions
Vanguard's announcement expressly states that its intent is to lower Management Expense Ratios by passing along the benefits of a better deal on the costs to license the use of the index that the ETFs track. Though Vanguard doesn't say, Canadian Couch Potato's post reviewing the change guesses the license fees might be 10-15% of fund costs. The change comes on the heels of ETF competitor Schwab's announcement lowering fees (see the IndexUniverse article here) on its ETFs. Hopefully the top ETF provider iShares' owner BlackRock will be making reductions as well - see a reference to the possibility in this Reuters news item. MER price competition is good for investors since fee reductions go right to the bottom line as higher returns. When MERs are down to 0.2% or less per year, as they are with many of the lowest fee ETFs, reductions may seem small but they still have an appreciable impact over the long term.

2) Changes in portfolio and likely future performance
Passive ETFs that mimic an index such as Vanguard's offerings will reflect any differences in index performance and as Canadian Capitalist's review of the news shows, the FTSE and the MSCI year-by-year and cumulative performance for the same category of fund - e.g. stocks of Emerging Markets countries - has differed a fair bit. The FTSE has garnered higher returns than the MSCI index by about 13% in total over the past ten years, according to IndexUniverse's Vanguard Changes Tricky for Investors. Of course, that difference from portfolio composition might not continue and might reverse over the next ten years.

3) South Korea - One big portfolio difference
It's not just Vanguard that is affected. FTSE, MSCI, Standard & Poors and Dow Jones all license their indices to various ETF providers who create ETFs to track those indices. What the indices include or exclude makes a big difference. The biggest difference currently is whether South Korea is considered a developed or an emerging market country and whether its stocks go into the ETF for that category. FTSE and S&P say it is a developed country, while MSCI and Dow Jones classify it as emerging.

South Korea matters. Its economy is the 12th largest by one measure of GDP cited by Wikipedia, ahead of Canada at 14th. It features huge companies like Samsung, Hyandai, Posco and Kia. If your intent as an investor is to hold a passive globally diversified portfolio, South Korea and its companies should be represented.

The problem is that by picking different combinations of ETFs based on different indices, supposedly covering different countries, South Korea may end up missed entirely, or duplicated (more on this in our post about "diworsifying").

A wider ETF problem - Inclusion or exclusion of Canada and the USA too
The problem isn't just South Korea, it happens with Canada and the USA too. Depending on the ETF and its index, broad multi-country ETFs can either include or exclude Canadian and US equities. For most investors the issue is likely to be duplication of holdings that are already in the single country ETFs they own as a core position, such as BMO's S&P/TSX Capped Composite Index (TSX: ZCN) for Canada or the SPDR S&P 500 (NYSE: SPY) for the USA.

The ETF Maze Map
To help investors sort through the confusion and pick which combinations of ETFs can go together to avoid duplications or omissions, we created the chart below. It shows the ETF provider and ticker symbols under the commonly used titles like Global/World, International, Developed, EAFE and Emerging and whether they exclude Canada, the USA or South Korea. In the chart, if those countries are not shown as excluded, by definition they are included. We also show Vanguard's ETFs as they will be after the index change to FTSE, though Vanguard intends to gradually transition the portfolio changes over several months starting in January 2013. The yellow line separates the category of about 46 Frontier countries, ranging from Argentina to Vietnam, since those countries do NOT figure in any of the World/ Global ETFs, despite the name. (Why a country like Greece still appears in everyone's Developed country ETFs while Kuwait, Oman and Qatar are no better than Frontier is a bit puzzling but the index providers make those decisions and the ETF providers follow.)

Example: buying Vanguard's VWO (Emerging Market) along with iShares Canada's XWD (Developed Market, though they call it World) means that South Korea is totally excluded (!) while Canada and the USA are included! If you also buy ZCN and SPY, you've got a lot of duplication - the USA is more than half of XWD, so if the USA/SPY is 20% of your portfolio and Developed/XWD is also 20%, your USA holding is actually 20% + half of 20% = 30% in total.

Beyond the ETFs and groupings on the chart, there exists in the ETF space a raft of sub-groupings of countries by region, like Europe, Asia, Pacific etc, or by custom creation, like BRIC (Brazil, Russia, India, China). Sub-dividing a portfolio with extra ETFs can get more complicated, though some investors may want to do it e.g. when they believe, as we suggested could well be the case in our recent post on European equities, that special opportunities exist. Hopefully, with the help of our chart, investors will at least know what they are buying and not get trapped in the maze.

Details of Country Classifications:

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.