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ETF Trends For 2016: Part 3, Management Fees

In part 1 of this series, we reviewed the growth of the ETF market in 2015 and introduced the series by covering currency-hedged products. In part 2 , we took a look at robo-advisors, a well-covered topic that could have a huge impact on the way ETFs are utilized. In this final piece in the ETF Trends series, we will cover management fees and the competition it causes between issuers, and a conclusion on the potential for the ETF Industry in 2016. The ETF Fee War While some issuers are creating funds for specific market niches, other issuers are taking a different approach when looking to stand out in the sea of possible funds, as articulated by Crystal Kim for Barron’s : Early this November, BlackRock (NYSE: BLK ), the largest exchange-traded fund provider by assets, trimmed fees by two to three basis points (two to three one-hundredths of a percent) on seven iShares Core ETFs. The expense ratio of the iShares Core S&P Total U.S. Stock Market (NYSEARCA: ITOT ) was taken down to 0.03%, winning the crown for cheapest ETF on the market-briefly. That is, until Schwab (NYSE: SCHW ) matched it by lowering fees by one basis point on four large-cap ETFs. The Schwab U.S. Large Cap fund (NYSEARCA: SCHX ) now stands toe-to-toe with its counterpart at iShares, fee-wise. For every $10,000 invested, the rival funds cost a mere $3. That’s cheaper than a copy of Barron’s at the newsstand. There are pieces covering the ETF price war going back to 2010, so this is by no means a new discussion topic for ETF investors. However, price wars continue to play a role in the ETF investment scene as a way to attract retail investors. The Trefis Team lays this relationship out for us: The largest avenue of growth for ETF providers over the coming years is expected to be the retail investor market, which remains extremely under-served. As retail investors are much more sensitive to expense ratios, asset managers have been trying to attract them with a string of low-cost ETFs. The following image is another from the ICI 2015 Investment Company Fact Book, showing the growth in ETF AUM by retail investors. Assets in ETFs accounted for about 11% of total net assets managed by investment companies at year-end 2014 and net issuance of ETF shares reached a record $241 billion. Click to enlarge While there are a number of funds digging deep to keep costs low in an effort to attach larger clients, the average ETF expense ratio is still 0.44%. This is mainly due to the number of active and narrow-focused funds that can still afford to charge investors more, because they are the only ones currently available in the space. But as market saturation continues, being the only player may not be a given. This is great news for investors interested in these niche offerings but aren’t willing to foot the bill at this time. For reference, the average mutual fund expense ratio is 0.70% (down from 0.90% in 2000 before ETF competition started to take hold), so it is no small feat that ETFs are as cost effective as they are today. But as issuers continue to fight for retail investors in the coming year, we should expect to continue to see expense ratios slashed. This slashing is not just good news for institutions, but the individual issuers who get to enjoy cheaper management fees as well. Concluding Thoughts For 2016: ETFs Continue To Grow When asked about the ETF industry in early 2015, Amy Belew, Global Head of ETP Research at BlackRock stated : The global ETP (Exchange-Traded Product) industry continues to grow at a double digit pace as ETPs attract a broader base of global investors than ever before. ETPs are being used by capital market participants looking for deep liquidity, to investors seeking precision exposures, to a growing segment of the market using ETFs as buy and hold investment vehicles. We are forecasting global ETP assets to double to $6 trillion over the next five years. While future trends within the ETF industry are impossible to perfectly predict, I believe this an industry that will only continue to evolve and grow to meet investors’ needs in 2016.

Reducing Volatility While Staying In The Stock Market With USMV

During February, we think investors should consider iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). In ranking approximately 860 equity ETFs, we combine holdings-level analysis with ETF-level attributes, such as bid/ask spread, expense ratio and volatility. According to Sam Stovall, US equity strategist for S&P Capital IQ, since 1946, there have been 56 pullbacks, or price declines of 5.0%-9.99%. They fell an average of 7% over a little more than one month and took fewer than two months to get back to breakeven. There have been 20 corrections (-10.0% to -19.9%) since WWII, erasing an average 14% from the value of the S&P 500. They typically took a bit more than four months to go from peak to trough and a similar number of months to recover fully. We think USMV is strong ETF for consideration for investors wanting to reduce the risk considerations of their overall U.S. equity exposure. We expect the market to remain volatile in February due in part to sluggish earnings and modest economic prospects, but we look to the S&P 500 index to end 2016 much higher than where it is currently trading. As such believe this ETF allows investors to stay fully invested while reducing the risk profile of their overall portfolio. Now is a good time, according to S&P Capital IQ, to look at low-volatility strategies. Yet it is important to understand how USMV is constructed. The ETF is diversified across all 10 sectors, but holds the least volatile securities within the sector. iShares, working with an MSCI benchmark, uses sector bands (+/- 500 basis points relative to a parent MSCI index at the semi-annual rebalance). As such, at year end, financials (22% of assets), health care (20%), information technology (15%) and consumer staples (15%) are the largest sectors. Relative to the parent MSCI index, tech is underweighted, while the other three are overweighted. Other sectors underweighted are industrials (4.5%) and energy (1.9%). From a sector perspective, USMV is different than its peer from PowerShares. That ETF has no sector bands and as such has more in financials (27% of assets) and less in tech (2%). USMV ranks favorably to S&P Capital IQ for all four risk consideration inputs to our ranking. Three of these, S&P Capital IQ Quality Rankings and Qualitative Risk Assessments, along with Standard & Poor’s Credit Ratings, are tied to the holdings. The relatively low risk of these holdings are well suited, we think, in the current choppy market. For example, Johnson & Johnson (NYSE: JNJ ) has an A+ Quality Ranking, a low risk assessment and AAA credit rating. S&P Capital IQ equity analyst Jeff Loo, who has a buy recommendation on the shares, view its capital deployment strategy of acquisitions and stock buybacks positively. In October 2015, JNJ announced a $10 billion stock buyback, and the shares currently have a 3% dividend yield. S&P Capital IQ sees earnings per share growing to $6.50 in 2016 and $6.82 in 2017, driven by pharma growth and restructuring efforts. Meanwhile, McDonald’s (NYSE: MCD ) has an A Quality Ranking, a medium risk assessment and BBB+ credit rating. S&P Capital IQ equity analyst Tuna Amobi, who has a buy recommendation on the shares, noted MCD reaffirmed its capital allocation initiatives after relatively encouraging Q4 results — including a 5% increase in global comparable sales — amid early positive signs on its multi-year turnaround strategy. After last year’s sweeping organizational changes Amobi sees further gradual progress on the turnaround initiatives, including an accelerated pace of global refranchising. S&P Capital IQ sees earnings per share in 2016 rising to $5.39 due to operating margin expansion and share repurchases. In addition, USMV earns a favorable ranking input for its below-average three-year standard deviation of 9.1 (ETFs tracking the S&P 500 index have 10.5). Daniel Gamba, managing director and head of BlackRock’s iShares Americas Institutional Business, told S&P Capital IQ in late January that the increased volatility in equity markets has made institutional investors more tactical in using minimum volatility products to lower risk. We think the increased usage of USMV by institutional investors has been a positive for all investors. The average daily trading volume in the past month spiked to 3.3 million, up from 2.0 million during the past six months. The bid/ask spread is $0.01, lower than most ETFs. In addition from a cost perspective, USMV has a modest 0.15% expense ratio. Year to date through January 27, USMV declined only 3.8%, falling less than half as much as the S&P 500 index. In 2015, during a relatively flat year with the broader index up 1.4%, USMV rose 5.5%. We like USMV based on its underlying holdings and from a cost/liquidity perspective. However, should the market volatility diminish quickly and equities to climb higher, this and other lower-risk strategies are prone to underperform in our opinion. Additional disclosure: http://t.co/AHwSBhyHHt

Smart Beta Strategy: Aces Australian Scrutiny

Paul Docherty, a senior lecturer at Newcastle Business School, University of Newcastle, in Australia, has studied the performance of the factors that underlie smart beta portfolios within the equity markets of that country. On the basis of a long time-series of data, Docherty has concluded that four such factors “all generate positive abnormal returns” in those markets: value, momentum, low vol, and quality. Diversifying across these four factors is the smart way to make use of smart beta , he thinks. The other factor in the usual list of five is size . Since Rolf W. Banz’ work in 1981 , there has been speculation that small firms generate greater return than do larger firms, after controlling for risk. But Docherty can’t find evidence for this in Australia. After accounting for illiquidity and transaction costs, the remaining “size effect” is insignificant. “Not an investable anomaly,” he says. This is in accord with recent international findings. But with the other four smart-beta factors? Value refers to the book-to-market ratio. This is also known as the HML ratio, from the phrase “high minus low”, given the Fama-French argument that companies with high book-to-market ratios (value stocks) outperform those with low ratios (growth stocks). Docherty mentions that there are several other ways to measure “value” aside from book-to-market. One might use the P/E ratio, for example, or compare cash flow to price. But book-to-market “is the superior proxy for value in the Australian equity market.” The HML ratio has had a good run over most of the sample period Docherty employs, beginning in 1990, and its cumulative returns across time are impressive, but it’s important to observe that “there is an evident reduction in the gradient of the cumulative returns in recent years.” Performance of the WML factor in Australia Mean St. Dev. T-Strat Sharpe Ratio Hit Rate Max Drawdown 1991-2015 1.29% 5.19% 4.27 0.25 63% -19.96% 1991-1995 0.31% 3.53% 0.68 0.09 53.3% -7.98% 1996-2000 1.15% 5.28% 1.68 0.22 65% -19.96% 2001-2005 2.61% 5.12% 3.95 0.51 71.7% -8.51% 2006-2010 0.89% 6.53% 1.06 0.14 61.7% -13.68% 2011-2015 1.37% 4.80% 2.15 0.28 64.9% -13.41% (Source: Docherty, “How smart is smart beta investing?” Table 3.) Moving on… the momentum factor (or “winner-minus-loser”, that is, WML) is the best-documented anomaly of the traditional five. Docherty cites a recent study by Vanstone and Hahn that reports that “the capacity of momentum investing in Australia is sufficiently large in dollar terms to support its practical implementation as an investment strategy.” Low vol has been under discussion as a factor in above-normal returns since a seminal paper by Black, Jensen, and Scholes in 1972. The notion of a low vol premium by definition implies that the actual security market line is much flatter than the one predicted by the Capital Asset Pricing Model. Significant Drawdowns Docherty’s data indicates that the mean monthly return on the vol factor in Australian markets is 1.45%, the highest monthly return of any of the five factors he looked at. Both the vol factor and WML share one drawback – both have seen significant drawdowns. The max drawdown for the vol factor in Australia over the covered period in 25.56%. Then, there is quality , or quality-minus-junk (QMJ). As in all fields, “quality” in the realm of capital assets is a tricky thing to define. As Docherty understands it, the term refers to asset growth and accruals (negatively) as well as to corporate governance and profitability (on the positive side). Quality, as so understood, has “relatively modest returns compared with other smart beta factors,” he finds, but it does provide a hedge against downturns in broad market movements. What is most intriguing about Docherty’s numbers is that the correlations among the factors he discusses “are quite low and, in many cases, negative.” Given this situation , the real question is not whether smart beta is smart (it is) or which factor is smartest (that depends on where one is in the business cycle, and other matters), but what mix of the four (or, if one wants to continue including size, what mix of the five) factors is optimal.