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The ABCs Of Mutual Fund Share Classes

Originally published on Nov. 19, 2014 You don’t need to read a prospectus to benefit from knowing the basics about mutual fund share classes. It will help you uncover your actual investing costs (especially when dealing with a broker), avoid unnecessary fees, and boost long-term performance. As you will see, even after you select a fund, it is crucial that you choose the most appropriate share class of that fund. Bringing Funds to the Marketplace Just like a farmer needs to get their crops to market, mutual fund companies work through multiple distribution channels to sell their products. These could include direct sales via online brokerages, sales to pension plans, through a broker, a registered investment advisor, and so forth. Each of these channels has different end clients and associated costs; and because of this, companies have developed different versions (share classes) of the same mutual fund to suit each situation. Typical Mutual Fund Fees Annual Expense Ratio – The ongoing fee to manage and administer the fund. Most investors will never notice this cost since it’s a tiny fraction taken from the share price (NAV) each day. Trading fee – A fee charged by the executing brokerage company/custodian, typically $0 to $50 per buy or sell order. Front-end Load – A sales charge applied when a fund is bought; it typically declines for larger purchase amounts. Back-end Load – A sales charge applied when a fund is sold; it typically declines over several years. Fund Share Classes with an Example “A” shares have a front-end load. “B” shares have a back-end load, but have a lower expense ratio if held long enough. “C” shares have no load after a short time, but have a higher expense ratio. Other shares such as “D” or “Institutional” exist. These shares typically have no load, but may have limited availability. The well-known Pimco Total Return Fund (MUTF: PTRAX ) provides a great illustration of how one mutual fund offers many different share classes of the same fund. Broker Assisted Investors After considering the overall costs from the table above, you will see where the costs are built into the mutual fund structure and sales channels. Brokers are typically compensated by the A, B, or C share classes, but also can get residual compensation via fees built into the mutual fund expense ratio (e.g. 12b-1 fees). Remember, brokers do not have a legal obligation to put you in the “right” share class. So if you are using a broker, be sure to give them more information on how you plan to invest or you could end up paying them larger fees than you should. With a broker for example, if you knew you were going to buy $10,000 of the Pimco Total Return fund, but sell it within 3 years, you will probably be better off with the “C” shares. However, if you have no idea how long you will hold the fund, the “B” shares may be a better bet – since the costs to own will decrease over time. If you had a substantial amount to invest for a long time, the “A” shares may ultimately be the cheapest option even though you are paying the 3.75% front-end load. Advisor Clients Registered Investment Advisors like us typically have “Institutional” share classes available to them. At our firm, we pay close attention to fund expenses and transactions costs for our clients. Because of this, we will frequently use more than one share class of the same fund, or two slightly different funds in the same asset class – all in order to minimize the long-term costs for our clients. It is certainly more complex to juggle the various share classes in a portfolio, but we believe you can use them to your distinct advantage.

The Best U.S. Equity Factor ETFs

A version of this article was published in the August 2014 issue of Morningstar ETFInvestor . Download a complimentary copy of ETFInvestor here . The way I see it, exchange-traded funds have a lot in common with food. There are many different foods, but only a handful of essential nutrients. Likewise, there are lots of exchange-traded funds, but only a handful of distinct factors that drive their returns. When scientists look at why a food is good or bad for health, they look at its nutrients. Red meat isn’t bad in and of itself but because it contains trans fat, saturated fat, and cholesterol. Analogously, when those of a scientific mind-set look at investments, they look at factor loadings or exposures. From this perspective, a bond portfolio is a bundle of duration, term, and credit risk factors. Factors are to assets what nutrients are to foods. They’re what really matter. My goal when picking ETFs is to find the most efficient ways to obtain desired factor exposures, in the same way a dietitian picks meals to achieve a certain balance of nutrients. In equities, there are five major factors: market, value, momentum, quality (or profitability), and size. (There’s also a low volatility factor, but very few funds offer true exposure to it; minimum- and low-volatility funds obtain their superior risk-adjusted returns from their quality and value exposures.) These factors have historically earned excess returns. The market factor is simply defined as the return of the total stock market. Value, momentum, quality, and size are all defined as long-short portfolios that go long stocks with the characteristic and short stocks with the opposite characteristic. Market and size generate returns as compensation for their risks. Value, momentum, and quality, on the other hand, earn much of their returns by exploiting investor misbehavior. Stock-pickers have been exploiting these styles for decades. Think of the three as distinct stock-picking strategies that have been distilled into simple rules. When picking funds, I believe you should look for ones that offer efficient exposure to value, momentum, or quality–ideally, all three. At the very least, your fund should minimize exposure to expensive, poor-returning junk stocks, which historically have chewed through capital. Almost all equity ETFs offer some combination of these five factors. However, the price of exposure to these factors varies a lot. Some funds offer exposure to desirable factors like value and quality but fail to capture excess returns because of poor construction or high fees. iShares Select Dividend (NYSEARCA: DVY ) , for example, has historically shown a lot of exposure to value and quality but lost all of the theoretical advantage that it should have earned and more because of a disastrous 2008. The index’s yield-weighting methodology had it chasing falling knives while its quality screens weren’t stringent enough to discern firms temporarily down on their luck from firms in mortal danger. One way to rank funds is by running their historical returns through a factor model to identify the ones with the highest exposures to value, momentum, and quality. This is a tempting approach because it seems objective and scientific. However, factor regressions produce point estimates that mask the reality that factor loadings for most strategies change over time, sometimes dramatically. For example, high-yield stocks historically exhibited neutral to negative momentum loadings. The highest yielders, after all, are usually beaten-down, boring stocks. However, over the past three years or so, high-yield stocks have actually exhibited positive momentum loadings because investors have been chasing yield and defensive stocks. Most of the time, you can’t expect a strategy’s factor loadings to be constant. Assessing factor strategies requires some qualitative insights to take into account this kind of uncertainty. To extend the dietetic analogy, our factor models are like tools that offer unreliable readings on nutrient content. You can be more confident in your readings if you know certain things, like the provenance of the ingredients in your meal, the reputation of the supplier, and so forth. To ensure you’re getting the factor exposures you want, look for the following: 1) Simple selection and weighting rules. Some funds, like Vanguard Dividend Appreciation ETF (NYSEARCA: VIG ) , don’t disclose all their rules, or are vague about them, like iShares’ Enhanced series of ETFs. When a strategy is complicated or opaque, it’s harder to predict its behavior. 2) The use of multiple signals to reduce noise. While factors are traditionally defined by a single characteristic, such as price/book, practitioners often use multiple signals to capture a factor. The platonic ideal of “value,” for example, is not fully captured by price/book but also other measures like price/cash flow, price/earnings, dividend yield, and so forth. A phenomenal business like Philip Morris International (NYSE: PM ) has negative book value, so it’ll never come up as cheap using price/book, but it could come up as cheap on other signals like dividend yield. 3) Diversified portfolios. Factor investing is a statistical exercise where lots of low-edge bets are aggregated. There’s a trade-off. The deepest tilts are obtained through focused, high-turnover portfolios, but doing so introduces more noise and slippage and reduces capacity. 4) Economic intuition. If a strategy uses rules that don’t make sense, throw it out, even if its back-tested or historical returns look good. I’ve seen some crackpots use astrological signals like “Bradley turn dates” to time their investments. With a few glaring exceptions (that I won’t name here), strategy ETFs don’t use off-the-wall rules. Even if a sponsor has a fantastic strategy that fulfills all these criteria, you want to make sure the sponsor can execute it. To abuse the food analogy more, this is like making sure your meal is made by a capable chef with high-quality ingredients in sanitary conditions–it doesn’t matter if a meal’s mix of nutrients is perfectly engineered if it makes you puke out your guts the next day. Here are some operational characteristics I look for: 1) Low assets in relation to estimated capacity. If you squeeze through a big trade on the open market, you’ll push prices against you. This insidious cost is often bigger than the expense ratio–sometimes by orders of magnitude–but it’ll never show up in a prospectus or annual report. At a certain point, a strategy becomes too bloated to absorb more assets; trading costs eat up too much of the expected excess returns. Unfortunately, market impact costs are hard to predict because firms can mitigate them through block trades (where they hand over a big block of shares to another institution at a modest discount to current market price), internal crossing trades (where they simply swap the stock with another fund in the same firm), and other means. This capacity is a function of an index’s construction, the market’s liquidity, and the fund manager’s transactional capabilities. Vanguard and BlackRock/iShares are probably the best indexers, so all else held equal, you should expect a Vanguard or iShares ETF to have much more capacity than another firm’s ETF. 2) Low fees. Enough said. 3) Stable sponsors. You don’t want to invest with an ax-happy sponsor who might kill your ETF if it doesn’t maintain a certain size. Here are the funds I like, in order of preference: Schwab US Dividend Equity ETF (NYSEARCA: SCHD ) SCHD is my favorite U.S. equity fund at the moment, which might seem strange given that it’s lagged the broad market since inception. However, it has three things going for it. First, its loadings to value and quality factors are sizable, both since its 2011 inception and its 1999 back-tested index inception. That its live and back-tested returns show big and fairly stable value and quality loadings is reassuring. Over its full history, the index exhibited a value loading of 0.6, a quality loading of 0.3, and no momentum loading. However, the fund favors big, defensive stocks, which reduces its expected return. I expect SCHD will largely keep up with the market but with much lower drawdowns and volatility. Second, it’s dirt-cheap in all respects, with a 0.07% expense ratio. The strategy’s turnover averaged 15% since launch. Moreover, the fund is not bloated to the point where its trades push prices around. Finally, its index, the Dow Jones U.S. Dividend 100, is sensibly constructed, even if it’s not what I’d have come up with. The index screens for U.S. stocks that have paid a dividend in each year for the past 10 years. This screen weeds out smaller, less durable, and more-speculative stocks. It then ranks the stocks by annual indicated dividend yield and kicks out the bottom half. The remaining stocks are ranked by cash flow/total debt, return on equity, indicated dividend yield, and five-year dividend-growth rate. The four rankings are equal-weighted, and the 100 stocks with the highest composite ranks are selected for the index. Note that the ranking criteria penalize firms that 1) don’t earn adequate cash flow for each unit of debt they assume, 2) aren’t earning big profits for each dollar of invested capital, 3) haven’t grown their dividends, and 4) are expensive. By using value and quality criteria, the index focuses on cheap quality stocks. I have a few quibbles with the index’s construction. The 10-year dividend screen is arbitrary. Is a 10-year dividend history that much better than a nine-, eight-, or seven-year history? I’d be hesitant to rule out a stock based on a single metric. Apple (NASDAQ: AAPL ) in 2013 was astoundingly cheap and high-quality by numerous metrics but couldn’t have made it into this fund because it resumed its dividend in 2012 after a 17-year hiatus. Vanguard Dividend Appreciation ETF ( VIG ) This is the quintessential quality fund. Its value and quality loadings are 0.1 and 0.3, respectively. Like SCHD, VIG will lag in rallies and do better in downturns. The fund’s main screen or signal is 10 consecutive years of dividend growth. For the most part, only high-quality firms make the cut. However, there are plenty of high-quality firms that haven’t grown dividends for 10 years straight, including Wells Fargo & Co (NYSE: WFC ) . An array of weaker signals is preferable to one exacting signal. Another ding to VIG is its secret quality screens. Vanguard worked with Mergent to craft this index, so the rules are likely to be sensible, but I’d sleep better if I could see them for myself. VIG is cheap, charging only 0.10%. However, the fund’s track record has attracted a torrent of inflows in the past few years. With almost $20 billion in assets, the average stock position of VIG is about twice the stock’s three-month average daily trading volume. It’s only going to get bigger now that Wealthfront, a fast-growing robo-advisor, uses the fund in its default allocations. Despite my concerns, it’s hard to beat VIG’s low fees, capable managers, and sound quality strategy. If you own it in a taxable account and have lots of capital gains, do not sell it. The likely drag from turnover costs is probably less than 0.2% a year. But if you can swap VIG for SCHD at low cost, go ahead. iShares MSCI USA Momentum Factor (NYSEARCA: MTUM ) MTUM is the best momentum factor fund by far. It’s cheap, charging 0.15%, and well-constructed. MSCI provides back-tested history for the index starting in 1975. The index’s momentum loading averaged 0.3 with no value exposure. Its much bigger rival PowerShares DWA Momentum ETF (NYSEARCA: PDP ) charges 0.65% for lower momentum exposure (its higher recent returns are from its higher market beta), an opaque methodology, and a literally unbelievable back-tested history. MTUM buys and overweights stocks with the highest risk-adjusted returns over trailing seven- and 13-month periods, excluding the most recent month (so, months two to seven and two to 13). It rebalances semiannually but can rebalance monthly using the shorter signal if a volatility trigger goes off. This allows the fund to react more quickly to market rebounds (think 2009), when traditional momentum strategies often get slaughtered. iShares MSCI USA Quality Factor (NYSEARCA: QUAL ) QUAL’s back-tested index, which begins in 1976, has a 0.3 quality loading but a negative 0.1–0.2 value loading. In other words, if you pair QUAL with a value fund, you’ll offset some of your value exposure and get a weak quality exposure. QUAL is best for investors who don’t want much value exposure. QUAL buys and overweights U.S. stocks with high return on equity, low debt/equity, and low five-year earnings growth variability. This methodology is similar to GMO’s quality strategy but without a valuation screen. It rebalances semiannually. iShares MSCI USA Minimum Volatility (NYSEARCA: USMV ) USMV’s back-tested index begins in mid-1988. Contrary to what you’d expect, USMV is simply another way to get value and quality exposure. It shows value and quality loadings of 0.2, with below-average market exposure. However, because its methodology doesn’t explicitly target value and quality stocks, its loadings have swung around dramatically over time. The index uses a risk model to estimate variances and correlations for U.S. stocks and an optimizer to create the lowest-volatility portfolio possible given a set of diversification constraints. In layman’s terms, it takes advantage of the fact that some stocks neutralize each other to lower overall portfolio volatility. I have some general comments on iShares’ factor funds. First, the MSCI indexes they use are for the most part transparent, simple, well-diversified, robust, and high-capacity. Second, the funds won’t offer deep tilts when combined. For example, if you own MTUM and QUAL in equal portions, your aggregate quality and momentum loadings will be around 0.15 each, pretty weak. Third, even though these funds aren’t big, billions of dollars are already tracking the MSCI indexes in separate accounts and other vehicles. It’s hard to tell when the strategies will get crowded. iShares Enhanced US Large-Cap (NYSEARCA: IELG ) As far as I can tell, the Enhanced series of ETFs are the first to charge passive fees for true quantitative active equity management. The funds combine several value and quality signals, with some optimizations to target lower-than-average volatility, achieve sector- and stock-level diversification constraints, and keep a lid on turnover. IELG is the cheapest of the funds, charging a 0.18% expense ratio, a price tag that puts it well below other long-only multifactor funds like AQR Core Equity (MUTF: QCELX ) . To elaborate, the Enhanced funds look for stocks with low price/earnings, price/book, earnings variability, debt, and accruals (a measure of earnings quality). Each signal is sensible by itself. I like that no single signal will rule out a stock, an improvement over blunt (but effective) heuristics like 10 straight years of dividend growth. Unfortunately, BlackRock isn’t clear about how stocks are selected and weighted, how often the strategy is rebalanced, or the process by which the model driving the strategy is updated. Preliminary results suggest IELG has a sizable loading to quality but surprisingly little exposure to value. However, given the fund’s low cost, low asset base, logical signals, competent managers, and sound provenance, this young fund is worth betting on. For an investor with a strong belief in factor investing, this is one of my top picks. Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Low Risk ETFs Beating SPY In 2014 – ETF News And Commentary

The U.S. economy had a shaky start to this year with a cold snap taking away all the warmth from Q1. To add to this, overvaluation concerns, worries over the withdrawal of QE support in the U.S. and stress between Russia and the West on the Ukrainian issue triggered a flight to safety in the initial months (read: 3 Low Risk ETFs for Market Turmoil ). Though spring sprung more jobs, better housing and manufacturing numbers, and raised confidence in the U.S. citizens leading the economy to advance 4.6% in Q2 and 3.9% in Q3, the global financial market again faltered to close out the year. Concerns over global growth especially in the big three foreign regions ─ Euro zone, Japan and China ─ and rising risks of a sooner-than-expected hike in the U.S. interest rates weighed heavily on stocks this month. Iraq instability, a protest in Hong Kong and Ebola crisis in West Africa have also taken a bite out of stock market returns. If this was not enough, oil prices have moved back to the recession-ridden phase of 2009, losing about 45% since the start of the year (read: Volatility ETFs in Focus on Oil Upheaval ). Russia has once again started to hit headlines for all wrong reasons, with the latest being an upheaval in its currency and bond markets. Notably, Russia resorted to an extremely steep rate hike on December 16 to plug the plunge in its currency which has halved in price against the greenback this year. However, such a desperate move was in vein as the ruble did not find success in arresting its protracted downturn. It seems that Russian tumult and the oil crash will contaminate the risk-on trade sentiment at the end of the year. Investors are getting out of high-growth and high-beta stocks across the globe and seeking refuge in safe and income-oriented assets thanks to sluggish global economic indicators. If this was the snapshot of the year, low risk equities ETFs have all reasons to perform impressively. After all, the S&P has added 12% this year compared to a stellar 35% returned last year. The market sentiment simply moved back and forth with each economic release in the event-loaded 2014. This is especially true as low risk investments can prove quite effective in one’s portfolio in arresting downside risks as compared to high beta products. It is one of the most popular investing themes at present, given the occasional jump in volatility since the start of the year. Below, we have mentioned two low risk ETFs which soothed investors’ nerves in 2014 having returned more than the broader market ETF SPDR S&P 500 ETF (NYSEARCA: SPY ) in the time frame. S&P MidCap Low Volatility Portfolio (NYSEARCA: XMLV ) This overlooked ETF looks to follow the S&P MidCap 400 Low Volatility Index. The product invests about $53.2 million in assets in 80 stocks. From a sector look, financials takes half of the portfolio followed by about 15% of assets invested in utilities and 7.4% in materials. The portfolio has minimal company-specific concentration risk with no product accounting for more than 1.63%. Church & Dwight Co., Alleghany Corp and HCC Insurance Holdings are top three choices. The product charges about 25 bps in fees. The fund is up 16.8% so far this year. PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA: SPLV ) This ETF provides exposure to about 100 U.S. stocks with the lowest realized volatility over the past 12 months by tracking the S&P 500 Low Volatility Index. Like other two choices, the fund is also widely spread across a number of securities as none of these holds more than 1.27% of assets. However, the product is tilted toward financials at nearly 33% share while utilities (18.1%), consumer staples (18.1%), industrials (12.2%) and health care (7.93%) round off to the top five (read: 3 Utility ETFs Surviving the Market Turmoil ). SPLV is the largest and the most popular ETF in the low volatility space with AUM of $4.98 billion. The fund charges 25 bps in annual fees and is up about 15.3% year to date.