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The 6 Best Passive Large-Cap ETFs

By Michael Rawson The S&P 500 outperformed 80% of active managers in 2014 and beat the small-cap Russell 2000 Index by more than 8 percentage points. Strong fund flows reflected investor preference for large-cap funds as the three exchange-traded funds with the strongest flows in 2014 each track the S&P 500, an index of large-capitalization stocks. While the S&P 500 is the most popular, it is not the only large-cap index that investors can choose. A total stock market index fund is usually the most efficient way for index investors to get exposure to the U.S. stock market because they offer comprehensive coverage of the market with very low turnover. However, there are at least two scenarios where it could make sense to hold separate size segment funds. They could be appropriate for investors who want to give an overweighting to certain size segments, such as small-cap stocks, when they believe that segment will outperform. However, it is very difficult to consistently get these calls right. Because different size segments tend to exhibit different risk and return characteristics, investors could also use these funds to exercise more control over their strategic portfolio allocations. In addition, investors may use size segment funds to balance out a portfolio of active managers. The chart below illustrates the annualized volatility and return for stocks sorted by market capitalization and grouped by quintile dating back to 1926. While smaller-cap stocks have generally offered higher returns over the very long term, there have been several market cycles that favored different size segments. The S&P 500 beat the Russell 2000 each year from 1994 through 1998, but that reversed in each year from 1999 through 2004. – source: Morningstar Analysts There is no industry-agreed-upon definition for large cap , so each index provider defines the large-cap universe in its own way. Morningstar defines large cap as all of the largest stocks, which in aggregate make up 70% of the market value of all stocks; this currently corresponds to stocks with a market cap larger than $17 billion. In terms of index performance, it’s a statistical dead heat. Because the indexes have similar risk and return profiles, the choice of which ETF to use largely comes down to factors such as fees, liquidity, tax efficiency, and personal issues such as which brokerage platform is used or how the other assets in the portfolio are positioned. There are 11 ETFs that track market-cap-weighted passive indexes, excluding mega-cap and total stock market funds that also land in the large-blend Morningstar Category. In terms of fees, they charge between 0.04% and 0.20%. While these fees are low relative to the average large-blend mutual fund, which charges 1.1%, there is no reason to pay more than necessary. We can eliminate the funds charging 0.20%. In fact, it is somewhat odd that iShares is willing to charge just 0.07% for iShares Core S&P 500 (NYSEARCA: IVV ) but charges 0.15% for iShares Russell 1000 (NYSEARCA: IWB ) , which offers similar exposure. The expense ratio is just one aspect of cost. Trading costs also have an impact on total return. While the underlying stocks in each of these indexes are mostly the same and are all liquid, some of the ETFs with fewer assets trade less and have wider bid-ask spreads. For example, the iShares MSCI USA (NYSEARCA: EUSA ) has just $57 million in assets and trades less than $1 million of volume a day. The average bid-ask spread of 17 basis points would quickly eat into the returns of a frequent trader. In contrast, SPDR S&P 500 ETF (NYSEARCA: SPY ) trades more than $20 billion a day, and its bid-ask spread is frequently less than 1 basis point. U.S. equity ETFs tend to be tax-efficient because of their ability to transfer low-cost-basis shares out of the portfolio through in-kind redemptions. However, there have been instances where they have issued capital gains. This is more likely to happen to ETFs with a smaller asset base or trading volume or that happen to switch indexes. The only ETF in this group that has issued a capital gains distribution in the past 14 years is SPDR Russell 1000 ETF (NYSEARCA: ONEK ) . Personal factors also enter into the equation. Brokers such as Schwab, Vanguard, and Fidelity offer trading commission discounts for using certain ETFs (check with your broker). A $10 savings per trade can have a big impact for those investing small sums or making frequent trades. Investors should also consider how their choice will have an impact on their overall portfolio. Investors who already have assets with one index family may want to stick with that suite of index products. For example, if you have a Russell 2000 fund for small-cap exposure, you may want to use a Russell 1000 fund for large-cap exposure to avoid overlaps. After eliminating the higher-cost, less-liquid, and less-tax-efficient ETFs from the list of 11, we are left with IVV, SPY, IWB, Vanguard S&P 500 ETF (NYSEARCA: VOO ) , Vanguard Large-Cap ETF (NYSEARCA: VV ) , and Schwab US Large-Cap ETF (NYSEARCA: SCHX ) . These funds track the four market-cap-weighted indexes in the table below. S&P 500 Unlike the other indexes listed, the constituents of the S&P 500 are selected by a committee that has some discretion over which stocks make it into the index and has stricter rules regarding public float and profitability for new index additions. These rules do not have much of an impact for large caps but can have a bigger impact for small caps. In addition, S&P does not follow a set rebalancing calendar, which helps to keep turnover low. Of the four indexes, S&P has the highest average market cap and includes the fewest mid-cap stocks. The lower exposure to mid-caps explains why the S&P 500 slightly underperformed the other indexes. However, the S&P MidCap 400 outperformed most mid-cap indexes. Of the three ETFs tracking the S&P 500, we prefer IVV or VOO over SPY. While SPY is the most liquid, it is technically organized as a unit investment trust, a more restrictive legal structure, which prevents it from engaging in securities lending, reinvesting dividends, and using index futures. Consequently, SPY has lagged the S&P 500 by more than its expense ratio. CRSP US Large Cap Index This benchmark is more comprehensive than the S&P 500. It targets the largest 85% of the market and applies buffering rules to limit turnover. This sweeps in both large- and mid-cap stocks. VV adopted this index in 2013. Vanguard has a history of working with index providers to refine best practices and negotiate better fees. In fact, it previously switched some index funds to MSCI from S&P. Russell 1000 The Russell 1000 Index dips even deeper into mid-cap territory. The average market capitalization of its holdings is $54 billion compared with $72 billion for the S&P 500. The index includes all but six of the stocks that are in the S&P 500 as well as many more mid-caps. IWB is lower-cost and has better liquidity than the ETFs from Vanguard and SPDR that track the same index. Dow Jones US Large Cap Total Stock Market This index tracks approximately the 750 largest U.S. stocks and is available through SCHX. Schwab offers a suite of ETFs based on Dow Jones indexes. The Dow Jones Small Cap Total Stock Market Index includes the next largest 1,750 stocks, while the mid-cap index encompass 501st to 1,000th largest stocks. S&P acquired the Dow Jones indexes business in 2010. Schwab’s size segment funds have the lowest expense ratios in their respective categories, and liquidity has improved as these funds have gained assets. 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.

The Refined ETF Approach To Emerging Markets Consumers

Summary More investors are diversifying with overseas exposure. Why investors should take a look at consumer sectors in emerging markets. Emerging market consumer sector ETF options. Investors have heard plenty about the rise of the emerging markets consumer in recent times, a theme easily accessed by a growing number of exchange-traded funds. Emerging markets investing, including doing so with ETFs, is changing, presenting investors with opportunities to take more tactical, thematic approaches to tap into the rise of developing world consumers. With many traditional emerging markets ETFs either too concentrated in the BRIC nations, excessively exposed to state-run enterprises or both, investors should rethink how they access emerging markets consumer trends. That includes making bets on some of the least developed developing markets. “Investors should focus on buying EM consumer companies in the least developed economies, as well as those EM companies geared towards domestic demand, rather than external demand through exports. Investors should look for stocks in the discretionary sector in countries where the consumption of staples has been satisfied, but consumption of durable goods has not,” according to Emerging Global Advisors , the company behind the EGShares family of ETFs. EGShares’ ETFs include consumer-focused offerings such as the EGShares India Consumer ETF (NYSEArca: INCO ) , the EGShares Emerging Markets Consumer ETF (NYSEArca: ECON ) and the EGShares Emerging Markets Domestic Demand ETF (NYSEArca: EMDD ). ECON, which carries a four-star rating from Morningstar, is up 15.4% over the past three years, enough to easily outpace the Vanguard FTSE Emerging Markets ETF (NYSEArca: VWO ) and the iShares MSCI Emerging Markets ETF (NYSEArca: EEM ) . The allure of ECON, one of the original dedicated emerging markets consumer ETFs, comes from its large combined weight to reform minded countries. For example, China, Mexico and India combine for over 41% of the ETF’s weight. “The new Indian government, led by Prime Minister Narendra Modi, intends to privatize state assets, increase foreign direct investment and reduce the fiscal deficit by cutting subsidies. There are also plans to deregulate the labor market and upgrade infrastructure. These improvements should unleash investment, increase efficiency, raise productivity and boost growth,” said EGShares in a whitepaper . If Modi delivers on the expected reforms, that could power INCO even higher. Often overlooked compared to other India ETFs , INCO also carries a Morningstar four-star rating. More important than that accolade is INCO’s performance. For much of the past year, India ETFs have been BRIC leaders, but INCO has shined especially bright with a gain of almost 77%. EMDD tracks the S&P Emerging Markets Domestic Demand Index, and draws from a country universe of Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Thailand, and Turkey. Though not a pure consumer ETF, EMDD does allocate a combined 56.6% of its weight to staples and discretionary sectors. The weight to those sectors is important because consumer sectors have been key contributors to emerging markets earnings growth in recent years. “Emerging market consumer sectors have delivered higher earnings growth in four of the last seven years when compared to the broader emerging market equity index. Although earnings have disappointed over the last two years, we believe this should be a temporary relapse since consensus earnings are forecast to rebound in 2014 and 2015. Based on these estimates, EGA calculates that the EM consumer sectors would deliver earnings growth of 4.1% in 2014 and 16.2% in 2015, respectively, surpassing the rates of growth offered by the overall emerging markets index (3.8% in 2014 and 9.0% in 2015),” according to EGShares. South Africa, China and Mexico combine for over 55% of EMDD’s country weight. The ETF’s index has an impressive dividend yield of almost 3.4%. EM Consumer Fundamentals Table Courtesy: Emerging Global Advisors Tom Lydon’s clients own shares of EEM.

XLF: How Would The Financial Select Sector ETF Fit In My Portfolio?

I’ll take a look at XLF to see if it makes sense for me. The liquidity is fantastic, but the description of the holdings sounded more diversified than the actual holdings in the portfolio. The ETF looks very solid for investors that have a large enough portfolio to make it worth investing a small percentage. The holdings aren’t bad, and the expense ratio looks very appealing. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the Financial Select Sector SPDR ETF (NYSEARCA: XLF ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. What does XLF do? XLF attempts to track the total return (before fees and expenses) of the Financial Select Sector Index. Substantially all of the assets (at least 95%) are invested in funds included in this index. XLF falls under the category of “Financial.” It sounds like the ETF would be very highly concentrated, but it includes everything from diversified financial services to REITs and banks. When I was first reading about the holdings, I was expecting more diversification than I found. You’ll see what I mean when I get to the holdings section. Does XLF provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as the basis for my analysis. I believe SPY, or another large cap U.S. fund with similar properties, represents the reasonable first step for many investors designing an ETF portfolio. Therefore, I start my diversification analysis by seeing how it works with SPY. I start with an ANOVA table: (click to enlarge) The correlation is just over 91%. That’s a strong correlation and substantially higher than I would expect for the REITs inside the ETF. I’m expecting the banks may be pushing the correlation higher. As an investor using modern portfolio theory, I can still work with 91%. Of course, the computed correlation wouldn’t mean much if the values were being distorted by poor liquidity. The average volume of more than 40 million shares per day suggests that liquidity shouldn’t be a concern. That’s a good sign for investors wanting verification of the statistics or wanting to know that they can exit the position with less concern about it deviating from NAV. Standard deviation of daily returns (dividend adjusted, measured since November 2013) The standard deviation is a bit high, but not absurd. For XLF it is .939%. For SPY, it is 0.736% for the same period. The ETF is definitely showing more volatility than SPY by a noticeable margin when we compare returns on a daily basis. Given the fairly strong correlation, I’m not expecting the ETF to be able to lower the risk level in the portfolio. Mixing it with SPY I run comparisons on the standard deviation of daily returns for the portfolio assuming that the portfolio is combined with the S&P 500. For research, I assume daily rebalancing because it dramatically simplifies the math. With a 50/50 weighting in a portfolio holding only SPY and XLF, the standard deviation of daily returns across the entire portfolio is 0.819%. With 80% in SPY and 20% in XLF, the standard deviation of the portfolio would have been .763%. If an investor wanted to use XLF as a supplement to their portfolio, the standard deviation across the portfolio with 95% in SPY and 5% in XLF would have been .742%. As expected, even solid diversification can’t quite eliminate the additional volatility. However, that does not necessarily indicate that there is anything wrong with the ETF. 40 million shares don’t trade hands without plenty of buyers. Why I use standard deviation of daily returns I don’t believe historical returns have predictive power for future returns, but I do believe historical values for standard deviations of returns relative to other ETFs have some predictive power on future risks and correlations. Yield & Taxes The distribution yield is 1.61%. The SEC yield is 1.52%. I like to see strong yields for retiring portfolios because I don’t want to touch the principal. By investing in ETFs I’m removing some of the human emotions, such as panic. Higher yields imply lower growth rates (without reinvestment) over the long term, but that is an acceptable trade off in my opinion. The yield is a little low for those purposes, but not low enough to make it unworkable. Expense Ratio The ETF is posting an expense ratio of .16%. I want diversification, I want stability, and I don’t want to pay for them. An expense ratio of .16% is great. I’ve got no issues there. That’s a very reasonable expense ratio to pay on the ETF. Market to NAV The ETF is at a .01% premium to NAV currently. Premiums or discounts to NAV can change very quickly so investors should check prior to putting in an order. For the extremely high volume of shares trading hands, I would expect the NAV and price to move hand in hand. Largest Holdings The diversification in the holdings isn’t going to be a strong selling point. I certainly don’t mind Berkshire Hathaway as a top holding, but to me this remains a bank ETF. The biggest REIT position is Simon Property Group (NYSE: SPG ). I have nothing against SPG, but it is also the biggest REIT position in most REIT ETFs. I like REIT ETFs, and I’m planning to use one or two in my portfolios. I don’t see much reason to get the same stock in the bank ETF, but with an expense ratio of only .16% it isn’t like I’d be getting charged much for holding it. (click to enlarge) Conclusion The correlation is a bit high, but given the major holdings I can’t expect anything less. I’m not overly bullish on the bank industry at the moment, but I’m not going to focus my ETF selections on my short term feelings about an industry. While I’m concerned about regulatory pressures, my concerns should already be priced into the stocks. For investors looking at the very long term picture, the extremely low expense ratio is great. When I’m putting together hypothetical portfolio positions, one of the things I include is the expense ratio of the ETFs to track the overall expense ratio on the portfolio. In that regard, I think XLF would do quite nicely. During my three year sample period the ETF did thoroughly outperform SPY. I wouldn’t count on it to happen again, but I would consider it as a significant possibility. Since I believe my regulatory concerns are already factored into the share prices for the major banks, I think the ETF would make a solid fit. The only real challenge I have in using the ETF is that I would want to limit the position to 5% of the portfolio. When the goal of the ETF portfolio is to minimize trading costs while maximizing diversification, investors have an incentive to avoid using ETF’s that are most suitable for small positions unless they have a way to trade it with no commissions. If I had a way to trade this ETF with no commissions, I’d probably put it in my portfolio. As it stands, paying the trading costs for 5% of the portfolio doesn’t offer enough benefits for me. Without substantial diversification benefits, I’m more likely to just use the extra money to buy more shares of the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). When my portfolio grows to the point that it is worth separating out another 5%, I may take another look at XLF. It’s a solid ETF that just doesn’t happen to be the right match for my smaller portfolio. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.