Morningstar Advisor - August/September 2011 - (Page 61)

movements in the NAV may predict movement in the index, tracking volatility will be reduced to reflect the fact that the ETF should not be penalized for stale prices in the index. In practice, there is some inconsistency in how the terminology is applied to index funds as opposed to active funds. For example, we want large and positive alphas for an active fund. For an index fund, however, we want a near-zero alpha but can accept negative alpha created by expense-ratio drag. Tracking error for an active fund refers to how closely the manager hugs the bench or swings for the fences. Tracking error on the order of 4% to 8% is not unexpected. But index funds are not supposed to swing for the fences. The index fund is supposed to “track” its index, and the tracking error would ideally be zero. Because tracking error for index funds is expected to be zero, sometimes the term “tracking error” is applied to the fund’s ability to match the index with a minimum holding cost. The Estimated Holding Cost and Tracking Volatility measures are based on a fund’s NAV. While large traders may be able to transact at or close to an ETF’s NAV, most traders have to deal with market prices. ETFs have a number of advantages when compared with mutual funds, but trading complexity is a clear disadvantage. The market price can deviate from fund NAV, particularly when the ETF’s underlying securities are illiquid. The less liquid an ETF’s underlying holdings, the more the market price can move from NAV before it becomes profitable for an arbitrager to step in and bring the market price back in line with NAV. These past deviations go into Morningstar’s new Market Impact measure. This measure is meant to capture the average impact (in basis points) of a $100,000 trade, as opposed to an instantaneous measure that will depend on current market conditions such as current limit orders or the bid/ask spreads on the underlying securities. ETFs vs. Index Mutual Funds Exhibit 2 Fund Fees: Holding costs include more than just the expense ratio, while Tracking Volatility adds to the uncertainty. ETF Estimated Holding Costs % Tracking Volatility % Confidence Interval Expense Ratio % iShares S&P 500 Index IVV SPDR S&P 500 SPY Vanguard 500 Index Investor VFINX Fidelity Spartan 500 Index Inv FUSEX T. Rowe Price Equity Index 500 PREIX Schwab S&P 500 Index SWPPX SSgA S&P 500 Index Instl SVSPX Dreyfus S&P 500 Index PEOPX Data as of May 31, 2011 0.09 0.16 0.14 0.07 0.27 0.14 0.20 0.45 0.05 0.03 0.05 0.11 0.15 0.27 0.24 0.16 –0.02–0.19 0.11–0.22 0.04–0.23 –0.14–0.28 –0.01–0.56 –0.39–0.66 –0.27–0.67 0.14–0.76 0.09 0.09 0.17 0.10 0.32 0.09 0.18 0.50 ment of these data points, there is no reason that they cannot be applied to index mutual funds. Obviously, mutual funds are created and redeemed directly with the fund company at NAV after market close, so there is no explicit Market Impact cost. ETFs hold up pretty well when comparing Estimated Holding Costs and Tracking Volatility. There is a clear linear relationship between expense ratio and holding costs (Exhibit 2). IShares S&P 500 Index IVV and SPDR S&P 500 SPY both have a 0.09% expense ratio, but the more flexible legal structure of IVV allows it to engage in share lending and reinvest dividends, keeping the Estimated Holding Cost at 9 basis points and Tracking Volatility at just 5 basis points. SPY, which does not engage in share lending, ends up with a higher Estimated Holding Cost (16 basis points). The larger the Tracking Volatility, the wider the uncertainty and confidence interval for the Estimated Holding Cost. Despite having a lower Estimated Holding Cost, IVV trails SPY in total volume. In fact, just about every security trails SPY—it trades an incredible $20 billion a day in average volume and maintains low Tracking Volatility. The result is a market impact cost of 0.1 basis points on a $100,000 trade. For IVV, which has ample liquidity (it trades about $370 million per day), the market impact is slightly higher, at 0.7 basis points. Rydex S&P Equal Weight RSP holds the exact same securities as SPY and IVV, but it equal-weights them, resulting in a higher weight in smaller and less-liquid names. Because a fund such as RSP appeals more to long-term investors than high-frequency traders or hedgers, daily trading volume is substantially lower, at about $50 million a day. Still, Market Impact averages around 2.2 basis points for a $100,000. When comparing fund expense ratios, it is important to take into account potential Market Impact costs. We believe that these three new data points provide investors with far better measures of passive manager performance than are offered by any other fund data provider. By accounting for this tricky issue of stale prices in index values, and by disaggregating the short-term and long-term return differences against the index, these new measures allow investors of all time horizons to choose the funds that work best for their particular purposes. And as index funds continue to accumulate assets, we hope that these new data points help ensure that the best managers win out in the end. K Michael Rawson, CFA, is an ETF analyst with Morningstar. While ETFs were the impetus for the develop- MorningstarAdvisor.com 61 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Contents
Contributors
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011