Thursday, February 15, 2007


Heresy! Apostasy! Revisionism! Doctrinal divergence! Implying an insurrection in the mutual fund industry is the equivalent of burning the American flag; slapping Mom in the face; crushing the apple pie with your foot. It desecrates everything we’ve learned about investing. What has happened to loyalty, to reverence, to respect? Ah! But you see that’s really what America is all about: progress, invention, innovation, transformation, and yes, even revolution.

If that sounds familiar, it’s because it was the opening paragraph of an article published in this column two and a half years ago, in August 2003, under the title, “The Mutual Fund Insurrection.” It referred to what was then, only through implication, the second most revolutionary structural change in the mutual fund industry that ever occurred. The first disruption was the recognition of indexing as a superior strategy to the use of actively managed funds. The second revolution referred to in the headline as a “resurrection,” was the creation of Exchange Traded Funds (ETF’s).

The article cited the existence (in August 2003) of 30 ETF’s, then marketed with about $30 billion in assets. A follow-up article in this column was published in June 2004, at which time those numbers had sharply escalated to 150 ETF’s with an asset value of $160 billion. As a clear indication of the explosion of interest in this type of investment vehicle, there now exists some 300 ETF’s with a value of over $400 billion. It is expected that 100 additional ETF’s will be offered in 2007, and Morgan Stanley expects this category to expand to $2 trillion within a few years.

For those still unfamiliar with ETF’s, they are very similar to index mutual funds in that they hold a portfolio that mimics a particular index such as the S&P 500 or the Dow Jones Industrial Average. Unlike mutual funds that are bought and sold at the day’s closing price ETF’s are traded and priced intra-day just like stocks. Whatever commission you now pay for buying and selling stocks will apply. They invariably have a much lower expense factor than actively managed funds and even most index funds. They are also more tax efficient than most index funds.

Years ago, within the advertising establishment, a common tactic employed to boost consumer interest and sales, was to repackage and remarket a product with the words, “new and improved.” As with all successful products, the entrepreneurial American spirit, rarely satisfied with the status quo, has recently intervened with several “new and improved” twists that will certainly add to the lure of the ETF concept and might be of interest to you. The publicity surrounding these innovative “improvements” has been intense. In the past several weeks, articles have appeared in Barron’s, Business Week, Forbes, most recently in U.S. News & World Report, several Internet sites, and the Wall StreetJournal describing these enhancements. In addition, a long op-ed piece appeared in the Journal written by one of the innovators, Professor Jeremy Siegel of the Wharton School of Business, and author of the seminal book, Stocks for the Long Run.

Traditional index funds as well as most existing ETF’s are structured based on “market capital weighting,” where company stocks with higher market values (the number of outstanding shares multiplied by the stock’s price) have a greater influence on the index’s performance than those with smaller valuations. That system leaves some indexes such as the S&P 500 dominated by the large cap stocks. For example, the 10 top valued stocks comprise close to 20 percent of that index.

But what if fundamental factors instead of market values were used to weight indices — factors such as dividends, sales, or earnings? Two individuals have taken the lead in developing this idea and translating it into two families of ETF’s. One is Jeremy Siegel mentioned above. The other is Robert Arnott, chairman of Research Affiliates, and editor of the Financial Analysts’ Journal. Both believe that fundamental indexing can provide better returns than those achieved by market cap weighted funds over long periods.

Sharply critical of both ETF’s and these newly formed heretical innovations, John Bogle, founder of the Vanguard Group and the creator of the first index fund based on the S&P 500 index states, “What troubles me is this talk of a new paradigm, a new wave of indexing replacing the old. It’s based on nothing but data mining.”

Be that as it may, both Siegel and Arnott agree that stocks that are overvalued are over weighted in a market-cap weighted portfolio, and stocks that are undervalued are underweighted thereby limiting optimal performance. They believe their new system rectifies this problem. There are some differences in their approach; however, both systems make for a more complicated investment process.

If you sign onto the fundamental weighting concept, decisions must be made as to which fundamental factors will produce the best returns. Siegel highly recommends dividends as the ideal solution, offering 30 different ETF’s predicated on this one factor. Some are based on large-cap, mid-cap, or small-caps; others are based on sector indices such as health and energy, while there are also international choices. Providing that many choices also sets the investor up for puzzling decisions. More information on these ETF’s including performance records can be found on Although in existence only a few months, some look pretty good.

When Arnott became disenchanted with market-cap weighted indexing, in 2003 he established an ETF that was equal weighted. It basically consists of the S&P 500 Index stocks but each is valued the same (0.20) regardless of price or market value. What gives credence to this concept is that an examination of the performance relative to the S&P 500 Index shows that this ETF, Rydex S&P Equal Weighted Index (RSP), has delivered 16.27 percent annualized returns over the past three years, compared to just 11.2 percent for the traditional S&P 500. Morningstar has just given this fund a 5 star rating. The reason for this outperformance is simple: RSP holds a significantly higher weighted proportion of small and value stocks than does the S&P 500, and they have been in favor for the past few years. That performance could switch when the trend changes.

Arnott’s new group of ETF’s that are based on a combination of sales, cash flow, book value and dividends, are offered by Power Shares under the title of Research Affiliates Fundamental Indexes (RAFI). While most are sector funds, at least two, RAFI US 1000 fund (PRF), and RAFI US 1500 Fund (PRFZ) are more diversified. They use a combination of sales, cash flow, dividends, and book value. Arnott claims that based on four decades of historical records (back testing) the RAFI 1000 fund would have outperformed the S&P 12.5 percent to 10.4 percent.

One factor that must be considered is that the expense ratio of the RAFI funds are .60 percent while the S&P ETF’s can be bought with expenses as low as .09 percent. Other critics, as described in The New York Times article, maintain that “the fundamental approach isn’t really indexing at all. After all, they contend, a fundamental index provider has to select a method for weighting stocks that it thinks is superior to the collective wisdom of the market.” Others contend that it is also a form of active management.

There is little doubt that the average investor would do better by investing in index funds than in actively managed funds. The question of which type of index funds would be best — regular mutual index fund, traditional ETF, or Fundamental ETF — is debatable. Some suggest waiting a while to determine whether fundamental indexing is truly superior.

If you want advice from the guy who is credited with creating the concept of indexing we need look no further than Burton Malkiel, the Princeton economist. It was his groundbreaking book, A Random Walk Down Wall Street, first published in 1973 that inspired John Bogle to found the Vanguard S&P 500 index Fund in 1975, the very first of its kind. An article in the January 15 th issue of U.S. News & World Report contained an interview with Professor Malkiel based on the publication of the latest update of his book (this is the ninth edition) that has sold over one million copies.

Asked what had been added in this newest edition, he replied, “The basic idea hasn’t changed. People are much better off with low-expense index funds than actively managed funds. But one of the big changes over the past several years is the proliferation of ETF’s, which are in my judgment, a fine product because they have low expenses and certain tax advantages.”

Commenting on which ETF concept he prefers, he says, “The best way to index is market-capitalization weighted [the traditional method], in which stocks are held in proportion to the total dollar value of their shares. If you use fundamental indexing or use dividends, you are taking active bets. Those active bets worked brilliantly over the first six years of the 2000’s because we were coming off a huge bubble. But I am convinced you will be much better off with capitalization weighting.”

He does offer this additional advice that can be summed up as follows:
  1. Invest in a total stock market fund (or ETF) that follows the Wilshire 5000 or the Russell 3000 rather than the S&P 500 index.

  2. Buy a world (international) fund.

  3. You should have a total bond market fund and TIPS (Treasury inflation protected securities).

  4. He says, “If you think as I do, that China is likely to be the best place to invest, try an ETF that trades under the ticker symbol FXI [iShares FTSE/Xiuhua China 25 Index Fund]. It is an index of the better Chinese companies and it’s got a low expense ratio.

(I must advise readers that I personally own shares in numbers 1, 2, and 4).

Malkiel points out that although institutional investors have about 30 percent of their money indexed, less than 10 percent of all dollars invested in stock mutual funds are in index funds. I’d bet with the institution.

I almost ended this article with that statement when it occurred to me that I was not aware what percentage of index funds was represented in my own portfolio. To insure that I was not positioning myself with a “Do as I say, not as I do” syndrome, I calculated that based on some recent purchases of additional index funds, they now represent 42 percent of the portfolio. While that does not mean it’s right for everyone, it does show, as the saying goes, “I put my money where my mouth is (or is it pen?).”

Thursday, February 01, 2007

Ethanol or Hybrids? — The Real Story, Part IV

Hey Dude! Are you still driving that old clunker? Don’t you think it’s time to get wheels that reflect your true personality, hidden character, and flamboyant attitude? Admit it! It’s really past time. So, as the old-time barkers used to say, “Do I have a car for you!” — an automobile you’ve seen only in your dreams. Small problem! — the one I have in mind has not even been produced — yet. But if you want an idea of what it will look like, here is a picture of the car that is scheduled to be delivered some time this year.

While Lotus, the British car company, is the designer, the guts of the car were the brainchild of a start-up group in California, Tesla Motors, who named this beauty the Tesla Roadster. (For the derivation of the name see the notes below). But I must be honest; there are a few obstacles that may dissuade you from considering this new dream car. For one thing, it’s a two-seater sports car, so no foursomes are possible for the Early Bird dinners. For another, it’s not likely that you will wish to park it at Publix, because the riot police might have to be called to control the crowds — Nieman Marcus? — maybe. Another, not so minor problem may be the price — in the $100,000 neighborhood. If you are impatient, a major drawback exists; production of the first hundred limited edition “Signature” cars for 2007 have not only been sold out, the demand is so great, the company has binding orders for an additional 120 cars, and there is now a wait list for delivery in 2008.

So what’s the buzz about this automobile that makes it so unique, so desirable that celebrities such as George Clooney, Larry Page and Sergey Brin (founders of Google), Elon Musk (Paypal), and Michael Eisner (former Disney) are probably on the buyer’s list? How about these statistics: Zero to 60 mph in 4 seconds (even a Ferrari can’t do that); a top speed of 135 mph; there is no engine noise and no tail pipe emissions (in fact there is no tailpipe); there is only one moving part in a motor that is about the size of a watermelon weighing only 70 pounds; only two forward and one reverse gears; and gas mileage? — let’s put it this way, operating cost will be one penny per mile. How can that be? It’s simple — the car is powered completely by a 6,831 cell lithium-ion energy storage system (basically, electric batteries) and a network of computers to control them; and it’s re-charged by plugging it into an electric outlet. Incredibly, a three-hour charge will be good for some 250 miles of driving, the battery life will extend beyond 100,000 miles, and a service facility will be available in the Miami area. That’s what all the buzz is based on.

So, what do you say, man? Do you think you can handle this car, one that may be the precursor to an electric car society? If the price bothers you, and the thought of embarking on an early-bird dinner without another couple is unthinkable, how about a more prosaic version, perhaps a sedan, selling in the $50,000 range? Supposedly, that’s due out in 2008 from the same company.

Imagine! A car propelled by electric battery power. What a quaint idea — at least in the mind of our illustrious president who, in a speech this past Labor Day said, “You know, one of these days, you’re going to have a -- batteries in your automobile that will enable you to drive the first 40 miles without gasoline, and your car doesn’t have to look like a golf cart.” Please, Mr. President — why the ambiguous “one of these days?” Did your speech-writers once again rely on “faulty intelligence,” failing to come up with information about the Tesla Roadster? And consider this:

A few weeks ago, GM announced its intention to eventually produce a car (named the Volt) with exactly the attributes mentioned by the president. Its lithium-ion batteries will enable you to drive the first 40 miles without gasoline on a single charge, and it doesn’t look like a golf cart. Although its propulsion system is powered by electricity, beyond 40 miles, batteries are replenished by virtue of a small gasoline powered generator allowing a total range of 640 miles. A full recharge is accomplished by plugging into a 110-volt outlet for about six hours. This car however, is much less efficient than the Tesla since during the period its gasoline engine is running, the car will attain only about 50 miles per gallon. Neither price nor a production date has yet been established. Inhibiting progress on the full electric car is the industry’s wait for a cheaper battery system since, for example, the cost for the ion-lithium battery system for the Volt is estimated at $10,000.

The Dawn of the Automobile Age

Ironically, despite this progress, we were possibly closer to an electricity based automotive industry 100 years ago than we are today. Believe it or not, the first (crude) electric carriage was invented by Robert Anderson of Scotland sometimes between 1832 and 1839. The first in America was created by Thomas Davenport in 1842. However, it was not until the late 1890’s that Americans began to exhibit a real interest in the concept. Most of the early vehicles were no more than electrified versions of carriages and surreys. In fact, the word “car” evolved as a shortened version of “carriage.” In 1897, the Electric Carriage and Wagon Co. of Philadelphia introduced a commercial fleet of New York City taxis. At the time, three types of engines competed for dominance — steam, electric, and gasoline. By 1900, out of a total of 2,370 automobiles in New York City, Boston, and Chicago, 1,170 were powered by steam, 800 by electric, and only 400 by gasoline.

In looking back, each of these technologies probably had more deficiencies than advantages, but the invention of the electric starter system, that replaced the hand cranking requirement for the gasoline internal combustion engine, helped push gasoline to the top. This, despite efforts on the parts of Thomas Edison and his close friend Henry Ford to secure a place for the electric car. Edison was unsuccessful in his attempt to develop a satisfactory battery; a failure we have to hope will not be repeated in our time. If the emphasis on ethanol subsidies was instead directed to battery research, the day of mass production of plug-in electric vehicles would be much closer at hand.

The Battery Battle

Speaking of batteries, the Alliance Bernstein report alluded to in last month’s article emphasized the critical importance of this component, writing, “Many analysts think that batteries are the limiting factor in the proliferation of hybrid technology. The nickel batteries available today simply do not offer enough energy storage or power to allow a vehicle to run long distances on electricity alone, which is key to higher fuel efficiency. We disagree. To date, investment in improving battery technology has been restrained in anticipation of technological advances in composite materials , particularly lithium. We expect significant performance improvements as lithium-based batteries replace nickel-based batteries before the end of this decade.”

Key to the success of the battery operated car, is the concept of plugging the car into a regular electric outlet, preferably overnight to take advantage of the electric grid’s greater availability and lower prices. Studies have confirmed that the electric grid could handle the increased load.

Apparently, the battery technology itself is not the main problem. GM’s chief engineer, Nick Zelinski, has stated that individual batteries are already good enough. “We’ve got enough data at the cell level to feel the technology is there.” However, the challenge is packaging the cells into large battery packs and testing them in actual vehicles — although Tesla Motors obviously has resolved that problem it its vehicle.

Hydrogen — the Ultimate solution

Interestingly, automakers have even made progress toward the next, and perhaps the ultimate solution to the fossil fuel problem — the Hydrogen car. In October, of last year, a reporter for Fortune magazine described a test drive he took in a Chevy Sequel, GM’s test version of a Hydrogen fuel-cell powered vehicle. Ironically, things did not go too well, since the vehicle stalled out nine times on a 20 mile circuit. Since the “electronic gremlins” were easily fixed, the report claims “the Sequel is a genuinely bold and innovative engineering achievement.”

GM intends to lease 110 fuel cell equipped Sequels some time this year. They will be powered by a fuel stack driving an electric motor with a high pressure Hydrogen fuel tank a little bigger than those worn by scuba divers. This will give it a range of some 300 miles. BMW has also announced it will test 100 Hydrogen fueled cars this year.Fortune reports that Daimler Chrysler and Toyota have already put a few Hydrogen fuel cell busses in service.

Honda introduced a new fuel cell car, the FCX concept at the auto show in December in Los Angeles and at the Detroit show in January. Honda promotes the environmental advantages as “a completely clean vehicle — emitting nothing into the air but water vapor and significantly cuts carbon emissions.” Honda claims the car, a four-door sedan with a good size trunk, has a 270 mile range and will be placed in limited production by 2008.

Ford just introduced its “Flexible Series Hybrid Edge,” a car with what seems to be an ideal technology. For the first 25 miles it will be powered by a 336-volt lithium-ion battery that can be plugged in for recharging. At a depletion level of 40 percent, it will automatically shift to a Hydrogen fuel cell that will recharge the battery for 200 more miles of driving.

The Bad News

Despite the apparent progress related to the development of Hydrogen fueled vehicles, the immediate problem is the fundamental difficulty in extracting large volumes of Hydrogen and converting it into an energy form. In addition, there is a total lack of a Hydrogen delivery infrastructure. In fact it is not yet clear what the final form of Hydrogen will be — liquid, gaseous, solid, or pressurized. A number of companies are doing the research, including Stan Ovshinsly’s Cobasys. As a result, efforts to initiate a transformation from an oil based economy to one dependent on Hydrogen is, at this point, probably at least two decades away if not more.

This is best described in an article in Science News stating, “Even if this problem [Hydrogen extraction] is overcome and Hydrogen in fuel form was readily available [and it is not], a distribution system reliant on pipelines is impractical since Hydrogen has a tendency to leak from seals and gaskets.” Then, just imagine the years and money it will take to establish the equivalent of tens of thousand filling stations capable of providing Hydrogen.

In the Meantime

A more likely scenario appears to be that the current electric hybrid car (similar to the Prius) will be a bridge to a similar technology enhanced by plug-in capability. As battery technology improves, the full electric car with a plug-in system will evolve, by which time, hopefully, the Hydrogen economy will finally begin its rise to ultimate domination.

Author’s Note: If you wondered about the derivation of the name chosen by the company, Tesla Motors, you have to look to the genius inventor of the radio — and no, it is not Marconi. Or perhaps you might find the clue in the person who enables you to run your computer, toast your bread, and click on your lights. Thomas Edison? Nope! How about the inventor given credit for inventing X-rays — W.K. Roentgen? Wrong guy again — it was actually discovered a year earlier. What about the vacuum tube credited to Lee de Forest? — someone else. Forty years before the industry created fluorescent lights, this genius lit his laboratories with them.

Few are aware of the achievements of Nikola Tesla, a Croatian born in 1856, who came to America in 1884. Working a short time for Edison, he left as a result of a controversy involving Edison’s refusal to pay him his portion of royalty rights, and then worked with George Westinghouse. His discovery of a system that transmitted energy by wireless antenna was recognized in 1943 when the U.S. Supreme Court granted full patent rights to Tesla for the invention of the radio, nullifying prior claims by Marconi.

In addition, while Edison fought a battle to have DC current dominate, Tesla’s invention of AC current was adopted by the New York World’s Fair of 1899 and eventually became the basic format for electricity usage in the United States.

However, it was Tesla’s creation of the first AC induction motor in the 1880’s that convinced Matthew Eberhard to name his company after Nikola Testa. The motor in the Tesla Roadster is a supercharged update of Tesla’s original, powered by a copper and steel rotor that is spun by a magnetic field. There are no moving parts aside from the rotor. Undoubtedly, as a result, Tesla’s name will deservedly gain much greater recognition than it has in the past, and hopefully his genius will be more universally acknowledged.