Tuesday, November 01, 2005

Happy Anniversary, You’re Perfect, Now Change—Part III

A few years ago I wrote about the economist, Joseph Schumpeter. Although there have been many drastic changes in our lives since then, what has remained constant and unchanged is Schumpeter’s major contribution to the theory of economics, and its relevant application to today’s world. In fact, not many years ago, Business Week and the Wall Street Journal were so impressed by his revelations that the former once dubbed him “Today’s Hottest Economist,” and the latter called him “the most important economist of the 20th century.”

Some may argue that the Journal’s evaluation is an overstatement that overlooks the more widely accepted notion that John Maynard Keynes deserves that title. However, at the very least, others may be willing to split the difference by awarding the crown to Keynes for the first half of the 20th century, and to Schumpeter for the second half.

Ironically Keynes and Schumpeter were both born in the year 1883, Keynes in England, and Schumpeter in what was then the Austro-Hungarian Empire. Educated as a lawyer, Schumpeter, early in his career jokingly told friends he aspired to three goals: to be “the greatest lover of beautiful women in Vienna, Europe’s greatest horseman, and also the world’s greatest economist.” He later would roguishly admit to having achieved two of his three objectives without identifying which two he believed he attained.

Despite a series of unsuccessful early ventures, one as Austria’s finance minister, and another presiding over a bank that failed, with the rise of the Nazi party and Hitler, in 1932 he left his position as chairman of the economics department at the University of Bonn in Germany to accept a position at Harvard where he taught until his retirement in 1949.

Although he wrote several books, his most important contributions were collected in one titled, Capitalism, Socialism and Democracy, published in 1942. It was here that he emphasized it was the entrepreneur who created new competition, new ideas, new technology, and new modes of organization. These innovations in turn upend the established order, unleashing a “gale of creative destruction” that forces incumbents to adapt or to die. It is this “process of industrial mutation [that] incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”

If you are old enough to remember, there was a 20 or so year period ending in the early 1980’s, when there was a dearth of new ideas and new innovations, and the economy and the stock market was in a quagmire. By contrast, as we approached the 1990’s, a technology revolution generated an enormously creative and innovative period that drove the economy and the stock market to new heights. Of course, “creative destruction” also takes its toll on individual companies. Think of Xerox, Polaroid, Lucent, and perhaps now, even the American automobile manufacturers.

In line with Schumpeter’s thesis, the traditional stock market was upended to some degree by the introduction and popularity engendered by mutual funds. Mutual fund companies operating actively managed mutual funds have historically been some of the highest profit margin generators compared to other industries. Recently however, they have faced competition resulting from the increased interest in a relatively old product, index funds, first available on the market in 1975. And now, both actively managed funds as well as traditional index funds are facing a challenge from a relatively new innovative product that is becoming increasingly popular at a very rapid rate: Exchange Traded Funds (ETF’s).

How likely is it that ETF’s will become a force of creative destruction as visualized by Joseph Schumpeter, eradicating the concept of index mutual funds? Andrew Clark, a senior research analyst at the investment firm Lipper, claims that index funds are a dying breed. He says it won’t be long before the index fund loses its place as the king of passively managed funds to its nimbler and cheaper rival, the exchange trade fund. He is quoted, “My personal opinion is that index funds are living on borrowed time.”

Although the subject of ETF’s was covered herein about three years ago when their benefits first began to be appreciated, their growing popularity—and growing they are—could transform them into the newest investment paradigm. Exchange Traded Funds are securities that hold a basket of equities or bonds as do traditional mutual funds. However they are more like index funds in that they are passively, not actively managed, since each one is constructed to track a specific index. Unlike mutual funds that are priced only at the end of each trading session, ETF’s trade like stocks and are priced continuously throughout the day. They can be sold short, bought on margin, and both stop and limit orders can be applied. Another major advantage of ETF’s is their tax efficiency, even when compared to index funds (see below.) If your portfolio is based on a particular asset allocation model (and it should be), it is easier to manage with ETF’s in one brokerage account than if it is comprised of a group of index funds held by various fund families.

A major consideration is the fact that expenses are usually considerably lower than actively managed mutual funds and in most cases even lower than those charged by index funds. That advantage however, has recently been challenged in the arena of the broadly diversified indexes such as the S&P 500 and the Total Stock Market. Fidelity announced they cut their fees for five of its stock index funds including the two mentioned, to 0.7 percent. This reduces the expense factor to below Vanguard’s index fund fees, and are now lower than comparable ETF’s. A major plus for investors is the fact that fund families are reducing fees based on competition within the industry and introducing more competitive products such as ETF’s.

The benefit of the generally lower expense ratio of ETF’s is offset to some degree by the brokerage commissions (the same rate that is applied to stocks) when buying and selling. As a result, ETF’s are normally not recommended as an investment to be held short term. Nor are they recommended for those using a systematic (monthly, for example) dollar cost averaging program. (However, online broker, Sharebuilder Securities, does offer investors making regular automatic investments in ETF’s or stocks an opportunity to trade for as little a $1 to $4 a trade.) Nevertheless, with sharply discounted commissions available (as low as $7-$8 a trade), if an ETF is held for a reasonable length of time, that would still be cheaper than an ongoing higher annual expense levy. One detriment is the fact that many ETF’s are volatile and illiquid. Another is the ease of buying and selling might result in an individual investor treating ETF’s as a short-term trading medium. While a relatively high proportion of trading volume in ETF’s is actually generated for that reason, it is a game played primarily by financial institutions and financial professionals. Others should beware.

What is causing consternation within the traditional mutual fund industry is the sharply increased interest in the ETF alternative represented by the dramatic 47 percent growth in assets to $252 billion as of the end of July from $172 billion a year earlier. According to Financial Research Corp., ETF assets are expected to reach $812 billion by 2009. Net new investments in ETF’s exceeded those in traditional index funds in four of the last five years. Last year, 60 percent of every dollar invested in index funds flowed into ETF’s. While the pattern of growth is impressive, total assets are still a far cry from the $8 trillion held by investors in traditional mutual funds. At least a part of this rapid growth is the increased usage of ETF’s by investment advisors and by companies adding them as choices within 401(k)s.

There are currently more than 190 different ETF’s (134 in domestic stocks, 48 in international, and a few in bonds), all tracking almost every known index, and more are being added just about every week. This allows investors to develop portfolios that include broadly diversified indexes such as the S&P 500 Index (SPDRS), the Dow Jones Industrial Index (DIAMONDS), and the NASDAQ 100 (QUBES). Also available are more focused indexes that track sectors such as energy, biotech, foreign countries, and even gold. The choices amongst ETF’s are greater than that of traditional index funds.

Perhaps paranoia is setting in, or else I would like to flatter myself and think that each time I select a topic to write about, that information is somehow leaked to The New York Times. This seems to be happening with increasing frequency, including this most recent incident: As I was finishing this article, on October 16, The Times ran a ¾ page article headlined, “A New Place to Hunt for Dividends From Funds.” The funds it was referring to were…Index Funds and ETF’s. Quoting Don Phillips, managing director of Morningstar, The Times stated in part, “All mutual funds and ETF’s are required to pay expenses out of dividend and interest income before using fund assets to cover costs. The lower a fund’s expenses, the higher its income stream and the higher its yield. Conventional mutual funds, which tend to have higher expenses as it is, have further reduced yields by folding marketing fees and commissions into their annual expense ratios, Mr. Phillips said. That gives ETF’s and index funds an even bigger advantage.”

The Times article mentions two higher yielding ETF’s that pay dividends of three percent or more: iShares Dow Jones Select Dividend Index, and Power Shares High Yield Equity dividend Achievers. (It should be noted however that the prices of both funds are down for the year.) Vanguard has filed to offer a new fund, The Vanguard Dividend Achievers. Power Shares Capital management recently issued three additional dividend-focused ETF’s. Usually, but not always, dividend income from ETF’s qualifies for the 15 percent tax rate. (The above is provided for your information and is not to be considered as an investment recommendation.)

Whether or not ETF’s will create Schumpeter type creative destruction remains to be seen. However, the advantages they offer certainly warrant serious consideration by investors. And to think that John Bogle started this index investing ball rolling 30 years ago. So once again, Happy Anniversary, You’re Perfect, Now…let’s sit back and watch the Changes multiply.


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