ETFs and Index Funds

Generally, index funds are mutual finds that try to replicate the movements of an index of a specific financial market.  For our purposes, we are most interested in index funds that reflect the market movement of different equity asset classes, such as large cap, mid cap, or small cap.

Some index funds are further characterized as growth, value, or blend within their market capitalization.  Index funds can include real estate investment trusts or REITs.  Different types of fixed income assets can be purchased through index funds, such as short term, intermediate term, or long term bonds.

ETFs are simply index funds that can be traded during the day on an exchange.  In comparison, orders to buy or sell index funds are executed at the end of the day. (more…)

Rebalancing Value Holdings

Last week there was an interesting article on value stocks on the Seeking Alpha blog.  The author concludes that value stocks have higher returns than growth stocks because they are more risky.  He goes on to state that the under performance of value stocks this past year is part of the normal variance in return for an asset with a high risk premium and that it presents a buying opportunity.

More on ETFs

Recent discussions of ETFs on the CompuServe BetterInvesting forum has raised a number of interesting questions. Here are some thoughts on those questions.

1. Including Mid-Cap ETFs in a Portfolio

Equally weighting large-cap, mid-cap, and small-cap ETFs in a portfolio by dollar value will result in over weighting of mid-cap stocks.  Using Vanguard ETFs as an example, a portfolio with equal amounts of large-cap, mid-cap, and small-cap blend or core ETFs will result in an asset allocation of 31% large-cap, 48% mid-cap, and 20% small cap stocks.  In contrast, a portfolio with equal dollar amounts of both large-cap and small-cap blend ETFs will result in an asset allocation of 51% large-cap, 28% mid-cap, and 31% small cap stock.

The reason for this weighting is that both large-cap and small-cap ETFs include some mid-cap stocks. The “X-Ray” feature in the portfolio section of Morningstar is a helpful tool to estimate the actual asset allocation of U.S. stocks in your ETF portfolio. (It does not work well if you include the international ETFs, as it does not distinguish between domestic and foreign stocks.) Also, the prospectus for the ETF should describe how the ETF portfolio is constructed.

Here are two graphic files showing the asset allocation for hypothetical two-ETF and three-ETF portfolios.  You can compare how various Russell core indices did over the past 12 years.

2. Combining Growth and Value ETFs

There does not appear to be any advantage in holding an equal dollar weighting of growth and value funds in a portfolio. A single market (“core” or “blend”) ETF seems to achieve the same return. Looking again at Vanguard large-cap and small-cap ETFs, an equally weighted combination of growth and value provided about the same year-to-date return as a single market (blend) ETF. However, for mid-cap stocks, the combination of growth and value exceeded the market blend ETF by 2.5%. This probably resulted from slight imbalances over the year in growth and value holdings in the three mid-cap ETFs.

Even though growth stocks did much better this year than value stocks, I still prefer a combination of core and value ETFs. This tilts the style weighting toward value. Over most long term periods, value stocks have performed better than growth stocks,

Here is a spreadsheet comparing returns for the various U.S. ETFs.

3. International ETFs

Admittedly, this is a confusing area. There are a number of different international stock indices. In addition, the available ETFs do not necessarily mirror the existing the offerings of the related index mutual funds. To add to the complexity, the fees charged by some international ETFs and many international index funds are high.

One approach for achieving good international stock diversification is to hold a combination of low fee ETFs or index funds for developed markets and emerging markets (with great weight on the developed markets). Developed markets include Europe, Asia, and the Pacific. (See slides 20 and 21 from this presentation.)

By way of example, here are the current Vanguard international ETFs:

  • Vanguard Europe Pacific ETF (70E/30P) (VEA)
  • Vanguard European ETF (VGK)
  • Vanguard Pacific ETF (VPL)
  • Vanguard FTSE All World ex-US ETF (52E/24P/5NA/19EM) (VEU)
  • Vanguard Emerging Markets ETF (VWO)

One can cover the international asset classes fairly well with any of these three combinations: (1) VGK + VPL + VWO, (2) VEA + VWO, or (3) VEU + VWO. Take a look at the Vanguard web site; the ETF summary pages show how they break out by region and country. Note that VEU already includes some holdings in emerging markets.

The spectacular returns these past several years from international stocks reflect, in part, the declining value of the dollar. At some point the dollar will bottom. So I would weight international stocks somewhere between 35% and 50% of the equity portion of the ETF portfolio.

While it is counterintuitive for those of us who have worked hard to master the NAIC methodology, a portfolio consisting of 4-7 ETFs can reduce risk and improve performance (compared to a broad U.S. market index such as the S&P 500).

Finding Index-Based Mutual Funds and ETFs

Some have asked how to find low cost, index fund and index-based ETFs. The links in the previous post may help. Also, here is a list of index funds and index-based ETFs. This is not an all inclusive list. It just identifies some of the more well known funds and ETFS.  It also shows their expense ratios and some past rates of return.

Another good list of index funds and index-based ETFs can be found at This website contains of comprehensive list of index funds and index-based ETFs on its suggested portfolios page.  This site has a great deal of helpful information.

Using Index-Based Funds and ETFs

Here are the handouts from the DC Chapter of BetterInvesting class today on “Using Index Funds and Index-Based ETFs to Build a Core portfolio.” Class Handout.

If you are interesting in learning more about Index Funds and Index-based ETFs, here are some resources that might be helpful.





Other Data

Looking at Portfolio Returns

It has been almost six months since we have looked at portfolio returns.  The big question is what type of portfolio does best.  The portfolio of index-based exchange traded funds seem to be winning.

The graph below shows cumulative returns for two equity portfolios and the S&P 500 (with dividends reinvested). The first portfolio is a diversified portfolio made up of exchange traded funds. The second portfolio is a classic NAIC/BI growth stock portfolio. Both are “real money” portfolios and the returns are based on actual positions. The returns are cumulative (not annualized) internal rates of return calculated from August 27, 2006.

The portfolio of exchange traded funds continues to have the best return. The NAIC/BI portfolio and the S&P 500 are about even. Note that the comparison only covers a period of 13 months.

Comparison of Returns

Returns from Stock Portfolios

A Quantitative Look at Returns from Value and Growth Stock Portfolios

As a long term NAIC/BI investor, I have started taking a closer look at returns of growth stocks in comparison with other asset classes, e.g., value stocks, international stocks, REITs, and bonds. There is very little data showing historic return for NAIC/BI portfolios.

The NAIC Growth Fund is one possible source. It has had a total return (based on NAV) since its inception in 1991 of 9.6%. However, a portfolio of three Vanguard index funds consisting on 25% large cap growth, 50% mid cap growth, and 25% small cap growth funds returned 12.0% for the same period. It may not be fair to use the NAIC Growth Fund for comparison since it is a relatively small fund and it incurs fixed expenses to comply with various SEC requirements. It cannot operate as efficiently as an individual investor’s portfolio.

Anecdotally, some NAIC/BI investors have done very well over time. It appears that some of their success results from using the NAIC/BI methodology as one tool in a larger investing toolkit. These investors use the NAIC/BI methodology to evaluate growth stocks, especially growth and quality, but they also apply a value approach when buying or selling. They buy high quality growth stocks that are on sale and sell them when they become overvalued. I would expect the returns of these portfolios to be closer in return and risk to the blended or value portfolio described below. (more…)

Investing Podcasts

With the advent of digital broadcasting via the Internet, you can find a growing number of investment-related programs. However, they vary in quality and content. Here are two excellent broadcasts available in MP3 format.


Comparison of Index-Based Portfolios

The following graph shows total returns for two portfolios and the S&P 500. The first portfolio is a well diversified portfolio made up of exchange traded funds. The second portfolio is a classic NAIC/BI growth stock portfolio. Both are “real money” portfolios and the returns are based on actual positions. All returns are internal rates of return calculated from August 27, 2006.

So far, the ETF portfolio has out performed both the S&P 500 and the NAIC/BI growth stock portfolio. The total return for the ETF portfolio for the past eight months is 18.9%.