Passive-Aggressive Shenanigans?

The new S&P Index vs. Active report is out. It might be a game changer, if you can cut through the spin.

I’ve professed my unbridled love for the Standard & Poors Index vs. Active scorecard many times. It’s simply the best, most consistent, most fair-minded way we have of really analyzing the active vs. passive management debate. We write about it every six months when it comes out (and indeed, we reported it here last week.)

I still love it, but I have to say, the PR folks at Standard &Poor’s should tuck in their shirts, because their bias is showing.

It’s not the data. The data are great. It’s the headlines.

In the 2008 year-end report, the introductory text crowed about the one-year results. “The belief that bear markets favor active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008.”

So how is it that the 2009 report carries the headline “Annual Matchups – No Clear Trends” and this rather hedgy text: “Short-term outcomes (such as periods of 12 months or less) of the index versus active debate are less consistent than longer-term outcomes. This notion is demonstrated by the active versus index matchup for each of the last 10 years.”

Why not just let the data speak for themselves, and perhaps use a headline that actually reflects the news, such as:

"2009: Best year in a decade for active management"

Because, let’s face it, it was. Here’s the total picture showing how the actively managed fund universe compared with the broad market: In 2009, only 41.67 percent of active managers failed to beat the bogie.

Is it fair to say there’s “no clear trend” in those numbers? Sure. Is the long-term story still one of active managers being almost the probabilistic equivalent of a coin toss?” Absolutely. But I do feel the need to call out S&P’s shenanigans here. Active management does have its good years, and this was, simply, one of the best. The most stunning examples aren’t even in the headlines, though. They’re buried in the numbers. A few more high spots: Let’s look at the one-, three- and five-year asset-weighted returns of active managers vs. the S&P 500.

This is the marquee fight, for sure, and I’m sad to say, it’s one that active managers are now winning. The numbers were similar if you just look on an equal-weighted basis, but asset-weighted by definition captured the experience of more investors.

Of course, the real story here is that even with the average active manager beating the market over the last five years, the onus was still on investors to go find one of those winners. The S&P 500, on the other hand, was available to anyone who showed up.

But I think there’s another story here that’s worth looking at, and that’s one of benchmark relevance. Let’s look at one category where active looks like the best thing since sliced bread: “Government Long Funds.” In this category, active managers returned 4.85 percent in 2009, whereas the “index” lost a whopping 12.18 percent. That kind of outperformance usually makes careers. But let’s really get under the hood.

The SPIVA methodology relies on Lipper to decide what funds go in which buckets. Into the category of “Government Long Funds” go the Lipper mutual funds considered “General US Government Funds” and “General US Treasury Funds.” The benchmark against which they’re measured is the Barclays Long Government Index, which tracks paper reaching out as far as 21 years, and has a current duration of almost 13. (By comparison, the BarCap Aggregate, which covers effectively the whole investable bond market, has a duration of about 4.5).

And what’s actually inside the Lipper “General US Government” category? According to Lipper, the sole distinction there is that funds must have 65 percent or more of their assets in government or agency debt. That’s a big bucket, and one that includes things like DXKLX, the Direxion Monthly 10-Year Note Bull 2x Fund, or the Vanguard Intermediate-Term Treasury fund (VFITX), neither of which strikes me as a classic “Long” fund as we apply the term to fixed-income portfolios.

A deeper pass through the fixed-income buckets reveals similar oversimplifications. Some categories, like New York municipal funds, are obvious. The more general categories, however, are rife with opportunities for mischaracterization, and I fear there’s a substantial level of that going on here.

My point is not to cast aspersions on SPIVA—at some point, you always have to make certain choices in a methodology in order to get the work done. My point is simply this: It always pays to look beyond the headline and down into the data, to question the results that seem too crazy to be true, and to draw your own conclusions.

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BABs: Beautiful If You’re Not Rich

Despite the Wall Street Journal’s worries about Build America Bonds, they can be great for your portfolio, especially if you’re not super-wealthy.

The Journal is out today with an article on the growing market for—and criticism of—Build America Bonds. BABs, as they are known, are a special type of municipal bond created last April as part of the federal stimulus effort. They are designed to help municipalities raise money to invest in infrastructure projects. Wall Street firms have earned more than $1 billion selling $78 billion in BABs, the Journal said.

The way they work is simple: Unlike traditional municipal bonds, these bonds are taxable. To offset the tax hit, the Federal government pays a 35 percent subsidy on the interest payment. For instance, if my great state of Maine were to issue a BAB paying 6 percent interest, the federal government would cover 2.1 percent of that interest payment.

In essence, BABs allow municipalities to offer bonds to the taxable market without paying out more in interest than they would on tax-free bonds. That’s a good deal for municipalities because the size of the tax-free bond market is limited, and BABs open up an entirely new avenue for sales.

To date, most investors have been interested in BABs because they were initially priced at extremely attractive rates. Even today, the PowerShares Build America Bond Portfolio (NYSEArca: BAB) ETF is paying a 5.31 percent 30-day SEC yield, which compares favorably to various other non-BAB bond ETFs. You can earn 4.03 percent on the iShares Barclays Credit Bond ETF (NYSEArca: CFT), 4.32 percent for the PowerShares Insured National Municipal Bond Portfolio (NYSEArca: PZA) and a measly 1.78 percent on the iShares Barclays Aggregate Bond ETF (NYSEArca: AGG). Given that the historical default rates on municipal debt are much lower than corporate debt (and more or less on par with the Aggregate), the higher payouts are attractive.

One overlooked benefit of BABs is that they make municipal debt relevant for people who are not super-wealthy (people like me). After all, the lower your tax rate, the less valuable the tax-free status is.

With BABs, the federal government applies the 35 percent interest rate kicker regardless of your tax bracket. That means, all else being equal, anyone earning less than $372,950 is likely to be better off buying BAB or individual BAB bonds than plowing money into actual municipal debt.

There are a thousand caveats to that statement, of course. Liquidity in individual BABs is limited, although the BAB ETF trades fairly well. More importantly, BABs and the BAB ETF can be much more volatile than broad-based muni bonds. Since inception in November 2009, the BAB ETF has underperformed most broad-based muni bond ETFs on a total return basis by more than 2 percent, as that volatility has taken its toll.

Still, given that it’s paying out more than 1 percent per year in higher yields than competing muni bond ETFs, it could be attractive for investors.

The current BAB program is set to expire in 2010, although existing bonds and interest subsidies will continue, and the change should not impact the ETF. The Obama administration is looking to expand the program indefinitely, although it plans to bring the interest rate subsidy down to 28 percent. That could lower the average yield on an ETF like BAB a smidge. Still, for most investors, it will remain a pretty nice deal.

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Senator Johnson To Investors: Drop Dead

Politics are colliding with exchange-traded funds and index funds in a major way, for both good and bad.

First, the bad news: U.S. Senator Tim Johnson (D-South Dakota) appears to have scuttled reform efforts that would have forced brokers selling investments to act in the best interests of their clients.

Currently, broker/dealers are required only to recommend investments that are “suitable” for their clients. That’s a far cry from the fiduciary standards that apply to true registered investment advisers, who are required by law to put their clients’ interests first.

The move to apply “fiduciary standards” to brokers grew out of the financials scandals of 2008, which created a climate for investor-friendly reform. Early drafts of reform bills currently working their way through the Senate Finance Committee had language that would apply fiduciary standards to brokers. But late last month, Senator Johnson inserted an amendment that would delay any decision for 18 months while the Securities and Exchange Commission studies the matter further.

The move is a clear delaying tactic aimed at postponing the discussion to a point where consumer anger over the scandals has subsided. As has been reported in many locations, the question of the fiduciary standard has already been studied to death.

I would submit that no study was needed in the first place: Should people providing investment advice be able to act against the best interests of their clients? The question is absurd on its face.

There are plenty of good brokers out there, and I doubt they are worried. If they’re good, they’re already acting according to a fiduciary standard (or would like to if their firm allowed it). The only folks who are worried about a fiduciary standard (and the ones who are lobbying Senator Johnson with huge money) are the folks who want to sell products like PHYS at a 5 percent commission.

On the flip side, a news piece from Pensions & Investments shows that there’s still hope in the political system. According to P&I, a new Department of Labor proposal about what kind of investment advice can be delivered to direct contribution retirement plans could heavily favor index funds.

I’ll quote directly from the piece: “The proposal, released by Vice President Joe Biden at a Feb. 26 White House briefing would bar the use of performance data from computer models that generate advice, placing greater reliance on fees, which favor index funds.”

It goes on to quote from the proposed rule:

“While some differences between investment options within a single asset class, such as differences in fees and expenses or management style, are likely to persist in the future and therefore to constitute appropriate criteria for asset allocation, other differences, such as differences in historical performance, are less likely to persist and therefore less likely to constitute appropriate criteria for asset allocation.”

That’s music to my ears …

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PHYS: Not A Gold ETF, And A BAD Deal

In the words of Star Wars' Admiral Ackbar: “It's a trap!"

I guess you know your town is on the map when the carnies show up and start taking the rubes.

Last week, the “Sprott Physical Gold Trust” started trading on the New York Stock Exchange under the ticker PHYS. Almost immediately, the media starting singing its glory: “New Gold ETF Prospectus Reveals Exciting Feature,” wrote Seeking Alpha contributor ETFdb. Invest with an Edge had similarly glowing coverage.

Unfortunately, PHYS is not an ETF. And its “exciting feature?” Well, that turns out to be a trap.

Not An ETF

I define an ETF as an open-ended mutual fund that trades on an exchange and uses a creation and redemption mechanism to keep its share price in line with its NAV.

PHYS trades on an exchange, but the comparisons stop there.

The company doesn't try to hide this. The prospectus states:

As a closed-end fund, PHYS comes with all kinds of warts that do not apply to ETFs. For starters, PHYS was sold at a 5 percent commission. That is, the price offered to initial investors in the fund was $10 a share, but the NAV took an immediate haircut to $9.50, because 50 cents went into the hands of the good folks at RBC Dominion Securities, Morgan Stanley Canada, BMO Nesbitt Burns and other underwriters. ETFs never come with initial underwriting commissions.

That might not matter to investors who purchase it on the open market, but there are other warts that do.

For instance, as with all closed-end funds, there is no way for PHYS to issue new shares, which means there is effectively no way for the security to actually track the price of gold. Sure, it might, but if the shares trade at a premium, it's impossible for an arbitrageur to go buy gold, turn it into shares, sell them on the open market and drive the market price back to NAV.

PHYS does have a redemption feature, but it's severely crippled. The PHYS redemption window is only open once a month, and it comes with a lag. Investors who want to redeem shares of the fund can submit a request to the company on the 15th of the month. If the redemption request is large enough (bigger than a single gold bar), the redemption will be processed at least in part for physical gold at NAV at the end of the month (13-15 days later). If you're redeeming lots smaller than a physical gold bar or just want cash, you get dinged for at least 5 percent off of the value of the fund.

That's not exactly a liquidity option. Let's just say that market makers aren't lining up to ride this “lightning-quick” 15-day flawed redemption process to ensure that the fund stays close to fair value.

The Big Tax Trap

But those flaws pale in comparison with the “exciting feature” that ETFdb notes in its article: the tax treatment.

According to the fund's prospectus, “Any gains realized on the sale of units by an investor … may be taxable as long-term capital gains (at a maximum rate of 15% under current law).”

It sounds like the Holy Grail. One of the vexing problems of funds like the SPDR Gold Trust (NYSEArca: GLD) is that, no matter how long you own it, you will owe 28 percent taxes on gains because the IRS considers all gold investments to be collectibles. PHYS claims to have found a way around this problem, creating a gold bullion fund that qualifies for true long-term tax treatment. Brilliant!

Except it's not.

The IRS isn't stupid. It's going to get its money somewhere. And in this case, it looks like it's reaching into the pockets of PHYS' most loyal, buy-and-hold investors to grab that 28 percent for the U.S. Treasury.

Understanding why gets into the weeds of the prospectus, but it's important to do, because the implications are huge. Here's the relevant paragraph:

Let me parse that for you.

You, Mr. Long-Term Buy-and-Hold, purchase shares of PHYS and stuff them deep in your portfolio, confident that you'll only pay long-term gains of 15 percent when you eventually decide to sell. Meanwhile, a hedge fund buys shares of PHYS, rides them while gold is rising, and then redeems them back to the fund company.

To meet this redemption, the trust either sells a pile of gold to pay cash or redeems out physical gold bars. Either way, the trust will book that sale with the IRS based on the current price as gold, and will be taxed at the 28 percent collectible rate on any gains. But funds never actually pay taxes: They pass them along to shareholders. So that 28 percent gain accrued by the hedge fund activity? That's going to be paid by you, even though you never sold a share.

I guess I'll have to agree with the headlines—that's certainly an exciting feature. I suppose getting a root canal without the gas is “exciting” too.

ETFs treat all investors fairly. PHYS not so much.

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ETFs Are Not Really Transparent

Proponents of exchange-traded funds love to say that ETFs are “fully transparent.” They’re lying.

The concept of “transparency” in ETFs is so pervasive that people just assume it’s true. Look at almost any ETF provider’s Web site and you will see the word “transparency” highlighted as one of the key benefits.

If you go to www.ishares.com, for instance, you’ll find the following, right at the top of the page:

You can see similar messages at State Street Global Advisors, PowerShares, Vanguard and others.

But there is actually no rule requiring index-based ETFs to disclose their portfolios any more frequently than traditional mutual funds. And for many ETFs, portfolio disclosure is either incomplete or significantly delayed. And the problem is getting worse.

The Myth Of ETF Transparency

The myth of ETF transparency stems from the fact that ETFs must publish their “creation baskets” at the end of every day. The creation basket is the shopping list of securities—tickers and numbers of shares—an institutional investor (aka, an “Authorized Participant”) must deliver to an ETF issuer if he or she wants to create a tranche of new shares in an ETF. For instance, the creation basket of the SPDR S&P 500 ETF (NYSEArca: SPY) will likely contain all 500 stocks in the S&P 500 in approximately the same weights as those stocks that exist in the index.

Creation baskets are often extremely close to the actual holdings of a fund, but they don’t have to be. For large-cap domestic equity ETFs, they’re usually identical. But as you move into less liquid areas of the market, a significant gap can develop between the contents of the creation basket and the holdings of the underlying fund, all the way until they are so divergent that the ETF issuer just asks for cash.

Take the iShares MSCI Emerging Markets ETF (NYSEArca: EEM). Due to an index licensing issue with MSCI, iShares only discloses the full portfolio for EEM on its public Web site on a month-end basis. As of March 1, 2010, the last portfolio holdings data available was as of Jan. 29, 2010.

If you have access to a Bloomberg machine (costing >$20K/year), you can see the full portfolio. I imagine if you picked up the phone and talked to someone at iShares on any given Tuesday, they’d probably fax it to you as well. And what you’d find is that the actual holdings differ significantly from the creation basket.

We’re not talking small differences here. Samsung has almost a half-percent bigger role in the creation basket than it does in the ETF. The reasons for these discrepancies aren’t nefarious—they’re common sense. The basket is simply smaller, ignoring the least liquid, hardest-to-buy securities. One assumes that those securities might be purchased in a later basket, if the manager really felt they needed them for tracking purposes. But in general, the basket is optimized to be “easy to buy” for the AP. That’s a good thing, because an involved AP means lower spreads on the ETF itself.

Most iShares—indeed most ETFs—provide full portfolio-level disclosure on their public Web sites on a daily basis. But some, like EEM, have halting disclosure at best.

A Worse Case: ProShares

ProShares’ family of leveraged ETFs is another example of imperfect disclosure. ProShares ETFs hold swap arrangements as their core asset. Swaps are privately negotiated contracts whereby two parties agree to exchange a pattern of returns. In the case of ProShares, it will agree with a bank to deliver anywhere from 200 to negative 300 percent of the daily return of a benchmark index.

These arrangements generally work well, but they do come with some measure of credit risk for investors. If one of the underwriting banks were to go bankrupt, shareholders could lose money (although usually not more than 5-10 percent even in the worst-case scenario).

ProShares is not required to disclose the counterparties of its swaps, and it chooses not to do so.

Full transparency? Not really.

The Worst Offender: Vanguard

Vanguard is by far the worst offender on the transparency front. Vanguard refuses to disclose its portfolios on anything approaching a daily basis. In fact, it treats its ETFs just like mutual funds: It only discloses their portfolios every 90 days, and even then it applies a 30-day lag. Right now, for instance, the most up-to-date holdings information you can get on any Vanguard ETF (and this includes both public and Bloomberg data) is as of Dec. 31, 2009.

The Vanguard problem is made worse because it optimizes its creation baskets (which, by law, it does disclose), so that they represent very narrow windows on a fund. For instance, the Vanguard Total Bond Market ETF (NYSEArca: BND) had 4,219 holdings as of Dec. 31, 2009, but its creation basket is typically less than 50 securities.

Index Transparency Vs. Fund Transparency

ETF advocates would tell you that the lack of true fund-holding transparency doesn’t matter, since ETFs track indexes and you can always see what’s held in the index. ProShares uses the phrase “index transparency” to describe its ETFs, which is accurate.

But as covered recently on our site, ETF tracking error has exploded, with wide gaps opening up between index and ETF performance.

I love the idea of ETFs being “fully transparent.” And most of them are, with complete portfolios published on provider Web sites on a daily basis.

But an increasing number of ETFs fail the test. The ETF industry should commit to true transparency, from Vanguard to ProShares to everyone in between.

(Ironically, actively managed ETFs—unlike their index-based cousins—must disclose their full portfolios on a daily basis. Who knew that actively managed funds could be more transparent than index products?)

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The views expressed by those blogging are for informational purposes only and should not be construed as a recomendation for any security.