The rapid growth of the ETF space, both in terms of AUM (28.7% annualized growth from $83 billion in 2001 to $1,337 billion in 2012) and number (25.1% annualized growth from 102 ETFs in 2001 to 1,194 ETFs in 2012) has greatly benefited investors by offering cheap, liquid exposures to an ever-increasing number of betas. Investors can get exposure to nuclear energy (Market Vectors Nuclear Energy ETF (NLR)), equities in the social media space (Global X Social Media Index ETF (SOCL)), Chinese real estate (Guggenheim China Real Estate ETF (TAO)) or merger arbitrage (IQ Merger Arbitrage ETF (MNA)).
While this explosion in available exposures, especially the more granular ones, is undoubtedly beneficial to investors, it also makes due diligence that much more important when deciding which ETFs make the most sense to use in implementing a trade.
As an example, let’s consider an investor that believes that US large-cap value stocks will outperform US large-cap growth stocks during the next 12 months. The investor would like to go long a U.S large-cap value ETF and short a U.S. large-cap growth ETF. The question is which ETFs to choose. iShares alone has four different pairs that could be used:
- S&P 500 Growth (IVW) / Value (IVE) ETFs
- Russell 1000 Growth (IWF) / Value (IWD) ETFs
- Morningstar Large-Cap Growth (JKE) / Value (JKF) ETFs
- Russell Top 200 Growth (IWY) / Value ETFs (IWX)
One would probably assume that if the view (value outperforming growth) is correct, then the investor can make money regardless of which of the four pairs are used to implement the trade.
As usual, the truth is not that simple.
For the sake of brevity let’s focus on two of these pairs: IVW/IVE and JKE/JKF. Using the available price history for these ETFs (as well as SPY for comparison purposes), we can look at some basic performance data.
|7/04 to 5/13||SPY||IVW||IVE||JKE||JKF|
|Annualized standard deviation||21.2%||19.8%||22.3%||20.7%||22.2%|
|Beta to SPY||1.00||0.91||1.02||0.93||0.99|
First, a couple of quick observations about this data:
- It can be dangerous to listen to commonly held market wisdom without verifying the claims independently. Many readers have probably heard others say that growth stocks are more risky that value stocks or that value stocks will have lower betas than growth stocks. Neither of these statements held water over the period examined. In fact, both of the growth ETFs had lower peak-to-trough drawdowns during the global credit crisis (49% for IVW and 53% for JKE) than the value ETFs (62% for IVE and 60% for JKF)
- While the two value ETFs do indeed behave more similarly to each other than to the growth ETFs and vice versa (based on volatility, beta and correlation), they are not perfectly correlated and exhibit some clear performance differences. For example, both of the ETFs tracking the S&P indices outperform the ETFs tracking the Morningstar indices.
Digging into the websites, fact sheets and prospectuses of the four ETFs, we can start to put together a picture as to why the funds may perform differently over time:
- Methodology: Neither the S&P-based ETFs nor the Morningstar-based ETFs disclose the exact methodology that is used to identify growth and value stocks. However, it is disclosed that the Morningstar based ETFs (JFE and JFK) use a methodology that is proprietary to Morningstar. From this we can conclude that there may be discrepancies as to what is categorized a growth stock and what is categorized a value stock.
- Diversification: The Morningstar-based ETFs are more concentrated than the S&P-based ETFs. As of 5/28/2013, JKE and JKF have 94 and 80 holdings, respectively. This compares to 295 holdings for IVW and 358 holdings for IVE. The number of holdings IVW and IVE also indicate that there will be some overlap between the holdings of IVW and IVE given that the investment universe for both ETFs is the S&P 500.
- Sector Exposures: IVE is tilted towards Industrials and Consumer Staples and away from Energy and Telecom relative to JFE. IVW is tilted towards Health Care, Industrials and Materials and away from Technology, Consumer Goods and Services and Financials relative to JFK.
- Fees: The management fee on the Morningstar-based ETFs is 25bps compared to 18bps for the S&P ETFs.
These differences end up making all the difference in the world to the investor. A long value/short growth strategy using IVE and IVW would have returned 167bps (ignoring transaction costs) annually with 11.0% volatility. The same strategy implemented with JFE and JFK would have lost 75bps annually with 7.2% volatility.
Choosing the right ETFs for your trade can be just as important as formulating the correct trade thesis when it comes to your bottom line.