August 17, 2015: ETF or Mutual Fund Based Portfolios

Aug 18, 2015 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

For regular SAA and TAA portfolios, the next re-balance will be on Monday, August 31, 2015. You can also find the re-balance calendar for 2014 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

ETF or Mutual Fund Based Portfolios

We have been long asked to address the general ETF vs. mutual fund issue in portfolio building. A very glaring and specific example (that has been asked many times by our users) is the performance difference between the two Goldman Sachs Global Tactical portfolios, listed on Advanced Strategies, that are based on ETFs and index mutual funds respectively: 

Portfolio Performance Comparison (as of 8/17/2015):

Ticker/Portfolio Name YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 5Yr Sharpe 10Yr AR
P Goldman Sachs Global Tactical Include Emerging Market Diversified Bonds -0.2% 2.8% 10.7% 10.1% 0.99 13.0%
P Goldman Sachs Global Tactical Include Emerging Market Diversified Bonds ETFs -4.2% -2.0% 8.8% 7.2% 0.68  

Note: the blue line chart is for the ETF portfolio. We apologize for the problem of shortening a long portfolio name in our charting software. 

The ETF portfolio has under performed the mutual fund portfolio by a big margin. As many users are following the ETF portfolio, this year’s under performance is especially painful (-4.2% vs. -0.2%). 

It is thus imperative for us to investigate this discrepancy more seriously. Upon the close examination, we found that the two portfolios sometimes had a very different holdings (for example, the current holdings of these two portfolios are materially different: even though the first two holdings are the same, the same holding is materially different (ETF portfolio holds international stock EFA while the mutual one holds a Vanguard bond fund)). 

This is caused by the following two factors. 

ETFs and mutual funds are not tracking the same index

ETFs used in the ETF portfolio do not completely track the same index as those mutual funds. For examples, Vanguard long term Treasury bond fund (VUSTX) has effective duration 16 years while iShares 20+ Year Treasury Bond (TLT) has effective duration 17.32 years, based on Morningstar.  Another example is the international stock funds’ performance discrepancy:

Portfolio Performance Comparison (as of 8/17/2015):

Ticker/Portfolio Name 1 Week
Return*		 YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR
VGTSX (Vanguard Total Intl Stock Index Inv) -2.5% 2.2% -5.2% 7.1% 5.5% 4.4%
EFA (iShares MSCI EAFE) -0.9% 7.0% -0.7% 10.6% 8.0% 4.3%
VUSTX (Vanguard Long-Term Treasury Inv) 1.2% 0.3% 7.9% 2.5% 6.7% 6.8%
TLT (iShares 20+ Year Treasury Bond) -0.3% -0.1% 9.3% 2.3% 7.4% 7.0%

Note from the above, even though EFA (iShares MSCI EAFE) has a very similar 10 year return compared with VGTSX (Vanguard Total Intl Stock Index Inv), their short term performance difference is huge: last 1 week -2.5% vs. -0.9% or 2.2% YTD (Year To Date) vs. 7.0%!! No wonder it causes the different transactions in the two portfolios. 

Unfortunately, we can not find exact ETF substitutes for many Vanguard index funds used in the mutual fund portfolio. This is especially true for many bond funds. 

ETF NAV vs. Price Issue

It is well known that ETF has a major problem that its price might not track its NAV closely, at least not daily. The famous example is that during the severe market meltdown in 2008 right after Lehman’s bankruptcy, high yield bond HYG had a huge price drop which made its price 20-30% lower than its NAV at some points. In fact, in the above table, Vanguard Total Intl Stock fund VGTSX had started to track MSCI EAFE stock index several years ago, which is the same index EFA is based on. However, one can see that the two behave much differently!

In general, due to trading activities, an ETF’s price can be temporarily driven out of sync with its underlying index. Furthermore, the dividend and other distributions can also affect the index tracking. There are also other factors that can affect such a temporary price vs. NAV discount or premium. For example, ETFs’ prices on an option expiration day can be more volatile. It used to be only on the 3rd Friday of every month when most options expire. However, with the advent of weekly options, now prices on Fridays are more volatile.

Again, for a long term investor, buying and holding ETFs for a long time will make very difference from buying and holding a similar index mutual fund. However, in a shorter term, prices of ETFs can be driven out of sync and it is thus better to rely on index mutual funds instead. 

Benchmarks Based ETF Portfolio 

One solution is to still stick to ETFs but instead using their corresponding index mutual funds to calculate trend scores. By doing so, at least we are moving closer to the mutual fund portfolio. Here is what we did for the new portfolio P Goldman Sachs Global Tactical Benchmarks Based Include Emerging Market Diversified Bonds ETFs: 

This portfolio is the ETF version of the portfolio P Goldman Sachs Global Tactical Include Emerging Market Diversified Bonds, which uses index mutul funds.

However, it is different from P Goldman Sachs Global Tactical Include Emerging Market Diversified Bonds ETFs as it is using another separate parameter Benchmarks to calculate trend scores instead. The Benchmarks parameter consists of an array of index mutual funds, each of which corresponds to the ETFs in the Funds parameter. Both parameters should have the EXACT number of funds. Otherwise, its result can be wrong. 

Basically, an ETF’s trend score is calculated using its corresponding mutual fund instead of it’s own return. However, the portfolio still invests in ETFs, not the mutual funds in the Benchmarks parameter. 

Portfolio Performance Comparison (as of 8/17/2015):

Ticker/Portfolio Name YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 5Yr Sharpe 10Yr AR
P Goldman Sachs Global Tactical Include Emerging Market Diversified Bonds ETFs -4.2% -2.0% 8.8% 7.2% 0.68  
P Goldman Sachs Global Tactical Benchmarks Based Include Emerging Market Diversified Bonds ETFs -1.5% 1.1% 9.2% 8.9% 0.86  
P Goldman Sachs Global Tactical Include Emerging Market Diversified Bonds -0.2% 2.8% 10.7% 10.1% 0.99 13.0%

See the detailed year by year comparison and other stats >>

The performance has been improved and now it is closer to that of the mutual fund based portfolio. However, the still over 1% return difference is still noticeable. They are mostly due to the mismatch of ETFs and their mutual fund counter parts (see below for a more convincing argument). 

As a result of the above studies, we would like to recommend users to start to use/migrate to this new ‘benchmarks based’ portfolio if you plan to use ETF portfolio. We are convinced that index mutual funds provide more reliable transaction/rebalance/trading signals than ETFs. 

We want to emphasize that for both basic  Strategic Asset Allocation (SAA) and Tactical Asset Allocation(TAA) based portfolios, we have been using index mutual funds as asset benchmarks from day one. It is really  some of these advanced ETF portfolios such as the GS GTAA ones that should be a cause of concern. 

ETF vs. Index Mutual Fund Apple to Apple

We stated in the above that the return difference between the ‘Benchmarks Based ETF’ portfolio and mutual fund portfolio is mostly due to the mismatch of ETFs and mutual funds. In fact, if we reduce our candidate funds to a smaller subset that consists of only the core asset funds, we eliminate the problem caused by the different benchmarks tracked by an ETF and its corresponding mutual fund in the above comparison. For example, our famous Six Core Asset based ETFs based portfolios are tracking the index mutual fund based portfolios reasonably well: 

Portfolio Performance Comparison (as of 8/17/2015):

Ticker/Portfolio Name 1 Week
Return*		 YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR
Six Core Asset ETFs Strategic Asset Allocation – Equal Weight Moderate -0.5% -0.3% -3.2% 2.9% 4.9% 5.3%
Six Core Asset Index Funds Strategic Asset Allocation – Equal Weight Moderate -1.0% -3.0% -5.8% 1.7% 4.3% 5.2%
Six Core Asset ETFs Strategic Asset Allocation – Optimal Moderate -0.6% 1.3% 0.4% 5.8% 6.8% 5.5%
Six Core Asset Index Funds Strategic Asset Allocation – Optimal Moderate -0.9% -0.5% -1.5% 5.2% 6.5% 6.0%
Six Core Asset ETFs Tactical Asset Allocation Moderate 0.0% -2.9% -4.8% 5.1% 5.7% 9.5%
Six Core Asset Index Funds Tactical Asset Allocation Moderate 0.4% -2.5% -4.3% 5.1% 5.4% 9.3%
VFINX (Vanguard 500 Index Investor) -0.0% 3.4% 9.6% 16.7% 16.5% 7.6%
VBINX (Vanguard Balanced Index Inv) 0.1% 2.3% 6.4% 10.7% 11.3% 6.9%

See detailed year by year comparison and stats >>

Both equal weight SAA and TAA ETF portfolios did better than their index fund portfolios in the last 10 year time frame, while the SAA optimal index mutual fund portfolio did better than its ETF counter part. 

As another experiment, we look at the following two portfolios that uses GS GTAA strategy but only uses 5 major asset index ETF or mutual funds. 

Portfolio Performance Comparison (as of 8/17/2015):

Ticker/Portfolio Name 1 Week
Return*		 YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR 10Yr Sharpe
P Goldman Sachs Global Tactical Benchmarks Based Major Asset ETFs 1.3% -5.2% -0.4% 7.6% 8.9% 12.2% 0.78
P Goldman Sachs Global Tactical Benchmarks Based Major Asset Index Funds 1.3% -5.8% -0.3% 7.4% 8.9% 12.7% 0.89

Detailed comparison link >>

Now the two portfolios are tracking more closely to each other. 

Though the above by no means serves as a complete proof to the effectiveness of ETFs in place of their corresponding index mutual funds (so long as they track the EXACT index), it does give us confidence in using ETFs. 

To summarize, ETFs can be an effective mean to invest to obtain its index performance. On the other hand, due to ETFs’ short term volatile deviation from their index mutual funds, one should use index mutual funds as the means to calculate and guide rebalance/trading signals. 

Market Overview

The Chinese currency devaluation in the last week can be a very significant event that might cause global market and economy turmoil. Whether it signals the beginning of a full blown currency war remains to be seen. However, the event did confirm the global deflation concern. In fact, both long term bonds and yield sensitive REITs rose more last week. They now are ranked above others, backing to the strengths they had in earlier this year. 

We still view the bull market has gone a long way and one needs to be cautious. Sticking to a well designed, well balanced plan within one’s risk tolerance has been the best way to navigate through market’s ups and downs.

For more detailed asset trend scores, please refer to 360° Market Overview. 

We would like to remind our readers that markets are more precarious now than other times in the last 5 years. It is a good time and imperative to adjust to a risk level you are comfortable with right now.  However, recognizing our deficiency to predict the markets, we will stay on course. 

We again copy our position statements (from previous newsletters): 

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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