Index ETFs Have the Edge Over Actively Managed CEFs

You may have been reading about the latest "rage." More specifically, several prospective fund providers are gearing up to offer actively managed exchange-traded funds.

In previous posts, I have argued AGAINST using newfangled, actively managed ETFs. For one thing, you lose the tax efficiency and lower costs that come with index ETFs. What's more, index ETFs are more "trade-able." The exceptionally low volume on actively managed ETFs adversely impacts price execution, resulting in an unnecessary hit to overall performance.

Actively managed ETFs do not differ all that significantly from the closed-end funds (CEF) currently available in the marketplace. Some people may want you to believe that there are big differences. They'll point to slightly lower costs. They'll talk about greater transparency on the active ETFs.

Still, closed-end funds do represent diversified baskets of stocks (i.e., fund) that trade like individual securities (i.e., stock). It follows that if we wish to get an idea of how actively managed ETFs will fare against traditional index ETFs, we can make a reasonable comparison to actively managed closed-end funds (CEFs) that are already in existence.

1. China -- The China Fund (CHN) versus the iShares FTSE China 25 Index Fund (FXI). The China 25 exchange-traded index fund, FXI, has been around for nearly 4 1/2 years. That may not be a long time horizon, but it is long enough to look at 3 1/2 years of bullish price movement and 1 year of bearish price movement.

Since the index ETF, ticker FXI, began trading on October 4, 2004, it has gained roughly 53% in value. If one chose the actively managed closed-end fund, ticker CHN? The gain was a significantly less robust 18%. (But what's 3,500 basis points between friends, right?)

2. Mexico -- The Mexico Fund (MXF) versus the iShares MSCI Mexico Index Fund (EWW). The index ETF for investing in Mexico, ticker EWW, has been around for a much longer time period. In fact, over the last ten years, EWW has an astonishing gain of 233%!

Surely, we're going to be even more mesmerized by the extraordinary benefits of stock picking skill by the actively managed Mexico Fund (MXF), right? Well, 141% is a superb return over the last decade. Nevertheless, it falls wayyyyyyyyy short of the index ETF, EWW.

3. Japan -- The Japan Equity Fund (JEQ) versus the iShares MSCI Japan Index Fund (EWJ). Perhaps stock picking in emerging areas like China, Korea, Mexico... perhaps indexing is better for countries where the companies are less well-known. But what happens if you pick a highly developed market like Japan, a country with the 2nd largest economy in the world?

The 10-year return for the iShares MSCI Japan Index Fund (EWJ) was effectively 0%, not unlike the return for major U.S. equity indexes. Still, the active management prowess of the Japan Equity Fund (JEQ) was a lot less sumptuous with a negative return of -35%. Ouch!

In fairness to the closed-end funds that are actively managed, I DID NOT sample 30 or more of them. In that manner, I might have come up with something that is statistically relevant.

That said, there are studies that show index funds outperforming their peers 80%-85% of the time. Why an investor would hope to find the one fund out of five where stock picking might make the difference is beyond me.

In truth, traditional index ETFs have numerous advantages over most actively managed ETFs as well as actively managed CEFs. Will there be exceptions to the general rule? Sure. Nevertheless, sticking with well-known, widely used, traditional index ETFs will make your life easier... and probably, a whole heck of a lot more profitable.

Disclosure: Pacific Park Financial, Inc. may hold positions in the ETFs, mutual funds and/or index funds mentioned above.

Comments

[mavericks:]

This is like comparing apples with oranges. Are you citing NAV performance comparing CEF's with ETF's or market price performance? Most of the CEF's I follow have FAR outperformed the market since the November lows. But then, I only follow CEF's with high yields...most of which use options or leverage to achieve their over-sized payouts. I agree that you're better off buying ETF's if you're looking international.

I have found CEF's to be the canary in the coal mine since they can make moves before the market does. I also like CEF's because you really compete against mostly small investors who jump on the band wagon when the discounts/premiums get too wide. Many CEF's have gone from 20%+ discounts and 20%+ yields to PREMIUMS in only 3 months!! Either CEF's are in a bubble right now or we are in for a major up move in the market. I personally, have shifted more to ETF's right now but its only a matter of time before CEF's go to big discounts again!!

Feb 07 10:10 AM

[donzelion:]

I guess if your index fund could eliminate a few Fannie Mae, Freddie Mac, and AIGs early in their declines, then its performance should stay a notch or two above pure index funds. Sort of a reverse of a core'n'explore...

Now, here's the scary part of the story: say one massive "adjusted index fund" came along, which ran on the S&P index BUT could drop 50 stocks they think will underperform. Anyone who makes that list, if they're in an industry dependent on trust (e.g., banks, certain contractors, etc.), would get creamed if they made the drop list - and every other investor followed along. SO: the better an active managed ETF does, the more likely it is to become a self-fulfilling prophecy, no?

Feb 07 11:19 AM

[Roger Schre...:]

Gary, Your arguments make no sense. Comparing Actively Managed ETFs to Index-Type ETFs is not a reasonable thing to do. Actively Managed (anythings) can vary so greatly, whose to say which be better or best. All I know is that passive investing in anything is stupid - it eventually fails.

Whether or not actively managed succeeds, fails, or does goes back and forth depends on who is managing it and how sound their process is - this is not something that can broadly be defined as a "good or bad thing."

Costs are one thing, but if good management overcomes them, who cares! I don't care if the charge 500 basis points a year, if they can outperform the disaster of buy-and-hope, it's a better value!

You get all hung up on the stuff that distracts investors from making money. Almost everything we have be told about investing is wrong - this is just another one of those myths and distraction that keeps investors from making money.

Roger Schreiner
Schreiner Capital Management, Inc.

Feb 07 12:50 PM

[ALue167:]

I need higher yields & find them more in CEFs like REZ GGN EMF UTF MTP GCS BGR

Feb 07 01:52 PM

[BlueOkie:]

ETFs are the new kid on the block. For comparisons, how much history is needed? I think the jury is still out.

Feb 07 01:52 PM

[Alan Young:]

Last month CHN paid a dividend equal to about 22% of its market price. I suspect that the author only looked at market-price charts, not at total returns.

Feb 07 02:14 PM

[Chamois16:]

Not a very persuasive argument. CEF pay out higher distributions, particularly country funds, and its not clear that that the comparisons are based on total returns. Finally comparisons can be made either on NAV basis or market price basis. You can't compare a CEF market price with an Index ETF NAV.

One of the advantages of CEF is the ability to exploit periodic excursions from equilibrium discounts common to each fund. That doesn't ccur with ETF subject to creation unit arbitrage, usually penalizing the ETF holder in favor of the arb. There are times in a market cycle in which index ETF outperform CEF and vice versa.

The article seems to be comparing an investment vehicle which is at best nascent (how many truly actively managed ETF are out there). with CEF which have been around for a long time and are particularly suited to sspecific asset classes.

You would do better to limit your comparison to index ETF vs actively managed ETF when sufficient data becomes available, and not try to deal with the vaery different attributes of CEF

Feb 07 03:04 PM

[bsharvy:]

Seems like a valid argument for the buy-and-hold investor. For a trader, CEF's can provide opportunities based on the discount to NAV. A CEF tends to be more volatile than an index.

Feb 07 08:43 PM

[hoover:]

Neither index ETF's nor actively managed ETF's have been around long enough to compare generally with CEF's, which have been around for a long time. The only problem with managed funds (CEF's, OEF's or managed ETF's) is that the investor doesn't know what advantage if any he is getting from "management" fees. Managed funds churn a lot of stocks. They collect nice fees. A manager with today's banker's scruples, may run a "managed" fund by using a basic index fund approach, collecting kickbacks on stock trades due to useless churning, and collect a mangement fee for doing nothing. Using an index approach for the core investments in the "managed" fund, assures that the fund doesn't perform much worse than the general market -- which IS the typical performance of managed funds. The investor is simply paying fees for nothing in return -- but I am not suggesting all of them are run like that.

Feb 07 09:00 PM

[H.J. Huneycutt:]

Just from glancing at historical prices (adjusted for dividends and splits) on Yahoo Finance, it would appear that FXI might be more volatile than CHN.

From Oct 12, 2004 to Feb 6, 2009, I come up with this result:

FXI = +67.4%
CHN = +22.8%

However, from January 3, 2007 to Feb 6, 2009, I come up with this result:

FXI = -24.3%
CHN = -13.3%

Admittedly, I know virtually nothing about either FXI or CHN, but just from those figures, it would appear that they are structured much differently and that maybe the "apples to oranges" comments are accurate.

Feb 08 10:43 AM