By Michael Rawson, CFA
U.S. equity markets have rebounded nicely from their mid-March dip. However, amid rising gasoline prices, fears of inflation, and increased global instability, equity investors have every right to be seriously concerned about the market going forward--and about what they are paying in order to invest in stocks.
Obviously, investors can buy a diversified basket of U.S. stocks either through an open-end mutual fund or through an exchange-traded fund. But with typical mutual fund expense ratios ranging from 1.2% to 1.7%--and even many institutional mutual fund expense ratios ranging from 0.5% to 0.8%--we like to highlight some ways that a cost-conscious investor can use ETFs to implement themes similar to those of smart, well-respected active mutual fund managers at a fraction of the cost.
Of course, this is just an exercise in replication that will only give you returns that are correlated with the active managers' recent bets. So, while you will pay lower fees, you won't have the benefit of the active manager as your investment steward. We also don't know their holdings in real time, and a primary reason you pay up for active managers is to have them change their holdings at opportune times. You'll have to adjust your holdings according to your own evolving judgement once you decide to use other instruments, like ETFs, to capitalize on their most recent ideas. For many investors, paying up to actually own those managers' funds may be a good idea.
Channeling Contrafund and Jensen with ETFs
Five-star mutual funds Fidelity Contrafund (FCNTX) and Jensen J (JENSX) have a lot in common. Both are run by former Morningstar Fund Manager of the Year award winners and both are firmly in the large-cap growth style. Digging beneath the surface, however, the two mutual funds have some substantial differences. At $79 billion in assets under management spread over 484 holdings, Contrafund, which charges 0.91%, is a giant. Although just 30% of Contrafund's assets are in its top 10 holdings, it has a large overweight in information technology, with a 7% position in Apple (AAPL) and a 5% position in Google (GOOG). It also has an underweight to industrials and defensive sectors such as health care and consumer staples.
Meanwhile, Jensen, which charges 0.92%, has $3.9 billion in assets invested in just 28 stocks, with the top 10 holdings comprising 47% of assets. Though a growth fund, the portfolio is underweight technology and overweight industrials and consumer staples.
One ETF, PowerShares QQQ (QQQ), also known as the "Cubes" or the Qs, is a great way for investors to replicate Contrafund's bullish view on tech, as QQQ has a large weight in Apple and Google and almost 64% of its assets invested in technology. However, we would note that that weight in Apple will fall once the NASDAQ-100 Index, which QQQ tracks, is rebalanced.
Jensen's view on high-quality consumer staples and industrials could be mimicked by one of two ETFs: Vanguard Dividend Appreciation (VIG) or iShares Dow Jones US Industrial Sector Index (IYJ). Over the last four years, Jensen has had a higher correlation to VIG than it has had to the S&P 500. Of Jensen's 28 stock holdings, 19 also are in VIG, which has 142 holdings. Some of the biggest holdings of Jensen that are also large holdings in VIG include Abbott Laboratories (ABT), 3M (MMM), Emerson Electric (EMR), and Medtronic (MDT).
With a concentrated portfolio like Jensen, quality becomes more important. Nearly 75% of Jensen's assets are invested in firms with economic moats, which Morningstar's equity analysts define as sustainable competitive advantages. Remarkably, none of Jensen's holdings is rated as no-moat.
In contrast, Contrafund has just 27% of assets in wide-moat stocks. In fact, "moaty" firms such as Procter & Gamble (PG), Colgate-Palmolive (CL), and Nestle (OTCPK:NSRGY) were among those that Contrafund's portfolio manager Will Danoff was recently selling, as he increased his underweight to consumer staples stocks. At the same time, he was increasing his weight in energy stocks such as Schlumberger (SLB), Anadarko Petroleum (APC), EOG Resources (EOG), and Halliburton (HAL).
ETFs that can help investors follow Danoff's more bullish view on energy stocks include iShares Dow Jones US Oil Equipment & Services Index Fund (IEZ) (0.47% expense ratio), which has high exposure to both SLB and HAL (which together make up close to 30% of IEZ's assets), and its sister ETF, iShares Dow Jones US Oil & Gas Exploration & Production Index Fund (IEO) (0.48% expense ratio), which has high exposure to both APC and EOG, both of which are top-five holdings.
Keep in mind that although these two mutual funds may fall in the same corner of the style map, this may not be the case down the road. Jensen's profile has remained consistent over time--it's always very high-quality focused, concentrated, and has very little turnover, so it is more likely to continue resembling VIG. However, Contrafund is a completely different story. Danoff is moving quickly, so he doesn't have an easily explainable style or mandate, and it's hard to pin down his approach, given how fluid it is. Today's similarities are likely just one intersection along two divergent paths.
Tracking Bill Gross Through ETFs
Morningstar Fund Manager of the Decade Bill Gross has been outspoken about his disdain for Treasuries in light of quantitative easing. While in aggregate, the $230 billion PIMCO Total Return (PTTDX), which costs 0.75%, is underweight U.S. Treasury bonds, there are pockets of the yield curve where Gross is less bearish. For example, compared to the Barclays Capital Aggregate Bond Index, PTTDX is underweight short-term U.S. Treasury Notes, which offer little compensation with their scant yield. He also is underweight the very long end of the Treasury yield curve--the segment with the longest duration and hence the most interest rate risk. But in the middle, Gross seems some opportunity. In his view, rates are artificially too low by 150 basis points. But even if rates rise modestly over the next few years, he feels the yield compensation will likely offset any decline in principal, which would present little downside risk in intermediate-term bonds.
One way in the ETF world to implement this view would be to go long iShares Barclays 3-7 Year Treasury Bond (IEI) (0.15% expense ratio). Investors who manage their own bond portfolios can mimic Gross' moves by lightening up on long-term bonds while an aggressive trader might buy iPath US Treasury Long Bond Bear ETN (DLBS). This exchange-traded note provides inverse exposure to long-term bonds and does not suffer from the volatility drag of some other inverse bond products.
According to Gross, Treasury investors can receive a haircut on their investment not only through default, but also through a more surreptitious currency devaluation. PTTDX has a bet against the U.S. dollar, implemented using exposure to emerging-market bonds, commodity-linked currencies, and European financial hybrid securities. ETF investors can implement such a view using WisdomTree Emerging Markets Local Debt (ELD), which provides exposure to foreign-currency, emerging-markets sovereign bonds. The fund is active in that managers have some discretion in picking bonds from countries with fiscal discipline and liquid bond markets. Currently, Brazil, Indonesia, Mexico, and Malaysia are the largest weights.
Keep in mind that Bill Gross won the Fixed-Income Fund Manager of the Decade award for a reason. He's possibly made more money for more investors than any other person ever, which is performance worth paying for. Following his broader assumptions with ETFs will not give you exposure to the dozens of smaller bets (which have historically paid off in a big way) that he is making along the yield curve and within each fixed-income sector.
ETFs for International Exposure
Among actively managed mutual funds, Harris Associates is known for its stable of fundamental, bottom-up stock-pickers who take long-term, high-conviction bets. Although it would be difficult to replicate their stock-picking ability with ETFs, we can piggy-back off of their macro-economic views. Morningstar International-Stock Fund Manager of the Decade David Herro, comanager of Oakmark International I (OAKIX), saw value in the aftermath of the Japanese disaster. He recently stepped up to the plate and increased his exposure to Japan. The Japanese companies he owns--such as Daiwa Securities, Toyota Motor (TM), Canon (CAJ), and semiconductor producer Rohm--are global in nature. Exposure to large-cap Japan can be obtained through iShares MSCI Japan Index (EWJ) (0.54% expense ratio). While Hero retains some flexibility when it comes to the hedging decision, investors who feel that the appreciation of the yen has reached its zenith might consider WisdomTree Japan Hedged Equity (DXJ) (0.48%). The fund tilts toward dividend-paying companies and hedges its currency exposure, so it stands to benefit if the yen weakens.
OAKIX also has large exposure to developed Europe, and Switzerland in particular, through holdings such as NSRGY and Credit Suisse (CS), Adecco, and UBS (UBS). IShares MSCI Switzerland (EWL) includes each of these stocks. Holdings of U.K.-based companies are underweight relative to other international mutual funds. ETF investors might use iShares MSCI EMU (EZU) (0.54%). Unlike a broader pan-Europe fund, such as the popular Vanguard European ETF (VGK) (0.14%), EZU does not invest in companies domiciled in the United Kingdom, Switzerland, and other non-euro European countries.
Robert Goldsborough significantly contributed to the content of this article.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.