ETF Observer December 2014

30 Pages·2014·1.94 MB·English

ETF Observer
December 2014
Morningstar ETF Observer | December 2014
Contents
A Heavy Dose of Tryptophan Can't Stop the Market Rally 1
Market Barometer 2
ETF Assets and Flows 4
ETF News and Industry Dashboard 5
Should Investors Be Thankful for Interest-Rate-Hedged Bonds? 7
What Kinds of ETFs Are Making Capital Gains Distributions in 2014? 10
A Dynamic Approach to Value Investing Abroad 14
What Robo-Advisors Really Bring to the Table 17
Spotlighting Mortgage-Backed Securities & REITs 19
ETF Spotlight: Vanguard Mortgage-Backed Securities ETF (VMBS) 20
ETF Spotlight: Vanguard REIT ETF (VNQ) 24
©2014 Morningstar, Inc. All rights reserved. The information, data, analyses, and opinions contained herein (1) include the confidential and proprietary information of Morningstar, Inc., (2) may not be copied or redistributed, (3) do not constitute investment advice
offered by Morningstar, Inc., (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) arenot warranted to be correct, complete or accurate. Morningstar, Inc. shallnot be responsible for any trading decisions,
damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.
Morningstar ETF Observer | December 2014 Page 1 of 28
ETF Insight A Heavy Dose of Tryptophan Can’t Stop the Market Rally
November was another bad month for the bears—especially those of the Chicago variety (c’mon guys!).All
major U.S. equity benchmarks posted gains for the month, and assets continued to pour into U.S. equity
ETFs. In all, some $24.4 billion in new investor capital flowed into U.S. equity ETFs over the course of the
month—about two-thirds of which went into funds offering exposure to large cap stocks. Interestingly,
actively managed U.S. equity mutual funds saw $11 billion in outflows in November, bringing the group’s
year-to-date tally to $86.8 billion, and putting it on course for its ninth consecutive year of net outflows.
Ben Johnson, CFA
Director of Manager Research
It was another busy news month in ETF Land. M&A activity once again made headlines, as New York Life
Passive Strategies
Investment Management announced it was acquiring IndexIQ, and Cleveland-based asset manager Victory
[email protected]
[phone] Capital said it was buying registered investment adviser and fledgling ETF provider Compass EMP. We cover
these items in more detail in our “News” section.
This month’s installment of ETF Observer features four articles and two fund spotlights from our Passive
Strategies research team. In the first article, Tom Boccellari sets out to answer the question: should investors
be thankful for interest-rate-hedged bond funds? Bob Goldsborough follows with a detailed rundown of
anticipated 2014 capital gains distributions across the major ETF providers. While the vast majorityof ETFs in
the sample Bob studied—nearly 90% of the 712 funds in question—are not expected to distribute any
taxable capital gains this year, there are a number of notable exceptions that underscore the fact that ETFs’
tax efficiency is not an air-tight proposition. Alex Bryan picks up from there with an in-depth analysis of
Schwab International Large Company (FNDF). Sam Lee then contributes his take on the value of “robo”
advisors. If nothing else, these platforms may serve as a useful benchmark to guide buyers (investors) in the
“credence good” market for financial advice. Lastly, this month we spotlight Vanguard Mortgage-Backed
Securities ETF (VMBS) and Vanguard REIT ETF (VNQ).
Best,
©2014 Morningstar, Inc. All rights reserved. The information, data, analyses, and opinions contained herein (1) include the confidential and proprietary information of Morningstar, Inc., (2) may not be copied or redistributed, (3) do not constitute investment advice
offered by Morningstar, Inc., (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) arenot warranted to be correct, complete or accurate. Morningstar, Inc. shallnot be responsible for any trading decisions,
damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.
Morningstar ETF Observer | December 2014 Page 2 of 28
U.S. Market Barometer
1 Month 3 Month 1 Year
Price/Earnings
Time Period: 01/12/2009 to 30/11/2014
20.0
18.0
16.0
14.0
g)
n
o
M) (L12.0
T
T
atio (10.0
R
E
P/
8.0
2010 2011 2012 2013 2014
Price/Book Value
Time Period: 01/12/2009 to 30/11/2014
3.0
2.5
2.0
g)
n
o
M) (L1.5
T
T
o (
ati
R
B
P/1.0
2010 2011 2012 2013 2014
S&P 500 TR USD MSCI ACWI NR USD MSCI EAFE NR USD
MSCI EM NR USD
©2014 Morningstar, Inc. All rights reserved. The information, data, analyses, and opinions contained herein (1) include the confidential and proprietary information of Morningstar, Inc., (2) may not be copied or redistributed, (3) do not constitute investment advice
offered by Morningstar, Inc., (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) arenot warranted to be correct, complete or accurate. Morningstar, Inc. shallnot be responsible for any trading decisions,
damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.
Morningstar ETF Observer | December 2014 Page 3 of 28
Market Performance
Trailing Total Returns
U.S. Equity Market 1 Month YTD 1 Year 3 Yr Annlzd 5 Yr Annlzd 10 Yr Annlzd 15 Yr Annlzd
S&P 500 TR USD 2.69 13.98 16.86 20.93 15.96 8.06 4.66
Wilshire 5000 Total Mkt TR USD 2.48 12.77 15.68 20.67 16.17 8.38 5.26
DJ Industrial Average TR USD 2.86 9.92 13.42 16.86 14.41 8.27 5.82
NASDAQ 100 TR USD 4.54 22.23 25.94 25.28 21.03 11.60 3.18
Russell 2000 TR USD 0.09 1.99 3.99 18.36 16.69 7.78 7.95
Global Equity Market
MSCI ACWI NR USD 1.67 6.21 8.04 14.77 10.05 6.70 3.94
MSCI EAFE NR USD 1.36 -1.49 -0.02 12.02 6.38 5.25 3.37
MSCI EM NR USD -1.06 2.54 1.06 5.27 3.54 9.45 8.25
S&P 500 Sectors
5.4
Consumer Discretionary 8.6
11.2
5.5
Consumer Staples 17.2
17.9
-8.5
Energy -8.2
-5.4
2.3
Financials 13.2
15.6
3.4
Health Care 27.0
28.1
3.1
Industrials 10.0
14.7
5.3
Technology 22.2
27.3
1.4
Materials 7.6
12.8
1.2
Telecom Services 9.7
9.4
1.2
Utilities 24.6
25.8
2.0
S&P US REIT Index 27.8
28.1
-10.0 -5.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0
1 Mo YTD 1 Yr
Trailing Total Returns
U.S. Fixed Income Market 1 Month YTD 1 Year 3 Yr Annlzd 5 Yr Annlzd 10 Yr Annlzd 15 Yr Annlzd
Barclays US Agg Bond TR USD 0.71 5.87 5.27 3.00 4.10 4.79 5.66
Markit iBoxx Liquid IG TR USD 1.01 8.74 8.65 6.83 7.00 5.98 6.55
BofAML US HY Master II TR USD -0.71 4.04 4.63 9.80 9.88 7.93 7.45
Morningstar Short-Term US Govt TR 0.24 1.19 0.92 0.70 1.25 2.94 3.77
Morningstar Short-Term Corp TR 0.20 2.00 1.86 3.30 3.19 3.77 4.75
Morningstar Intermediate US Govt TR 0.91 4.37 2.82 1.60 3.47 4.78 5.72
Morningstar Intermediate Corp TR 0.57 5.21 4.71 6.11 5.88 5.80 6.71
Morningstar Long-Term US Govt TR 2.33 16.35 13.90 3.72 6.87 6.80 7.57
Morningstar Long-Term Corp TR 1.06 12.58 12.58 8.05 8.39 7.19 7.93
S&P Preferred Stock TR USD 1.29 14.37 13.14 10.70 10.35 4.94 —
©2014 Morningstar, Inc. All rights reserved. The information, data, analyses, and opinions contained herein (1) include the confidential and proprietary information of Morningstar, Inc., (2) may not be copied or redistributed, (3) do not constitute investment advice
offered by Morningstar, Inc., (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) arenot warranted to be correct, complete or accurate. Morningstar, Inc. shallnot be responsible for any trading decisions,
damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.
Morningstar ETF Observer | December 2014 Page 4 of 28
Top 10 ETF Providers
Top 15 ETF Inflows in November
Top 15 ETF Outflows in November
©2014 Morningstar, Inc. All rights reserved. The information, data, analyses, and opinions contained herein (1) include the confidential and proprietary information of Morningstar, Inc., (2) may not be copied or redistributed, (3) do not constitute investment advice
offered by Morningstar, Inc., (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) arenot warranted to be correct, complete or accurate. Morningstar, Inc. shallnot be responsible for any trading decisions,
damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.
Morningstar ETF Observer | December 2014 Page 5 of 28
ETF News New York Life Buys IndexIQ
M&A in the ETF industry continues.
On Dec. 4, New York Life Investment Management announced it will acquire IndexIQ, an exchange-traded
fund provider with about $1.3 billion in ETF assets that focuses heavily on alternative ETFs. NYLIM,which is
New York Life’s third-party global asset management business, plans to integrate IndexIQ into the firm and
market its ETFs through the firm’s MainStay Investments platform, which has $101 billion in assets under
management. Focused on alternative ETFs, IndexIQ issues 11 ETFs and one $228 million mutual fund. Terms
of the deal were not disclosed. Expected to close in the first half of 2015, the transaction is the third major
Robert Goldsborough acquisition in the ETF world in the past few months, and came several days after asset management firm
Analyst, Passive Strategies Victory Capital announced that it would buy Compass EMP, a recent entrant in the ETF space that issues five
Manager Research
small ETFs. Terms were not disclosed. Both deals follow Janus’ announcement that it will acquire
[email protected]
VelocityShares’ parent for $30 million.
[phone]
PureFunds Launches “Cyber Security” ETF
On Nov. 11, PureFunds rolled out a passively managed ETF that tracks an index of companies in the cyber
security industry. Despite its whimsical ticker symbol, the subsector that PureFunds ISE Cyber Security ETF
HACK focuses on is a serious one that is constantly in the news, as evidenced by recent hacking incidents at
Sony, J.P. Morgan, and Target. HACK tracks a modified capitalization-weighted benchmark, with its large
holdings including Vasco Data Security VDSI, Imperva IMPV, Palo Alto Networks PANW, and Qualys QLYS.
Even by the standards of subsector-level ETFs, HACK is on the pricey side, charging 0.75%.
2 China Bond ETFs Debut
In November, Global X and Van Eck each launched ETFs devoted to onshore bonds from China: Global X GF
China Bond ETF CHNB and Market Vectors ChinaAMC China Bond ETF CBON. Both funds use subadvisors that
are qualified foreign institutional investors to invest directly in Renminbi-denominated bonds issued in
mainland China. Both ETFs charge 0.50%.
5 Firms Announce ETF Closures and Delistings
The paring of ETF sponsors’ portfolios has continued apace in November and early December, as no fewer
than five ETF providers announced the delistings of a total of 13 funds. First, VelocityShares announced in
early November that later that month, it would liquidate and delist three emerging markets-oriented ETFs:
VelocityShares Emerging Asia DR ETF ASDR, VelocityShares Emerging Markets DR ETF EMDR, and
VelocityShares Russia Select DR ETF RUDR. Then, shortly before Thanksgiving, Russell Investments
announced plans to shutter its lone remaining ETF, Russell Equity ETF ONEF, in late January. The
announcement came some two years after Russell liquidated 26 U.S. ETFs and thus almost entirely exited the
business of issuing U.S. ETFs, although the firm continues to sponsor ETFs in Australia and of course serve as
a major index provider for other ETF firms. ONEF had a paltry $7.2 million in assets as of press time.
Also during Thanksgiving week, Teucrium announced the mid-December liquidation and delisting of its
Teucrium Natural Gas ETF NAGS and its Teucrium WTI Crude Oil ETF ETF CRUD, neither of which has more
than $2 million in assets. And that same week, EGShares announced that right after Christmas, it will delist
and liquidate the similarly tiny EGShares Emerging Markets Dividend Growth ETF EMDG and EGShares EM
Dividend High Income ETF EMHD, both of which launched in mid-2013.
Finally, Van Eck announced that in mid-December, it will delist five small and narrowly focused ETFs: Market
Vectors Bank and Brokerage RKH, Colombia COLX, Germany Small-Cap GERJ, Latin America Small-Cap
LATM, and Renminbi Bond CHLC. At press time, none of the five funds had more than $16 million in assets.
©2014 Morningstar, Inc. All rights reserved. The information, data, analyses, and opinions contained herein (1) include the confidential and proprietary information of Morningstar, Inc., (2) may not be copied or redistributed, (3) do not constitute investment advice
offered by Morningstar, Inc., (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) arenot warranted to be correct, complete or accurate. Morningstar, Inc. shallnot be responsible for any trading decisions,
damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.
Morningstar ETF Observer | December 2014 Page 6 of 28
U.S. ETF Industry Data Dashboard
Morningstar data as of December 1, 2014
Industry Vitals
Total # of ETPs currently listed 1,667
ETFs 1,455
Total ETF Assets $1.96 trillion
ETNs 212
Total ETN Assets $27.2 billion
Total ETP Assets $1.99 trillion
Active ETFs
Actively Managed ETFs 121
Total Assets $18.3 billion
% of Total ETP Assets 0.92%
New Active ETFs Launched in November 0
Coming and Going November YTD
New Launches 12 186
Delistings/Closures 5 66
Net Change 7 120
Pending Closures 10
Notable ETF Filings in November
Ÿ First Trust filed to rename its First Trust Value Line Equity Allocation Index ETF the First
Trust Total US Market AlphaDEX ETF TUSA
Ÿ Source filed for Source Euro STOXX 50 Hedged ETF
Ÿ Guggenheim filed for the Guggenheim S&P High Income Infrastructure ETF
Ÿ WisdomTree filed for WisdomTree Europe Hedged SmallCap Equity Fund
Ÿ ProShares filed for ProShares Short Gold Miners, ProShares UltraShort Gold Miners,
ProShares Short Junior Gold Miners, ProShares UltraShort Junior Gold Miners, and
ProShares Ultra Junior Gold Miners
Ÿ Global X filed for Global X SuperDividend Emerging Markets ETF
©2014 Morningstar, Inc. All rights reserved. The information, data, analyses, and opinions contained herein (1) include the confidential and proprietary information of Morningstar, Inc., (2) may not be copied or redistributed, (3) do not constitute investment advice
offered by Morningstar, Inc., (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) arenot warranted to be correct, complete or accurate. Morningstar, Inc. shallnot be responsible for any trading decisions,
damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.
Morningstar ETF Observer | December 2014 Page 7 of 28
Perspective Should Investors Be Thankful for Interest-Rate-Hedged Bonds?
Investors are likely better served by traditional bond funds.
November 26, 2014 Coupon payments generated nearly 90% of the Barclays U.S. Aggregate Bond Index's returns since its
inception in January 1975, despite falling interest rates, which pushed bond prices higher and yields lower.
Yet, nearly all of this index's volatility came from changes in bond prices, caused by changes in interest rates.
Because changes in bond prices tend to generate a minority of the total return and most of the risk,interest-
rate hedging seems like a promising way to significantly reduce price volatility without giving up much return.
However, this hasn't been the case.
Thomas Boccellari Investors can hedge interest-rate risk by reducing duration, a measure of a bond price's sensitivity to interest
Analyst, Passive Strategies rate movements, to zero. Because individual zero duration bonds do not exist, interest-rate-hedged bond
Manager Research funds short Treasury futures to bring the portfolio's duration to zero. For example, at the end of October 2014,
[email protected] SPDR Barclays High Yield Bond ETF (JNK) had a duration of 4.3 years. This means that for every 1% increase
[phone]
in interest rates, the fund will likely lose about 4.3%. An investor looking to decrease that duration to zero
could short a five-year Treasury Note futures contract, which has a similar duration. The short Treasury future
position cancels the long corporate bond positions. This creates a portfolio with almost no interest-rate risk. If
interest rates were to increase 1%, the long portfolio would decline roughly 4.3%. However, the short position
would appreciate roughly 4.3% and offset the decline leaving the investor with minimal--if any--losses. While
it will detract from the investor's total yield, a Treasury that has the same duration as a corporate bond
almost always has a smaller yield.
On paper, this sounds fantastic. By removing one of the two major factors of bond price volatility,investors
are essentially left with only credit risk. However, interest-rate hedging is not free. In addition to the
transaction cost of shorting the treasury future, the investor foregoes interest to short the Treasury futures.
For instance, at the end of October 2014, the ProShares Investment Grade-Interest Rate Hedged (IGHG)bogy,
the Citi Corporate Investment Grade (Treasury Rate-Hedged) Index, had a long portfolio yield of 3.9%and a
short portfolio yield of 2.4% leaving investors with a 1.6% yield.
Historical Performance
If historical performance is an indication, the cost of interest-rate hedging is probably not worthit. For
example, the Citi Corporate Investment Grade (Treasury Rate-Hedged) Index underperformed the Bank of
America Merrill Lynch U.S. Corporate A 10-15 Year Index over the past few years, despite both havinga
similar duration (nine-plus years) and credit rating (A). Over the trailing five years through October 2014, the
interest-rate-hedged index generated a 2.9% annualized return, while the non-interest-rate-hedged index
posted a 7.4% return. This is not surprising because interest rates, on average, declined over this period
helping the non-interest-rate-hedged index's performance. Additionally, the hedged index offered a lower
yield--which accounts for a majority of a bond fund's returns.
However, what is surprising is the two indexes' volatility. The interest-rate-hedged index's annualized
standard deviation over the trailing five years through October 2014 (8.1%) was actually higher thanthat of
the non-interest-rate-hedged index (6.1%). This may be partially because the Treasury bonds, which the index
shorts, were more volatile than corporate bonds. For example, the Barclays U.S. Treasury 7-10 Year Index's
trailing five-year volatility through October 2014 (6.2%) was greater than that of the Barclays U.S.Corporate
Investment Grade Index (4.2%). This could be partially explained by weak correlation (0.6) between the long
corporate bonds and short Treasury futures over the trailing five-year period. Instead of the volatility of the
two portfolios offsetting, it became additive. Another possible reason is that lower-coupon bonds, like
Treasuries, tend to be more sensitive to rate changes than similar maturity bonds with higher coupons.
Effectively, investors were giving up yield for poorer returns and more volatility than a non-interest-rate-
©2014 Morningstar, Inc. All rights reserved. The information, data, analyses, and opinions contained herein (1) include the confidential and proprietary information of Morningstar, Inc., (2) may not be copied or redistributed, (3) do not constitute investment advice
offered by Morningstar, Inc., (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) arenot warranted to be correct, complete or accurate. Morningstar, Inc. shallnot be responsible for any trading decisions,
damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.
Morningstar ETF Observer | December 2014 Page 8 of 28
hedged portfolio--not a very attractive trade.
This comparison might be unfair, however. After all, the index was designed to perform well during periods of
rising interest rates. Since the index's November 2008 inception, there have been two periods when the 10-
year Treasury yield was increasing over a period of a year of more: December 2008 (2.42%)–April 2010
(3.85%) and July 2012 (1.53%)–December 2013 (2.90%).
Over the first period, the non-interest-rate-hedged index posted a 1.7% annualized return, despite the rising
10-year Treasury yield putting downward pressure on bond prices. However, the interest-rate-hedged index
eked out a 0.20% return advantage, but with greater volatility (10.8%) than the non-interest-rate-hedged
index (6.2%).
During the second period, the non-interest-rate-hedged index posted a 1.0% annualized return. However, the
non-interest-rate-hedged index posted a negative annualized return of 0.1%. Once again, the interest-rate-
hedged index had nearly 2 times the volatility (9.6%) as the non-interest-rate-hedged index (5.3%).
If the hedged interest rate index didn't offer better performance when interest-rates rising offered such a
significant tailwind, they are unlikely to offer better performance over most periods. Interest-rate-hedging
funds also tend to have higher costs than non-interest-rate-hedge funds, which can erode their returns.
The Barclays U.S. Aggregate Zero Duration Index, which the WisdomTree Barclays U.S. Aggregate Bond Zero
Duration ETF (AGZD) tracks, has not fared much better than the Citi Corporate Investment Grade (Treasury
Rate-Hedged) Index. While it provided slightly better risk-adjusted returns during the first rising-interest-rate
period, it does so at a significant reduction to total returns. Further, during the second period ofrising interest
rates, it provided worse risk-adjusted returns. Even if an investor could correctly guess when interest rates
were going to rise, the risk/reward trade-off does not seem very attractive for these funds.
©2014 Morningstar, Inc. All rights reserved. The information, data, analyses, and opinions contained herein (1) include the confidential and proprietary information of Morningstar, Inc., (2) may not be copied or redistributed, (3) do not constitute investment advice
offered by Morningstar, Inc., (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) arenot warranted to be correct, complete or accurate. Morningstar, Inc. shallnot be responsible for any trading decisions,
damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use.