By Jonathan Burton, MarketWatch
SAN FRANCISCO (MarketWatch) -- Many financial advisers and do-it-yourself investors feel like they have taken a double whammy: Not only have they been hit by the sliding market, but the stock pickers who run many of their mutual funds woefully underperformed the broader market.
Actively managed mutual funds have provided little shelter from the bear market that began in October 2007. Stock pickers in seven of nine U.S.-stock categories have trailed the corresponding Standard & Poor's indexes, investment researcher Morningstar Inc. found in a recent analysis of results through the end of January.
Investors, beware the volatility
As an investor, you can't avoid one bear market. But if you are constantly moving your investments around, you're in danger of experiencing multiple bear markets. MarketWatch's Chuck Jaffe explains. (April 6)
For those small investors who are vowing to give up trying to beat the market, that can mean turning to exchange-traded funds, investment vehicles that track designated benchmark indexes at some of the lowest investing costs around.
Yet switching to ETFs is easier said than done. About 700 U.S.- and international-stock ETFs jumble various sectors, strategies and styles. Even within a specific group -- large-company growth stocks, say -- ETFs aren't created equal. Complicating matters are "fundamental" ETFs, which blend elements of active management with conventional indexing methods.
Feeling 'let down'
How do you go about making a change?
One useful tool is available at Morningstar's Web site (Morningstar.com). Enter your existing funds' names or tickers, then click on the "Risk Measures" tab. The "Best Fit Index" is a handy yardstick to measure a comparable ETF.
For instance, Dodge & Cox Stock Fund /zigman2/quotes/202530840/realtime DODGX +0.70% is a popular offering that lost 45.2% in the 12 months through March 31. According to the Morningstar site, the large-cap fund's characteristics closely match the Russell 1000 Index. In that case, a representative ETF would be iShares Russell 1000 Index Fund /zigman2/quotes/209973077/composite IWB +0.05% which was down 38.2% over the same period.
/zigman2/quotes/209901640/composite SPY 464.72, +0.19, +0.04%
Another fallen star is Legg Mason Value Trust /zigman2/quotes/203623666/realtime LMVTX +0.50% , run by veteran manager Bill Miller. The fund, down 50.5% over the 12 months through March 31, mirrors the big-company Standard & Poor's 500-stock index /zigman2/quotes/210599714/realtime SPX +0.08% . Candidates for Miller's fund or another diversified U.S. large-cap portfolio include the SPDR S&P 500 ETF /zigman2/quotes/209901640/composite SPY +0.04% , iShares Dow Jones U.S. Index Fund /zigman2/quotes/200309091/composite IYY -0.03% , and the broad-market iShares Russell 3000 Index Fund /zigman2/quotes/208731962/composite IWV +0.04% .
Similarly, an exit strategy from Putnam Vista Fund would point to iShares Russell Midcap Growth Index Fund /zigman2/quotes/201652542/composite IWP -0.64% which culls from the Russell Midcap Index, while refugees from Dreyfus Small Cap Value Fund could find shelter in iShares Russell 2000 Value Index Fund /zigman2/quotes/202341160/composite IWN +0.61% . (Value stocks are sometimes referred to as diamonds in the rough, deemed cheap on the basis of such measures as share price to earnings per share. Growth stocks are those of companies with earnings growing at above-industry-average rates.)
/zigman2/quotes/207292160/composite VIG 166.78, -1.04, -0.62%
And disgruntled investors in dividend-oriented funds, such as Fidelity Equity-Income Fund /zigman2/quotes/202473300/realtime FEQIX -0.25% , could look to Vanguard Dividend Appreciation ETF /zigman2/quotes/207292160/composite VIG -0.62% , iShares Dow Jones Select Dividend Index Fund /zigman2/quotes/204321812/composite DVY +0.34% or PowerShares Dividend Achievers /zigman2/quotes/202314316/composite PFM -0.46% .
"A lot of investors felt let down last year by active managers," said Paul Justice, an ETF analyst at Morningstar. "Maybe they anticipated they would shield them from losses. Instead we saw they were just as, if not more, subject to market perils as a passive [index] approach."
Among Morningstar's favorite ETFs are three Vanguard offerings that Justice praises for "rock-bottom" investment-management fees: Vanguard Mega Cap 300 ETF /zigman2/quotes/207096016/composite MGC +0.12% for exposure to U.S. multinational giants and S&P 500-like performance; Vanguard Mid-Cap ETF /zigman2/quotes/209412709/composite VO -0.28% and Vanguard Small-Cap ETF /zigman2/quotes/201669247/composite VB -0.17% .
International markets are often seen as areas where research-driven managers can add value. But according to a Morningstar analysis, the average actively managed international fund lost a bit more than the overseas MSCI EAFE Index in 2008, 45.7% versus 43.4%.
For his model portfolios, investment adviser Tom Lydon, editor of ETFtrends.com, likes iShares MSCI EAFE Index Fund /zigman2/quotes/207663730/composite EFA -0.10% , iShares MSCI Emerging Markets Index Fund /zigman2/quotes/201454250/composite EEM -0.04% and Claymore/BNY Mellon BRIC ETF , which focuses on Brazil, Russia, India and China.
"Expenses are low, you know what you're buying, and from a diversification standpoint you should benefit over time," Lydon said.
Suppose you can't bring yourself to quit active management cold turkey. You might consider ETFs that put a twist on traditional index standards.
Index-tracking funds typically are populated according to market capitalization, or "cap-weighted," so the most highly valued stocks will be the biggest pieces of the pie. Exxon Mobil Corp., Procter & Gamble Co. and AT&T Inc. were recently the top three stocks by market cap in the S&P 500, for example.
The downside of cap-weighted indexes is that they can become overly concentrated at times when momentum rules, which happened to the S&P 500 in the late 1990s technology-stock boom. At the peak, tech stocks represented almost 35% of the benchmark. When the tech bubble burst, so did the S&P 500 and funds tied to it.
"Fundamental" ETFs were created largely in response to that boom-and-bust debacle. Instead of mimicking a cap-weighted index, stocks are ranked on measures such as book value, cash flow, sales and dividends -- qualities that guide bargain-minded value-stock buyers and would seemingly provide downside protection. A good example is PowerShares FTSE RAFI US 1000 Portfolio /zigman2/quotes/204234906/composite PRF +0.01% , a large-cap ETF whose top three stocks recently were Exxon Mobil, Wal-Mart Stores Inc. and Verizon Communications Inc.
But these newfangled ETFs haven't quite lived up to their billing. The FTSE RAFI US 1000 Portfolio lost an average of about 15.9% a year over the past three years through March 31, while the comparable cap-weighted iShares Russell 1000 Index ETF was down 13.3% a year over the same period.
"The jury is still out on these fundamentally indexed portfolios," said Mark Salzinger, editor of the Investor's ETF Report newsletter. "Their performance has not been that good, and their expenses are higher."
The poor showing has much to do with value investing being out of favor for the past couple of years, said Rob Arnott, chairman of Research Affiliates LLC, which developed fundamental index products for PowerShares.
"Fundamental index portfolios have a value tilt, and that's going to help you when value wins and hurt you when it loses," he said. "Has it lived up to people's expectations? No. A lot of folks heard what they wanted to hear -- long-term value added -- and assumed that meant all of the time. That's just not realistic."
Settling for average?
Still, both types of ETFs can edge most active managers on longer-term performance. That contradicts a common belief that index-fund investors must settle for average. In truth, most active funds fail to beat their benchmark in a given year, so index funds by nature tend to land in the upper half of their categories over long periods.
For instance, iShares Dow Jones U.S. Index recently landed in the top 42% of its peer group of large-blend funds over the past year, the top 56% over three years and the top 39% over five years, according to Morningstar.
"Indexes aren't average," said financial adviser Harold Evensky of Evensky & Katz in Coral Gables, Fla., who switched to ETFs years ago and nowadays favors iShares Russell 3000 Value and iShares S&P MidCap 400 Value Index Fund /zigman2/quotes/206752898/composite IJJ +0.11% as the centerpieces of a diversified portfolio.
"If you've got 100 managers all playing in the same sandbox, the index fund has to be in the top half because it has less expenses," Evensky said. "And since the active managers in the top half don't stay there all the time, the index over time gradually moves up.
"If I can be guaranteed funds that are always in the top half, that's pretty good," he added, "as opposed to trying to pick one that's going to be on top but may also end up on the bottom."
Since most ETF portfolios are based on published indexes, asset allocation -- which many financial advisers say accounts for most of an investor's return -- isn't such a guessing game. Said Kevin Ellman, head of financial-advisory firm Wealth Preservation Solutions in Ridgewood, N.J., who uses ETFs almost exclusively in client portfolios: "We're more convinced than ever that active management is not worth the expense."