The Appropriate Use Of Traditional Financial Analysis

Thomas E. Berghage

         If, as we suggested in the last chapter, traditional financial analysis measures are meaningful and appropriate for building indexes, and are extremely poor at predicting future security performance, then why not use them where they are appropriate and abandon them or replace them in the realms where they don’t seem to work?  Well, that is exactly what is happening.  There has been a rush to build and bring to market a whole host of index funds that trade like stocks.  They are called ETFs or Exchange Traded Funds and were first created back in 1993 by the American Stock Exchange.  ETFs act like index funds in that they track the index for a sector of the market, but they trade throughout the day just like stocks.

         Everyone seems to be jumping on the bandwagon.  San Francisco-based Barclays Global Investors, a unit of Barclays PLC in London is the biggest player in this new ETF market with 77 index funds called iShares.  They have accumulated over $20 billion in their equity funds and they plan on bringing out an additional six fixed income iShares by the end of 2002.  State Street Global Advisors has a number of ETFs that track Dow Jones style-specific and global indexes along with technology indexes from Morgan Stanley Dean Witter, and the Wilshire REIT index.  The Vanguard Group currently has two ETFs and plans on bring out an additional 20 in the very near future.  As of the end of January 2002 there were 102 ETFs with roughly $82 billion in assets.  That’s an impressive leap from $10 billion in 1998.  The rate of growth of index funds has more than tripled the growth rate of actively managed mutual funds during the past five years and now represents over 25% of all new retail equity investments.

         ETFs come in all sizes, shapes, and descriptions.  The American Stock Exchange called their first ETF a Spider (SPDR) for Standard & Poors Depository Receipt and the industry has been coming up with cute names ever since.  For the Nasdaq 100 they have “Qubes” (QQQ) and for the Dow Jones Industrial Average there are “Diamonds” (DIA).  Barclays Global Investors calls their ETFs, “iShares” (Index Shares) and Vanguard Capital Group calls their ETFs “VIPERs” for Vanguard Index Participation Receipts.

         The development and trading of ETFs has not been confined to the U.S. markets.  Barcays has ETFs called WEBs (World Equity Benchmark Shares) that are based on country specific indexes.  They were brought out in 1996 and are traded on both the American and New York Stock Exchanges.  There are now over 20 individual countries with ETFs along with several geographic regions such as Europe, South America and East Asia.  At the present time there are more ETFs traded outside the U.S. than there are traded in the U.S. This is such a rapidly growing area that by the time that this book goes to press there will be many more ETFs around the world for investors to chose from.

         Regardless of what they are called, ETFs are generally based on market indexes and consist of a basket of stocks that are structured like either an open-ended trust or an open-end mutual fund.  The later structure appears to be a little more efficient in that it allows reinvestment of dividends immediately, while the former does not. This could result in ETFs that use the unit investment trust structure having a slight cash drag on their performance.

        The ETFs are designed to combine qualities of stocks and mutual funds, and allow investors to buy or sell shares of entire portfolios throughout the trading day.  They also can be bought on margin or sold short.  Any type of order that can be used to purchase or sell a common stock can be used in ETF transactions.  There are even some transactions that you can perform with ETFs that you cannot do with stocks.  For example, ETFs are exempt from the up-tick rule that requires shares to be sold short only at a price higher than the previous sale.  Thus, these securities can be shorted on a downtick, which is very important during the major sell-offs that characterize bear markets.  Since research has indicated that about 90% of stocks will decline in value during a bear market, shorting a basket of stocks (as opposed to specific companies) would appear to be a useful strategy during a market downturn.  In fact, an analysis of SPDRs indicates that more than 20% of the shares outstanding are sold short in an average month (Kleiman, 1997).  

Advantages Of ETFs

     Lets briefly review the attributes that make ETFs such an attractive investment vehicle.

1. Traditional security analysis techniques work well for index fund construction.

2. ETFs provide the diversification needed to compensate for our inability to identify single good performing securities.

3. Investors have immediate in/out access for establishing positions.  They do not have to wait for the end of the day price.

4. There is instant price determination.  No need to wait until the end of the day.

5. Reduced capital gains distributions due to fewer transactions and redemption in kind. *

6. Investors have the ability to go short or buy on margin with no up-tick rule.

7. Operationally ETFs are less complex than futures.

8. Investors have mobility between fund “families.”

9.  Lower expenses.

* Institutional investors receive shares of the underlying trust’s stocks in exchange for the ETFs they redeem; individuals buying shares of ETFs do not redeem shares, they simply sell them on the exchange.

         One of the real advantages of ETFs is the diversification it offers to investors, the kind of diversification that sparked the growth of the mutual fund industry. It has long been felt by many in the industry that investors needed broader diversification and this can now be obtained through the use of ETFs. The broad low cost diversification offered by ETFs is something every financial planner should be applauding but its acceptance has been somewhat slower than expected. The mutual fund industry has been a powerful force in the investment arena and they are not anxious to give up that position. Now that the diversification offered by mutual funds can be obtained at a much lower cost through the use of ETFs, the mutual fund industry finds itself at a real crossroad.

        There is a movement underway, especially in the mutual fund industry, to create ETFs for actively managed portfolios, but there is considerable concern about the regulation and value of these actively managed ETFs.  Until we have the security analysis tools necessary to support the creation of actively managed portfolios we should proceed slowly and carefully.  As we pointed out in Chapter 2, financial analysts are poorly equipped to build these active portfolios.  Traditional financial analysis is great for constructing indexes, but it lacks the predictive power necessary for active portfolio security analysis.  Hopefully, buy the end of this book we will have provided at least a glimpse of the technology needed to expand the ETFs into the active portfolio arena.

We also need to be aware of the potential danger in the use of ETFs.  With the ease with which ETFs can be traded throughout the day it will be tempting to turn them into trading vehicles rather than investment vehicles.  If lack of diversification is the first major sin of investors, than the second major sin is over-trading.  Index mutual funds have attempted to restrict short-term trading by refusing to accept telephone exchanges, charging a redemption fee and limiting the number of round-trip transactions each year, but no such prohibitions exist for ETFs. Investors need to use the diversification offered by ETFs to structure broad based investment portfolios and they need to avoid the temptation to over-trade.

         For those using ETFs for investment purposes rather than as trading vehicles there is a real cost savings.  Because of the low turnover in these funds, transaction costs are kept to a minimum.  Kleiman (1997) compared the expenses of SPDRs and several popular U.S. index mutual funds and the average stock mutual fund followed by Morningstar.  His results are shown in Table 6-1

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Table 6-1

Stock Funds, Index Funds & SPDRs:

1995 Portfolio Characteristics

* Investors may pay additional fees for professional investment advice since the funds are available to individual investors only through registered investment advisors or certain bank trust departments.

** The Schwab 1000 Fund is an index fund that invests in the stocks that comprise the 1,000 largest publicly traded U.S. companies

     All of the index funds, as well as SPDRs, have lower expense ratios and lower portfolio turnover than does the typical stock fund.  The SPDRs are virtually 100% invested all of the time so there is minimal trading turnover and virtually no stock research costs.  All ETFs provide quarterly cash dividend distributions based on the accumulated dividends paid by the stocks held in the trust or fund minus a minimal annual fee to cover expenses.

Economic Concern

     There is a potential danger in the wide spread use of indexes as our equity investment tool.  Historically we have relied upon investment bankers and their analysts to channel funds to new emmerging companies.  If we move the investment process away from individual securities toward index based products we build a delay into the process.  Before Standard & Poors, Wilshire, and others include a company in their market segment indexes they want to see financials and operating history for several years.  To reduce the time delay current indexes introduce into the investment process we need a venture capital index and associated ETF.  It would be a very volatile index with high turnover, because of the high failure rate among new start companies, but it would allow investors to make a diversified commitment to this vital sector of the market.

Our economic system depends on a resource allocation process that is based on logic and merit; a system that rewards progress and performance and responds quickly to new opportunities.  Many corporations offer stock option incentive programs to their employees today to help motivate them and to reward good performance.  Psychologists will tell you that for a reinforcement to be effective it must be in close proximity to the event both in time and space. If the value of these stock options is based, not on merit, but on the company’s delayed inclusion in some stock index, the system loses a lot of its value. 

     Because organizations such as Standard & Poors, Russell, and Wilshire are constantly updating their indexes, adding and deleting companies on a regular basis, there is an excellent chance that good companies eventually will be recognized and added when appropriate.  The adding of these companies to the indexes is not done on the basis of their expected stock performance however; the additions and deletions are based more on maintaining the representativeness of the index, and the financial analysis tools we have at hand are excellent for accomplishing this task.

The Growth Of Indexing And ETFs

     The growth of Index Funds is symptomatic of a more basic problem, the failure of the money management and the security analyst communities to adopt new ideas and technology.  The information sciences are making tremendous progress harnessing technologies such as case-based reasoning, fuzzy logic, expert systems, genetic algorithms, neural networks, and evolutionary programming.  When is the last time you heard a financial analyst or portfolio manager talk about these technologies?  How many sessions at the annual meeting of the Association for Investment Management and Research (AIMR) have you seen devoted to these technologies?  How many articles on these technologies have you seen in the Financial Analysts Journal?  How many sections in the CFA training program are devoted to these technologies?  The answer to all of these questions is extremely few, if any.  Until this community embraces these and similar technologies and starts to train new members in their use, Index Funds will continue to win out and our economic system will be compromised.  To stem the tide of Index Funds, money managers must be able to add value to their managed portfolios.

Before we try to deal with the fundamentals of the analysis problem lets look at what our academic colleagues have been doing to add value to the investment process.  In the next two chapters we will review and discuss the two principal schools of scholarly thought now being taught in our academic institutions.