Bowes Prefers ETNs In Fixed Income

June 23, 2008

Advisor carefully weighs ETF pros and cons; remains comfortable with index mutual funds.

Photo of Chuck BowesChuck Bowes is agnostic when it comes to exchange-traded funds compared to index mutual funds.

But when it comes to costs, that's where the San Francisco-based advisor draws the line. And while he likes ETFs in theory, the more flexible structure of such funds don't always work to a long-term investor's advantage.

"The potential disadvantage with ETFs is in the more illiquid markets," said Bowes, a partner of Runyon & Bowes, which has offices throughout California.

"Tracking error can be a real problem in segments of the market where trading costs are high or trading volume is low," he added.

Bowes prefers Dimensional Fund Advisors for core positions. Right now, he's using mutual funds from DFA and a few select others with about 70% of his client assets.

In places like emerging markets, Bowes doesn't feel as comfortable with ETFs as index mutual funds. "We believe that the small-cap premium found in U.S. stocks also carries through to international markets," he said. "So it's important to include small-cap emerging markets in our portfolios. But we've found a lot of tracking error in emerging markets in general, especially with even-less-liquid small-cap funds."

Bowes is using mutual funds with about 70% of his client portfolios. In equities, he used to incorporate 11 different funds to gain exposure to different markets around the world. That's been cut to six.

"We've also added two new asset classes [commodities and international real estate] while reducing the total number of funds almost in half," Bowes said. "That is saving us about 15 basis points a year in expense ratios alone. And using fewer funds is providing another 50 basis points of benefits through less portfolio friction and trading costs."

An example he gives is in emerging markets. The firm's advisors used to go with three different funds to gain diversified exposure to developing countries. Those funds were: DFA Emerging Markets Small Cap (DEMSX), DFA Emerging Markets Value (DFEVX) and DFA Emerging Markets (DFEMX).

"But we found it very costly and burdensome to use three funds for emerging markets," Bowes said.

As a result, he's now using DFA Emerging Markets Core Equity (DFCEX) to cover all of those bases. It's an all-cap fund that tilts to value-styled stocks. "It's a very sophisticated, institutional-class strategy that allows us to capture the value and small-cap premium in emerging markets under a single, low-cost and tax-efficient umbrella," Bowes said. "We haven't found an ETF like it."

The firm also applies the same sort of strategy with U.S. stocks. He uses the DFA U.S. Core Equity Fund (DFQTX). It also takes a multi-cap approach. But unlike DFCEX, which had about 13% in small-caps heading into March, the domestic version had more than 20% invested in small-caps, according to Morningstar Inc. It also held a greater amount of mid-cap names compared with its emerging market's sister - as well as much more than the traditional total stock market fund such as the Vanguard Total Stock Market ETF (AMEX: VTI).

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