Beyond The Abstract: Morgan Stanley Report Lists ETF Pluses

June 25, 2008

New report describes advantages of ETFs versus mutual funds and includes interesting data.


Paul Mazzilli's research group at Morgan Stanley released a report on an issue that comes up frequently on—exchange-traded funds versus mutual funds.

"Exchange-Traded Funds: ETFs Provide Attractive Alternatives To Open-End Mutual Funds," dated June 4, 2008, covers a lot of familiar territory for people who know their ETFs.

But the document is at the very least a solid primer for investors who are new to ETFs. Moreover, a lot of that familiar territory is backed up with some interesting data nuggets that will be useful to investors and other market participants at all levels of knowledge.

ETF Advantages

The best example of this is the stats in the table that accompanies the report's assertion that ETFs are among the lowest-priced registered investment products. Actively managed domestic equity mutual funds have average expenses totaling 145 basis points; indexed domestic equity mutual funds have average expenses of 70 bps. Domestic equity ETFs, however, have average expenses of just 53 bps, with a weighted average of 29 bps.

The range for domestic equity ETFs is a rather wide 7-95 bps. Major market U.S. ETFs have an even lower average of 34 bps in fees, with a weighted average of just 15 bps.

The gap is even more significant when you move on to international funds. Actively managed international mutual funds charge an average of 167 bps, while indexed international mutual funds charge an average of 95 bps. International ETFs charge an average of 55 bps, and a weighted average of 48 bps.

The report also discusses the usefulness of in-kind transactions with regard to avoiding capital gains. A table cited in this section shows the capital gains distributions as a percentage of NAV for the S&P 500 SPDR (AMEX: SPY) and the average S&P 500 index mutual fund from 1993 to 2007. Since 1993, SPY has averaged 0.01%—and that was entirely due to 1996, when the fund had a capital gains distribution that was 0.12% of NAV. Meanwhile, the average for S&P 500 index mutual funds was 1.67%, and spanned a range from 0.11% in 2002 to a whopping 4.76% in 1995.

However, when I was reading this I had to remind myself that since these are average numbers, there could be quite a few S&P 500 index funds that didn't have capital gains anywhere near the average. (I don't have any stats for the Vanguard 500, for example, but I'd be willing to bet that any capital gains distributions it might have had during that time period were more comparable to those of the SPY than the average S&P 500 index fund.)

Despite the arrival of actively managed ETFs, most ETFs are still tied to indexes, so it's entirely appropriate that the report gives some updated statistics from Lipper on the performance of actively managed funds versus their benchmarks.

For the 10-year period ended December 31, 2007, 59% of large-cap blended funds underperformed their benchmark. A stunning 71% of large-cap value funds underperformed their benchmarks, while just 34% of large-cap growth funds did so.

But contrary to popular belief, small-cap managers didn't exactly shine. Seventy-three percent of small-cap blended actively managed funds underperformed their benchmarks for the 10-year period, and while large-cap growth managers had respectable performances, 64% of small-cap growth funds underperformed their benchmarks. Active small-cap funds did relatively well in value, however, with only 65% of those funds underperforming their benchmarks.

For active bond funds, the track record is even worse: Some types of active bond funds—intermediate-term corporate bond funds and long-term government bond funds - had a 100% failure rate in terms of beating their benchmarks. Short-term high-yield active fixed income-funds had the best performance versus their benchmarks—only 75% of them failed to outperform.


A Rapidly Expanding Field

The report also delves into the spectacular growth of ETFs, pointing out that 70% of the 698 ETFs in existence at the report's publication had been listed in 2006 or later, and it discusses that growth in terms of category. And this is where Mazzilli and Co. provide another really cool table—one that tells you how many ETFs were issued in 2005, 2006, 2007 and 2008 (year-to-date) and what categories they fall into.

Fifty-two ETFs were issued in 2005, for example, and most of those—44 ETFs—were U.S. equity funds. In the first five months of 2008, less than one-sixth of the 65 ETFs issued were domestic equity funds; instead, the largest concentration of launches was in international equity ETFs, which saw 25 launches (34 if you add in the 9 global equity ETFs that were also launched). In between those years though, you can see a story developing.

In 2006, a whopping 101 domestic equity ETFs were issued and just 24 international equity ETFs and five global equity ETFs. In 2007, domestic equity ETFs were slowing but still going strong, with 97 product launches. However, that same year also saw the launch of 53 international equity ETFs and 13 global ETFs—both categories essentially doubled the number of issuances from the previous year.

But 2007 was an interesting year for a few ETF categories. It was also the year that leveraged and inverse ETFs really came into their own: In 2006, that category saw the introduction of just 12 funds, but in 2007, that number jumped to 52 ETFs—or about 76% of the leveraged and inverse ETFs in existence at the time of the report's publication.

Fixed-income ETFs, long a neglected category in the ETF arena, also saw some dramatic changes, with 45 funds launching in 2007 alone. Before 2005, there were perhaps five fixed-income ETFs in existence, and none even launched in 2005. Those 45 ETFs launched in 2007 represent about 76% of the total population of fixed-income ETFs.

Morgan Stanley puts the total assets in ETFs at $607 billion as of the end of May. The market share for domestic equity is nearly 55%, while international and global equity combined stands at roughly 29% market share. Fixed income is the third-largest weighting at 7.4%, followed by commodity ETFs (5%), leveraged and inverse ETFs (3.1%) and currency ETFs (0.9%).

Which ETFs?

The report also lists the many ways ETFs can be used in asset allocation models and portfolios and offers samples of its own asset allocation frameworks and models. It's interesting to see which ETFs are being used in the portfolios.

For example, in its U.S. equity segment of its GWM Tactical Framework model, Morgan Stanley uses the iShares that track the value and growth versions of the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600 indexes, while its international equity segment uses only Vanguard ETFs—the Vanguard European ETF (AMEX: VGK), the Vanguard Pacific ETF (AMEX: VPL) and the Vanguard Emerging Markets ETF (AMEX: VWO).

The moderate fixed-income model for a $1 million portfolio puts about 35% of the total investment into the iShares Lehman MBS Index Fund (AMEX: MBB) and 30% into the iShares iBoxx $ Investment-Grade Corporate Index fund (NYSE Arca: LQD), with a 15% allocation to the iShares S&P U.S. Preferred Stock Index Fund (AMEX: PFF) and a 5% allocation to the SPDR Lehman International Treasury ETF (AMEX: BWX). That leaves 15% of the fixed-income portfolio unaccounted for, but the rest is designated for federal agencies - which are not represented by an ETF.

Finally, the U.S. sector model for a $1 million portfolio is based on the S&P 500's Global Industry Classification System (GICS), and not surprisingly, uses the Select Sector SPDRs, except for the telecommunications and technology sectors. Those two sectors are combined into one ETF in the SPDRs family, so Morgan Stanley uses the iShares Dow Jones U.S. Technology Index Fund (NYSE Arca: IYW) and the iShares Dow Jones U.S. Telecommunications Index Fund (NYSE Arca: IYZ), overweighting IYZ and underweighting IYW in comparison to the sector weights of the S&P 500.

The model also overweights the energy, health care and utilities sectors, while underweighting the financials, industrials, materials, consumer discretionary and consumer staples sectors.

In all it's a very interesting report for market participants of all levels of experience. There are the nuts and bolts of ETFs that will appeal to novices and offer a useful refresher for others. There's also the interesting data nuggets that one can glean from the tables provides within the report and which paint an interesting picture for people familiar with the growth of ETFs.

Finally, there's the model portfolios, which provide a glimpse at which ETFs are being used at one of the world's largest financial institutions and how—which should be of interest to investors at every level.


Heather Bell is assistant editor of She can be reached at [email protected].


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