Using ETFs to Mimic Mutual Fund Ideas

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Morningstar submits:

By Robert Goldsborough

In the investment world, some active mutual fund managers are treated like sages--and sometimes rightly so, given the incredible returns some have been able to rack up over extended periods.

However, those returns do come at a cost to investors: Typical mutual fund expense ratios range from 1.2% to 1.7%, and even institutional mutual fund expense ratios range from 0.5% to 0.8%. Are there ways for a cost-conscious investor--already smarting from the S&P 500's 3% decline so far in 2010--to play some of the investment themes that smart active fund managers are promoting these days, but for a fraction of the cost?

The answer: Most definitely. Through inexpensive exchange-traded funds, investors can pursue similar investment strategies and potentially enjoy returns comparable to those generated by active mutual fund managers--and do so far more cheaply.

Let's start with legendary Legg Mason Value Trust ((LMVTX)) manager Bill Miller, who in recent commentary told investors that "U.S. large-cap stocks represent a once-in-a-lifetime opportunity, in my opinion, to buy the best-quality companies in the world at bargain prices. The last time they were this cheap relative to bonds was 1951." Miller, of course, guided Legg Mason Value Trust to 15 consecutive years of outperformance of the S&P 500. And, despite his recent string of significant underperformance, Miller still has outperformed the benchmark since taking the helm of the fund in 1982.

Miller is putting his money where his mouth is. For example, at the 2010 Morningstar Investment Conference in June, he praised one of his top holdings, [[IBM]], as "the most remarkably mispriced name in the market," and he also touted other large-cap names, as well. As of June 30, his fund's holdings held mega-cap names such as IBM, Goldman Sachs ( GS ), Texas Instruments ( TXN ), Time Warner ( TWX ), Citigroup ( C ), and Amazon.com ( AMZN ).

With a fee of 1.69%, Legg Mason Value Trust should be viewed by investors as being on the expensive side. In the ETF universe, however, an investor can gain access to the same kinds of names far more cheaply. Investors might consider gaining similar exposure to Legg Mason Value Trust at a fraction of the cost by combining Vanguard Mega Cap 300 Index ETF ( MGC ), which is an extremely low-cost, diversified, size-pure investment in large-cap U.S. stocks (at just a 0.13% expense ratio), with a bank ETF such as iShares Dow Jones U.S. Financial Services ( IYG ) (0.48% expense ratio). Such a combination would give an investor major exposure to ExxonMobil ( XOM ), which Miller, in a July note to shareholders, said trades well below the market, has a yield greater than that of the 10-year Treasury, has above-market returns on capital, and sports a valuation that is "among the lowest the company has traded at in years." Additionally, investors IYG offers exposure to core Miller holdings such as General Electric ( GE ), Microsoft ( MSFT ), Goldman Sachs, Citigroup, Merck ( MRK ), Bank of America ( BAC ), IBM, Medtronic ( MDT ), American Express ( AXP ), Amgen ( AMGN ), Hewlett-Packard ( HPQ ), Amazon.com, Cisco Systems ( CSCO ), Wells Fargo ( WFC ), [[EMC]], UnitedHealth Group ( UNH ), Gilead Sciences ( GILD ), eBay ( EBAY ), Texas Instruments, Aflac ( AFL ), and Time Warner.

Another obviously influential investor is GMO's Jeremy Grantham, whose lengthy and often-contrarian quarterly missives are considered "must-reads" on Wall Street. Grantham's team includes portfolio managers William Joyce and Sam Wilderman. Grantham, who manages well-regarded and inexpensive (entirely because of their $10 million minimum required investment) mutual funds such as GMO US Core Equity ((GMCQX)) (0.37% fee) and GMO Quality ((GQLOX)) (0.39% fee), is also sounding the gong about the current attractiveness of high-quality stocks, particularly those in the large-cap space. In the case of GMO US Core Equity, Grantham's team focuses on trying to outperform the S&P 500 across a complete seven-year market cycle. GMO Quality, by contrast, aims to own high-quality names across all cap ranges, although, as a practical matter, almost 90% of the fund is invested in giant caps.

Using ETFs, investors have the ability to pursue the same types of strategies, but at a much cheaper cost. The best option for investors who are interested in owning a fund holding the companies GMO invests in--those with low debt, high returns on capital, and stable earnings--would be Vanguard Dividend Appreciation ETF ( VIG ), which holds a diversified portfolio of high-quality U.S. large-cap equities and charges an expense ratio of just 0.23%.

One of the most respected mutual fund managers and mutual fund industry executives today is T. Rowe Price's Brian Rogers, who manages the approximately 120-name T. Rowe Price Equity Income ((PRFDX)). Rogers invests in large-cap value names, and secondarily looks for companies generating significant dividend yields. Nobody disputes that his fund has generated reliable, solid returns over the last 20-plus years and is thought to be one of the industry's stalwarts. But the fund has an expense ratio of 0.72%--low by mutual fund standards but still high in the ETF world. Also, ETF investors can gain exposure to much of the same market segments as T. Rowe Price Equity Income--but by paying less than half of the costs--by investing in ETFs such as Vanguard Value ETF ( VTV ) (0.14% expense ratio), Vanguard Dividend Appreciation ETF ( VIG ) (0.23% fee), iShares S&P 500 Value Index ( IVE ) (0.18% fee), Vanguard High Dividend Yield Index ETF ( VYM ) (0.20% fee), or WisdomTree LargeCap Dividend ETF ( DLN ) (0.28% fee). Given that T. Rowe Price Equity Income is overweighted to financial companies, an option for reproducing its portfolio is PowerShares Dividend Achievers ( PFM ), which is more expensive than the other ETFs listed above (0.60% fee) but still cheaper than T. Rowe Price Equity Income.

In the fixed-income arena, Vanguard founder and investment-industry legend Jack Bogle recently told Morningstar he is "nervous" about the fixed-income markets and that, as a result, he would avoid long maturities. He counseled investors to instead consider investing half their fixed-income allocation in short-term or limited-term bonds, and the other half in intermediate-term bonds. Following Bogle's advice, one could, for example, invest in short-term bond mutual funds such as Vanguard Short-Term Bond Index ((VBISX)) (0.22% expense ratio) or Vanguard Short-Term Federal ((VSGBX)) (0.22% fee). Intermediate-term bond funds such as Vanguard Intermediate-Term Bond Index ((VBIIX)) (0.22% fee), Vanguard Intermediate-Term Tax-Exempt ((VWITX)) (0.20% fee), Vanguard Intermediate-Term Treasury ((VFITX)) (0.25% fee), and Vanguard Intermediate-Term Investment-Grade ((VFICX)) (0.24% fee) are also options.

Here again, however, an investor following Bogle's advice also has the ability to invest far more cheaply in ETFs in both of Bogle's recommended categories. On the short-term investment side of an investor's portfolio, there is iShares Barclays Short Treasury Bond ETF ( SHV ), while iShares Barclays 3-7 Year Treasury Bond ( IEI ) is an option for the intermediate-term side of a portfolio. Both ETFs cost just 0.15%, which is low by ETF standards and meaningfully lower than their mutual fund counterparts. An even lower-cost medium-term bond ETF is SPDR Barclays Intermediate Term Treasury Bond ETF ( ITE ), which charges just 0.13%. And given that Bogle recently told Morningstar that he has a slight preference for corporate bonds over Treasuries, a corporate-bond-minded investor could consider iShares iBoxx $ Investment Grade Corp Bond ETF ( LQD ), which is an intermediate-term bond ETF sporting just a 0.15% management fee.

These examples show that the low-cost ETF landscape is filled with all flavors of funds that can help investors more cheaply play any kind of investment theme, particularly those currently being championed by some of the best-known and most-respected mutual fund managers out there.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (( BGI )), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes. Tim handles their stock strategist posts (separate feed) if you need help formatting or have other Morningstar-related questions.

See also Friday ETF Wrap-Up: DBA Sinks, RWX Soars on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs


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