6. iShares
When ETFs started trading for the first time back in 1993, one of the first ETF families offered to investors was iShares. In 1996, Barclays Global Investors, which at the time was the company that owned iShares, managed the precursors of iShares, a series of World Equity Benchmark Shares referred to as WEBS. The 17 WEBS were developed by Morgan Stanley and they tracked Morgan Stanley Capital International’s (MSCI) single country indices. WEBS laid the foundation for BGI’s future ETF expansion. In 2000, the firm launched the brand name “iShares” by rebranding the WEBS and launching nearly 50 new iShares ETFs in one year. Over the course of a few years, iShares became the largest ETF manager in the U.S. and around the globe in terms of assets under management and number of products offered. According to BlackRock, iShares has global assets under management of more than $600 billion, with more than 460 iShares securities offered around the world.
In 2009, Barclays Global Investors and its business, including iShares, was acquired by BlackRock, which today is a leader in investment management, risk management, and advisory services for institutional and retail clients worldwide. On June 30, 2011, BlackRock’s assets under management (AUM) was $3.659 trillion.
The iShares family of ETFs covers virtually all asset class exposure including sectors, regions, fixed income, and commodities. Through the iShares family, investors can customize their portfolios so that they can have exposure to fit any investment theme. BlackRock says it invests heavily to carefully manage all fund performance drivers related to its ETFs. Known as “Total Performance,” the drivers include managing the fund’s taxes efficiently, minimizing trading costs, and minimizing risks.
Working with well-known index providers, iShares continually designs ETFs that track indexes giving exposure to the domestic, international, fixed-income, equity, and other asset classes that investors and traders desire.
Zero-Sum Market Game
iShares ETFs replicate indexes that are mostly cap weighted, and Paul Lohrey, Managing Director and the head of iShares U.S. Product Management for BlackRock, says what the investor is pursuing is a market return with those indexes, and the market in reality is a zero-sum game. In economic and game theory, a zero-sum game is the mathematical equivalent of a situation in which a participant’s gain or loss is exactly balanced by the losses or gains of the other participant or participants. If the total gains of the participants are added up, and the total losses are subtracted, they sum to zero. It is like eating a pie. A pie is only so big, and if one person takes a bigger share, there is less for the others. Eating a pie is a zero-sum undertaking, as are other endeavors in which there is only so much to go around.
Lohrey says that investing in a fund-tracking, cap-weighted index and constructing a portfolio with cap-weighted index funds means that the investor accepts that investing in the market is a zero-sum endeavor. To the extent to which an investor is investing in an index fund (for example, a total U.S. market index fund) all the fund participants in the marketplace can earn only the market’s return.
He explains a zero-sum game in an illustration that imagines that there is a market containing two securities and they are both equal in size. In this example, security A earns 10 percent and security B earns 5 percent. The market, in this case, earned 7.5 percent. The owner of security A would be very happy with his purchase, and the investor who owned security B would not be nearly as happy. The owner of security B, because his security lagged the market, would research other securities and decide to trade that security. Suppose the owner of security B convinces the owner of security A to sell his shares and trade for his security B, and the same performance continued. In this case, the new owner of security A would become a winner, because he now has a winning security, and the holder of security B moves to the losing side of the trade. Suppose the market still returns 7.5 percent; well, these transactions cost something. So the holder of security A did not actually earn 10 percent—maybe more like 9.5 percent. The security B holder did not earn 5 percent either—more like 4.5 percent. So, after expenses, the market didn’t earn 7.5 percent; it earned 7 percent.
Lohrey says that investors incur expenses, and some incur significant expenses, in terms of management fees, other fees, and expenses that are charged by the investment manager, as well as transaction costs. In the broader market, if you look at the total U.S. market, with its millions of investors in that market, their activity of buying and selling doesn’t return a higher amount of return for the market. Lohrey says, “There is only so much economic return that the market provides over a time period. The activity of investors sending shares back and forth among each other just changes the calculus of who the winners and losers are. All that activity drags the average investor down, and the average investor gets further away from that market return because they engaged in all this activity that increased their costs. And when I say the average investor, they own half of the security A I gave in the example, and half of the security B.”
Cap-Weighted Indexes Fill a Need
Lohrey says that when you invest in a cap-weighted index, you are buying the return of the market asset class you choose because you don’t believe that you have the insight to know which securities will perform better than others in that asset class. You can pay higher fees to an active fund manager to select the securities that might outperform the market, but you don’t have any assurance that his insights will produce a higher return after expenses and taxes than the index. So a broad cap-weighted index gives market exposure and is generally the best choice for many investors.
Cap-weighted indexes are simple. Lohrey states, “One of the hallmarks of a capitalization-weighted index fund is that there is very little trading to add or remove securities. The fund typically trades only when the index makes changes to its underlying securities, which is also not often.” To get better than a market return, participants have to engage in an effort to discern which subset of securities offers a better return pattern than the market as a whole, and there is no assurance the right subset will be chosen. Alternatively weighted indexes can be used, but those that are offered as ETFs often charge a higher fee, sometimes a substantially higher fee. Also, alternatively weighted ETFs can incur additional expenses in the form of more transaction costs.
“If you think about a distribution around the market’s return, hypothetically, you could broadly assume that half the market participants underperform the market and half outperform the market, because, again, it is a zero-sum game. There is only so much return that the market produces,” Lohrey says. The expenses shift that distribution such that the preponderance of investors experience a return after expenses that is lower than the market’s return. Lohrey says that those factors add up to an affirmative rationale that investing in cap-weighted indexes makes sense.
Weighting Other Than Cap Weighting Is Making a Bet
“Active managers make bets in their portfolios by choosing and weighting securities in an attempt to produce higher returns than the broad market, lower risk than the broad market, or both. They are trying to reflect their insights in their portfolios,” Lohrey says. He believes that alternatively weighted indexes are basically the same as actively managed funds. They are purposefully constructed differently than the basic market cap approach in an effort to achieve a better result than the broad market index, such as to produce higher returns, lower risk, or both.
He says that people often confuse the rationale for pursuing a traditional, market cap-weighted investment approach and believe it implicitly relies on market efficiency. It is true that cap-weighted indexes represent the collective view of what investors believe is the fair value for all the securities contained in those indexes. In reality, the collective view of investors is almost never right. Prospectively, there are combinations of securities that yield higher returns than the market without increasing risk relative to the market. The problem for investors, he thinks, is figuring out which combination of securities produces the desired result. Proponents of alternatively weighted indexes point to the past and observe that market cap-weighted indexes have not historically produced the best combination of return and risk for investors and that there are better ways to weight (or position) stocks in a portfolio.
He says that fundamental investor proponents say that their indexes are more efficient and that maybe in hindsight, over certain periods, they were more efficient. But prospectively, the fundamental index is simply the bets made by that index maker. He says the bet for the fundamental indexer is often that small cap and value, because they are usually heavily skewed to those factors in that construction, which helps yield a more profitable portfolio. “Just like a regular, traditional active manager puts together a portfolio, fundamental index providers believe that the indexes they’ve assembled, by whatever process they assembled it, are more efficient than the market,” Lohrey says.
Lohrey believes that a well-constructed, broad, cap-weighted index is fully representative of the publicly available stock market. Any deviation from this, in the form of weighting indexes to reflect a bias or a way of measuring the market, is a wrinkle that takes away from the index truly reflecting the publicly traded market. The public market does undergo shrinkage at times. Private equity, he says, does at times absorb some of the publicly available companies, which takes the companies off the market for public investors. The government, post-2008, has also taken large portions of publicly traded companies out of the market, therefore cutting down on the circulation of public shares. Recent government increases in regulation have prompted some companies to go private rather than face more government scrutiny. Some foreign companies have dropped their U.S. listings rather than face more regulation, necessitating these companies being dropped from some indexes.
Slicing and Dicing Cap-Weighted Indexes
Cap-weighted indexes can be sliced and diced to capture representation in whatever area of the market an investor desires, such as regions, sectors, cap sizes, and style. Lohrey says, “Compartmentalization of cap-weighted indexes is one of the great features of the cap-weighted construct. You can have different styles reflective of desired characteristics of securities, such as you can have a value index that reflects stocks that have appealing value characteristics, whether you’re looking at low-price-to-book ratios, low-price-to-earnings multiple, high-dividend yield, or other factors that are typical identifiers of value. Conversely, you can construct indexes that have attractive growth characteristics, such as stocks that have high projected earnings growth rates, and high estimated unit sales.”
Lohrey says that with capitalization weighted indexes an investor also has the flexibility of investing in different capitalization size ranges, such as large-cap or small-cap, and to do this objectively. By objectively, he means that essentially, through a rules-based process, the cap-weighted indexer can identify a home for every security. Lohrey says that by slicing and dicing using different cap-weighted indexes to gain a better-than-market return, an investor makes a bet, but this bet can be quantified and controlled within a cap-weighted scheme.
Using cap-weighted indexes, an investor will have clarity regarding the degree to which he chooses in his portfolio to deviate from a purely market cap-weighted construct. In Lohrey’s opinion, fundamental indexes are different in that fundamental weightings are dynamic. The factor loading of small-cap and value stocks is inherently dynamic and makes the construct change over time. This makes it hard to anticipate what direction fundamental weighting will take an investor, Lohrey believes, and an investor allows that dynamic process of weighting to allow his portfolio to drift, as the portfolio is exposed to these factor exposures over time.
Making Bets Using Asset Class Factors
As far as deciding what an investor should invest in to outperform the market, such as sectors, or cap size, or style such as growth or value, Lohrey says, “You can’t isolate purely one risk factor when you’re constructing bets.” He makes the point that sectors have different characteristics, and “there are some sectors that have more representation in small-cap and value, and some have more representation in large-cap and growth. Financials, for example, tend to be more value-oriented, and technology tends to be more large-cap, growth companies.
“In a way, you’re describing another way that in fact might be more intuitive for investors. It is intuitive for investors to think in terms of sectors, where it is hard for investors to think in terms of large-cap and small-cap. When you talk about a sector, such as technology versus healthcare versus energy, people understand, people tend to identify investments in that way.”
Cap Weighting Is the Purest Form of Investing
Lohrey thinks that the purest way to invest is through cap-weighted indexes. “In that way,” he says, “it’s not picking a view on the market, and it’s not paying someone else to take a view on the market. Investing this way is accepting what the market can deliver.” This is true of cap-weighted indexes in the small-cap, mid-cap, value, growth, and other asset classes, which all have cap-weighted indexes and are replicated by ETFs.
He says that fundamental index makers do not say why they have developed their indexing methods and why their methods are better. Lohrey says that the fundamental proponents point to a cap-weighted index formula and say that cap weighting is broken, and it never produces the most efficient portfolio. Fundamental weighting advocates, in Lohrey’s view, are just saying that fundamental weighting is better than cap weighting. He says, “But they don’t have an affirmative thesis as to why fundamental weighting does work.”