Numerous models of Nokia phones are pictured at the lobby of the Nokia headquarters in EspooKIMMO MANTYLA/AFP / Getty Images
Telecommunications is one sector where the utility of exchange-traded funds might be questioned. Because their holdings are concentrated, it is cheaper to capture the sector's price trend by directly purchasing the largest constituents of the ETF's index.
Stock commissions as low as $10 (U.S.) at most major online brokerages are what makes "unbundling" the telecom ETFs feasible. The cost of buying direct can be hammered down even more at places such as Interactive Brokers, where commissions are as low as $1 per board lot.
With commissions like these, telecom ETFs "look like good candidates for unbundling, particularly if you don't want to fully replicate them and instead opt for buying the top 10 stocks," says Norm Rothery, founder of StingyInvestor.com and publisher of The Rothery Report.
There are no ETFs for telecom stocks in Canada. There are two main ETFs for U.S. telecom stocks:
• iShares Dow Jones U.S. Telecom (IYZ-N)
• Vanguard Telecommunication Services (VOX-N)
According to Morningstar.com, the iShares Dow Jones U.S. Telecom ETF has 66.5 per cent of its assets in the top 10 stocks. The Vanguard ETF has 73.7 per cent in the top 10 holdings.
Let's show how costs can be reduced for these two ETFs through unbundling. First, a few simplifying assumptions: $15,000 invested for 20 years, $10 commissions, unchanged fund value ("Something you wouldn't want to happen!" says Mr. Rothery) and no dividend reinvestment.
1. Cost comparison: iShares Dow Jones U.S. Telecom ETF
ETF costs
• Annual expense: 0.48 per cent a year, or $72 per year
• Annual expense over 20 years: $1,440
• Commission to buy: $10
• Total cost for ETF: $1,450
Cost to buy the top 10 stocks
• Commissions: ($10x10): $100
Buying the top 10 stocks directly would save $1,350.
2. Cost comparison: Vanguard Telecommunication Services ETF
ETF costs
• Annual expense: 0.25 per cent a year, or $37.50 per year
• Annual expense over 20 years: $750
• Commission to buy: $10
• Total cost for ETF: $760
Cost to buy the top 10 stocks
• Commissions: ($10x10): $100
Buying the top 10 stocks directly would save $660.
The savings for buying direct would be less if there were changes to the index and the investor wished to update holdings accordingly. "Or you can just sit tight and opt for fee savings," Mr. Rothery says.
Indeed, according to Jeremy Siegel's The Future for Investors (2005), sitting tight may outperform the index. He found that when the S&P 500 index was not updated with new stocks, it outperformed the updated S&P 500. There is a tendency, Mr. Siegel said, to bring in growth stocks that have had substantial price runups, which tended to revert to the mean after inclusion in the index.
The savings for buying direct would also be lower when dividends are reinvested. However, this would also affect the ETF investor and would not apply to persons who consume income from their investments. For those who reinvest dividends, Mr. Rothery recommends that costs be minimized by pooling the dividends for a year and investing all at once.
Appendix: tracking error It might be supposed telecom ETFs should be avoided because they have very high tracking errors (the degree to which they diverge from their benchmark indexes). In fact, according to a Morgan Stanley study, the Vanguard ETF recorded the largest tracking error (1,708 basis points) of all unleveraged U.S. ETFs in 2009. The year before, the ETF's tracking error (569 basis points) was again one of the highest.
But these tracking errors reflect more of a problem with the underlying index. The MSCI U.S. Investable Market Telecommunications Services Index is dominated by a few large companies, particularly AT&T Inc. and its 49-per-cent weighting.
Telecom ETFs do not to follow the weighting pattern in this index. Not only is it highly undiversified, but for the ETFs to be compliant with Internal Revenue Service diversification standards (and avoid double-taxation), they must have less than 25 per cent of their assets in securities from a single issuer and no more than 50 per cent in securities that individually represent 5 per cent or more of assets.
Moreover, as of 2010, the tendency to large tracking errors will be substantially reduced in the case of the Vanguard ETF. A Feb. 26 news release from Vanguard Group Inc. reports a switch to a new benchmark index (MSCI US Investable Market Telecommunications Services 25/50 Index), which uses a weighting pattern in line with IRS requirements.
Special to The Globe and Mail