Cruddy Information on Exchange Traded Funds

Guide to Choosing Exchange Traded Funds

in Spite of Shifty Information

A Market Brief ™

by

Steven Kim

MintKit Investing

www.mintkit.com

Disclaimer. This brief is provided as a resource for information

and education. The contents reflect personal views and should not
be construed as recommendations to any investor in particular.
Each investor has to conduct due diligence and design a strategy
tailored to individual circumstances.

© 2011 MintKit.com
 Summary

The modern investor faces a raft of challenges due to the confounding nature of the
information available on exchange traded funds (ETFs). One of the stumpers stems from
the profusion of new-fangled vehicles for investing in a particular market. Another hurdle
lies in the occasional outcrop of blighted information which may be incorrect, outdated,
and/or misleading.

In the age of the Internet, one of the most popular resources for the investing public lies in
the online portal maintained by Yahoo Finance. Another fount of information for the
financial community is a rating agency named Morningstar, which has served for decades
as a beacon on communal pools such as index funds.

Sadly, though, the stalwarts of this breed are known to serve up faulty data at times. To
begin with, the information provided by two different sources may be incompatible with
each other. Worse yet, the figures displayed at a single Web site are at times internally
inconsistent.

For these reasons, the astute investor is obliged to mull over the data obtained before
making any crucial decision. Due to the pitfalls in store, a sensible course of action is to
compare a batch of figures against each other in order to assess their consistency.

Another safeguard is to give preference to elementary items of data over derived statistics.
Starting from basic nubs of information, the target figures can at times be calculated
manually with relative ease.

An example in this vein is to figure out the average return on investment for a particular
security based on the initial and final values of the price record. Another ploy is to check a
selection of numerical data against a graphic display in order to confirm that the figures
appear to be compatible.

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The knotty issues of this sort can be explored in depth by way of a case study involving the
energy sector. The application deals with the selection of exchange traded funds focused
on the market for crude oil. The standard bearer for each type of vehicle is presented,
along with a review of its performance in recent years.

From a larger stance, the goal of the exercise is to uncover the problems posed by
confounding data. A related task is to present a muster of guidelines for dealing with the
stumbling blocks.

* * *

Keywords:

Investing, Information, Data, Exchange Traded Funds, ETF, Index Funds, Energy, Oil,
Guide, Stocks, Market, USO, XLE, OIH, Sharpe, Risk, Commodities, Mistakes

* * *

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 * * *

Dastardly Data

An investor in exchange traded funds faces a number of stumbling blocks posed by

scrappy information. One hurdle lies in the profusion of index funds clamoring for attention.
Another stumper springs from the occasional outcrop of bogus data on the Internet, a
problem that can afflict even renowned and respected sources of information.

One of the most popular portals for the investing public is found in Yahoo Finance
(finance.yahoo.com). In addition, the financial media relies on to a rating agency named
Morningstar Inc. (morningstar.com) as a guiding light on communal pools such as index
funds.

Unfortunately, the information provided by these and other stalwarts may be incompatible
with each other. To make matters worse, the figures proffered by a single portal are at
times internally inconsistent.

The scourge of flawed data is most likely to afflict the portions of a portal that display
relatively novel functions. An example in this vein is a bunch of statistics on the volatility of
exchange traded funds. Another sample concerns a tally of risk-adjusted returns for
communal pools.

Due to the pitfalls in store, the prudent investor has to approach the data with a good deal
of caution. One way to cut down the likelihood of a disastrous flub is to check the figures
for consistency against each other.

Another workaround is to rely on primitive items of data as the groundwork for figuring out
the desired results through manual means. As an example, a virtual calculator may be
used to compute the average annual return for a fund over the past decade based on the
raw values of the price history.

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Another recourse is to review the numeric data against similar information in the form of a
graphic plot. In this way, the investor can readily confirm a number of crucial features.

For starters, the mindful investor can ensure that the numeric figures and plotted values
appear to lie within the same ballpark. In addition, the chart can provide the investor with a
visceral grasp of the texture and scope of volatility for the fund under consideration.

Case Study of Crude Oil

To dig deeper into these issues, we turn to a case study involving the energy sector. Within
this domain, a number of index funds are designed to track the price of crude oil, while
other pools are linked more loosely to the market. The standard bearer in each category is
presented, along with a survey of its performance in recent years.

Another topic involves a review of acute problems and handy fixes relating to flaky data. In
line with earlier remarks, one way to reduce the chance of a bungle is to cross-check a
bunch of data obtained from multiple sources of information. Another remedy is to
compare the numeric values against graphic charts to determine whether the data appear
to be compatible.

1. Get the Vital Signs for the Main ETF Tracking the Primary Market for Oil

When the folks in the financial media talk about the price of oil, they usually have in mind
the price of the nearby contract in the futures market. In the U.S., for instance, the futures
contract is grounded on a strain of petroleum known as West Texas Intermediate (WTI)
crude.

Given this backdrop, a simple way to structure an exchange traded fund is to track the
price of the commodity by way of the futures market. This scheme is in fact the main
approach taken by an ETF known as United States Oil. The security trades on the stock
market under the ticker symbol of USO.

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The objective of the pool is to mirror the current value – also known as the spot price – of
the light, sweet oil that serves as the standard product in the U.S. For this purpose, the
stewards of the fund rely on futures contracts based on WTI as well as comparable goods
like natural gas and liquid fuels. The index fund may also take up kindred assets such as
forward contracts on crude oil, or options on futures contracts for the commodity.

In return for looking after the pool, the custodians receive a maintenance fee. The net
charge comes out to some 0.78% a year of the assets under management. Unlike many
other funds, USO pays out no dividends to its shareholders.

According to Yahoo Finance, the value of USO at the end of February 2008 was $80.42
per share. On the other hand, the fund broke down later in the year and tumbled even
lower the following spring. After hitting a trough, the pool reversed part of the losses and
clambered back to $39.19 by the end of February 2011.

Based on the initial and final prices, the ETF lost a total of 51.2% of its value over the
course of three years. Put another way, the compound annual growth rate (CAGR) came
out to be negative 21.3%.

Any asset in the financial arena is apt to jump around rather than glide in a smooth way.
Given the fickle behavior, a straightforward way to pin down the degree of flightiness is to
examine the relative changes in value over time.

In this light, the boffins in the field of statistics cooked up long ago a universal scheme to
measure the degree of dispersion within a set of numbers. The standard measure is
called, sensibly enough, the standard deviation.

According to Yahoo Finance, the standard deviation for USO over the course of three
years came out to 39.27%.

By dividing the average return by the standard deviation, we can calculate the risk-
adjusted return. The resulting quotient is also known as the Sharpe ratio.

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We recall that the mean return on investment for USO over the past three years was
minus 21.3% per annum. Based on the ratio of the average return to the standard
deviation, we find that the risk-adjusted gain over this period was negative 0.54 units.

2. Gauge the Performance of the Vendors in the Oil Industry

The companies in the oil industry span the rainbow from the producers of petroleum to the
refiners and distributors of the fluid. Other players in the arena include the suppliers and
collaborators of the primary vendors.

When the price of oil rises, the companies in the industry tend to earn higher profits. By the
same token, the outfits are apt to face hard times when the commodity slumps.

From the standpoint of the financial community, the main advantage of buying a stake in a
company rather than the commodity itself springs from the implicit leverage on offer. In
other words, the investor in the equity is wont to get a bigger bang for the buck over the
long range.

As an example, a rise of 10% in the price of oil might lead to a spurt of 30% in the earnings
of a particular vendor. In that case, the equity in the company is apt to swell more or less in
line with the surge in profits.

In this segment of the market, the stalwart among index funds lies in an exchange traded
fund known as the Energy Select Sector SPDR (symbol XLE). The mission of the pool is to
match the price and yield, before taking expenses into account, of the equities included in
– surprise, surprise – the Energy Select Sector Index. The latter benchmark deals with the
producers of oil, gas and other fuels as well as the suppliers of equipment and services in
the energy sector.

The companies covered by the benchmark run the gamut from Exxon and Chevron to
ConocoPhillips and Occidental Petroleum. The membership also includes a number of
service providers as in the case of Schlumberger and Halliburton.

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The net expense for XLE comes out to 0.20% per annum of the funds under management.
On a positive note, though, the pool throws off a stream of dividends each year amounting
to some 1.27% of the value of the portfolio.

According to Yahoo Finance, the adjusted price of XLE at the end of February 2008 was
$72.89. Meanwhile the corresponding value three years onward was $78.54.

Based on these figures, the stock enjoyed a modest gain of 7.75% over the course of
three years. In that case, the average return was a mite over 2.5% per annum.

According to Morningstar, the standard deviation of returns was positive 27.33% over the
span of three years. The latter figure matched the value provided by Yahoo Finance.

Dividing the average return by the standard deviation results in a Sharpe ratio of some
0.09 units. Curiously, though, both Morningstar and Yahoo opined that the risk-adjusted
gain was 0.22.

The difference between the last couple of numbers is big enough to raise an eyebrow.
Unhappily, the portals appear to be inconsistent in the data that they display.

On a positive note, though, the exact value of the Sharpe ratio plays only a secondary role
in comparing the securities in this particular case. Whichever figure is chosen, the
performance of XLE happens to trounce the turnout for USO.

3. Size up the Service Providers in the Industry

The producers in the oil industry rely on a host of partners in order to ply their trade. The
actors in supporting roles include the band of service providers that assist the principals in
seeking out fresh deposits of petroleum. Another type of sidekick is the crew of hardware
agents that lease out the equipment needed to pump out the oil from the ground.

In the context of exchange traded funds, the mainstay is a pool called Oil Services
HOLDRs (OIH). The components of the fund include hulking firms such as Schlumberger

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and Halliburton as well as smaller players like Transocean and Baker Hughes. The fund
throws off a dividend yield of around 1.10% a year.

Based on the information from Yahoo Finance, the adjusted price of OIH was $166.32 at
the end of February 2008, while the corresponding figure three years later was $164.27. In
that case, the ETF lost about 1.3% over the course of three years. Put another way, the
takedown came out to roughly minus 0.41% a year on average.

According to Morningstar, the standard deviation of returns was 39.40%. Based on the last
pair of figures, the Sharpe ratio amounted to some negative 0.01 units.

4. Compare the Risk and Return

Among the trio of stalwarts in the energy sector, the index fund dealing with the service
providers turned in the best showing. For starters, XLE outpaced its rivals in terms of the
total payoff over the course of three years.

The runner-up was the index fund focused on the troupe of supporting players in the
energy sector. More precisely, OIH lagged the winner by a modest amount in terms of the
average gain. On the other hand, the performance adjusted for risk was more crummy.

By contrast, the tracking fund for crude oil turned in a solidly lousy performance. Since
USO lost a hefty chunk of its value over the 3-year span, there is scarcely any point in
comparing its risk-adjusted returns against its better rivals.

Tips on Exchange Traded Funds

An index fund represents a dandy way to invest in the energy sector or just about any
other domain. Within this category, the exchange traded fund is an efficient and convenient
vehicle for investment. The merits of an ETF, along with a battery of related topics, are
discussed in an article titled, “How to Beat the Investment Funds” (Kim, 2011).

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In sizing up the performance of an ETF, a baseline for comparison is an index fund that
tracks the stock market as a whole. To this end, the most popular benchmark used by
professional investors is the Standard and Poor’s Index of 500 giants listed on the U.S.
bourse.

For this benchmark, the ETF of choice has the ticker symbol of SPY. According to Yahoo
Finance, the Sharpe ratio for SPY over the span of three years ending in early 2011 was
0.19 units. The latter figure lay somewhere in the middle range of values we obtained
earlier for XLE, OIH and USO. Put another way, the popular vehicles for the oil market
straddled the level of risk-adjusted returns for the stock market as a whole.

As a rule, the risk-adjusted gain is apt to be somewhat less fickle than the return on
investment. In other words, the value of the Sharpe ratio for a given asset tends to vary
less than the average return. This tendency was reflected in the information published in
early March 2011 by the two main portals featured in this article.

On one hand, the mean return over three years reported by Yahoo Finance differed by a
hefty amount from the value that we calculated above for USO. The same was true of the
corresponding figure provided by Morningstar. In addition, the numbers supplied by Yahoo
and Morningstar differed from each other.

Even so, the values of the Sharpe ratio provided by the latter two sources were similar to
each other. If the displays for the risk-adjusted return were erroneous or outdated, they
happened to be awry by a like amount.

A chart of the price action provides an intuitive grasp of the behavior of any asset. The
exhibit below, courtesy of Google Finance, shows the relative performance of USO, XLE
and OIH over the course of three years starting from the end of February 2008.

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For the sake of confirmation, a similar plot from Yahoo Finance is displayed herewith.

Based on either of the foregoing charts, we can verify that XLE was less volatile than its
rivals during the upswing in 2008. The same was true amid the downleg in the following
year.

Another obvious outcome was the divergence of the cumulative changes in price. Clearly,
XLE was the winning vehicle over this rocky stretch.

In a nutshell, either of the graphic displays highlights the superior performance of XLE in
terms of lower volatility as well as higher returns.

On occasion, a qualitative review of this sort is enough to pick out the winner from a bunch
of prospective assets for investment. In that case, any analysis of the numeric data would
simply serve as a way to confirm the results of the visual scan.

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Caveats on Information Sources

The wily investor keeps in mind that the data supplied by any source can be incorrect,
inconsistent, and/or misleading. A case in point is an outdated value for the return on
investment, which can vary greatly over time.

A specific example lies the information provided by Morningstar Inc. According to the
figures displayed by the outfit in the early weeks of March 2011, the USO fund turned in an
average return of negative 14.74 percent a year over the course of three years ending in
February 2011. However, this result differed by a sizable amount from the value of minus
21.3% that we calculated above.

To add to the muddle, Yahoo Finance claimed that the average return over the same
stretch of time was negative 1.32% a year: a value that was thoroughly implausible based
on the graphic plots. Apparently, the figures displayed by both portals were way out of
date.

In the cant of the financial jocks, the difference in performance between a particular asset
and a target benchmark is known as the Alpha factor. Data of this stripe is provided by
Yahoo Finance for a given security under a section labeled “Risk”.

The corresponding page for USO claimed that the average level of annual performance
compared to a standard index – that is, the Alpha level – was minus 14.62%. In talking
about the “standard index”, the portal was referring to the S&P 500 benchmark (Yahoo,
2009). In addition, the mean return was listed as negative 1.32% per year.

Apparently, Yahoo Finance obtains some of the information on exchange traded funds
from Morningstar. As an example, Yahoo reported in March 2011 that the exchange traded
fund named SPY had an Alpha level of minus 0.03% compared to the standard index,
where the latter referred to the S&P benchmark. In informal terms, SPY lagged slightly
behind the market index.

The foregoing outcome was largely compatible with the results reported by the stewards of

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the fund itself. As an example, the pool snagged a total return of 10.08% on the net value
of the assets under management during the fiscal year ending in September 2010; by
comparison, the S&P index turned in a gain of 10.16% over the same period (State, 2010).

In other words, the pool lagged the benchmark by 0.06% over the course of the year. The
latter value lies in the same ballpark as the average value of minus 0.03% reported in
unison by Yahoo and Morningstar.

In addition to Yahoo and Morningstar, other sources of information can be problematic as

well. A case in point is a renowned outfit named StockCharts (StockCharts.com), which
serves as a staple resource for professional traders of a technical bent.

Sadly, the popular portal begged to differ with Yahoo as well as Morningstar. In particular,
the big kahuna of index funds – namely, SPY – was supposedly outpacing rather than
lagging its target benchmark. The remarkable claim is highlighted by the chart below,
which has been adapted from StockCharts.

The exhibit plots the ratio of SPY to the S&P 500 benchnmark over a period of three years
ending in February 2011. Over this stretch, the relative gain of the index fund compared to
the target benchmark was a tad over 6.8%. Put another way, the average lead of SPY over
the index itself was in excess of 2.2% per annum. The latter outcome is of course out of
whack with the nuggets of data that we obtained from other sources. An example of the

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divergence lay in the assertion by Yahoo that the relative change of SPY over the taget
index – as denoted by the Alpha factor – came out to negative 0.03% a year on average.

The price of oil can soar and plunge within the span of a single day. For this reason, the
commodity is unsuitable for investment by the faint of heart. More generally, the same is
largely true of any ETF linked to natural resources. Only a staunch player who can face
the tumult with aplomb should consider investing in this corner of the financial bazaar.

The performance of any asset depends on a variety of factors. An exemplar lies in the time
span used in the analysis.

For instance, consider a window of half a decade ending in early 2011. During this period,
XLE turned in a much better showing than OIH, which in turn beat USO hands down.

The chart below, from Yahoo Finance, depicts the behavior of XLE, OIH and USO over the
course of 5 years ending in early 2011.

The display highlights the sizable difference in performance by the funds during the stretch
of half a decade spanning the financial crisis of 2008 and its aftermath.

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Roundup of Stumpers and Fixes for ETFs

Amid the rapid growth of exchange traded funds, the heedful investor faces a couple of
serious challenges due to the welter of baffling information. One bogey lies in the number
and diversity of index funds clamoring for the investor’s attention. Another bugbear springs
from the publication of bogus data from otherwise respectable sources of information.

In seeking out the best pool for investment, an orderly approach is to begin by sorting the
raft of exchange traded funds into different types of vehicles. Within each group of ETFs,
the standard bearer can serve as a baseline for comparison and perhaps even the pool of
choice.

Moreover, a cogent way to deal with the slew of conflicting information is to compare and
contrast the figures provided by the leading portals. A related tactic is to review the data
from a particular source and determine whether the numbers appear to be internally
consistent.

In addition, the thoughtful investor ought to plot the data in a graphic form in order to
obtain an intuitive grasp of the movements in price. Another recourse is to confirm whether
the visual displays appear to be consistent with some crucial pieces of numeric data. An
example of the latter lies in the maximum level or the final value the price history.

As in any domain racked by lusty growth, the field of exchange traded funds is hamstrung
by a shortage of telling and reliable information. Looking at the larger picture, the swirl of
smog and confusion in the arena will doubtless clear up in fits and starts with the passage
of time.

In the meantime, though, the adept investor has to make up for the dismal state of affairs
by drawing on personal reserves of gumption and judgment. Given the advantages of
exchange traded funds, a modicum of extra effort is surely justified in order to round up the
proper information needed to build up a sound program of investment.

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References

Kim, S. “How to Beat the Investment Funds: Outrun Most Mutual Funds and Hedge Funds
while Earning a Bonus”. http://www.mintkit.com/beat-investment-funds – tapped 2011/4/6.

State Street Global Markets. “SPDR S&P 500 ETF Trust - A Unit Investment Trust -
Annual Report”. 2010/9/30. https://www.spdrs.com/library-content/public/SPY%20Annual
%20Report%2009.30.10.pdf – tapped 2011/4/6.

Yahoo Finance. “Modern Portfolio Theory Statistics.” 2009/4/22.

http://help.yahoo.com/l/us/yahoo/finance/mutual/fitapotheory.html – tapped 2011/3/25.

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