Recent Research: Highlights from September 2010

“Are Vanguard’s ETFs Cannibalizing the Firm’s Index Funds?” The Journal of Index Investing (Summer 2010). Anna Agapova.

Existing literature on ETFs and conventional index mutual funds suggests that the two fund types are substitutes for each other in terms of attracting investors’ money. Vanguard is an industry-leading index fund provider that offers both conventional index mutual funds and ETFs. The question is whether Vanguard experiences a substitution effect between its index funds and ETFs to the same degree as is observed in the industry in general. The examination of the substitutability of the two fund types can help explain Vanguard’s decision to offer ETFs that could cannibalize the firm’s existing products. Results of the article show that contrary to the initial expectations, Vanguard’s ETFs and corresponding index funds are not substitutes but rather complements. The flows of ETFs and index funds positively affect each other. Positive spillover effects, such as ETF tax efficiency, may help explain the synergy between Vanguard index products. The results can help fund families take advantage of similar efficiency spillover effects when structuring new products.

 

“Exploring the Cost of Investing in Socially Responsible Mutual Funds: An Empirical Study.” The Journal of Investing (Fall 2010). David M. Blanchett.

Socially Responsible Investing (SRI), also known as sustainable, socially conscious, or ethical investing, describes an investment strategy that seeks to maximize both financial return and social good for an investor. While SRI may be good from a moral perspective, it is less clear how well SRI portfolios performance against their non-SRI peers, both on a pure-return and risk-adjusted basis. This article explores that topic through an analysis of those actively managed mutual funds categorized as “Socially Conscious” from 1990 to 2008 (19 calendar years) and finds that while SRI funds tend to slightly underperform their non-SRI peers (–17 bps per year), they tend to slightly outperform on a risk-adjusted basis (+1 bps year), but the results were neither statistically nor economically significant. Perhaps the most important issue to be aware of with SRI is that the relative performance of SRI investments can vary materially against their non-SRI peers, even over extended periods (5 + years). This means an investor must take a long-term perspective towards SRI and that it may be difficult to apply the same type of investment monitoring screens against style peers for SRI funds as for non-SRI funds.

 

“Taking Burlington Northern Railroad Private.” The Journal of Private Equity (Fall 2010). Joseph Calandro, Jr.

Berkshire Hathaway took Burlington Northern Santa Fe Railroad private in November 2009 in a deal valued at $100 per share, which was approximately 31% higher than the railroad’s share price at the time. Surprisingly, the deal came under immediate criticism from sources relatively close to Warren Buffett, including his official biographer and the value investing professor at his alma mater. The criticism centered on the deal’s price and claimed, essentially, that Buffett uncharacteristically paid too much for Burlington. The author analyzes this deal by valuing Burlington at the time of its acquisition using the modern Graham and Dodd approach. In doing so, he found that it involves a situation that many private equity acquirers could face —namely, evaluating the purchase of a profitable and stable firm with seemingly low-risk expected improvements, which command a higher multiple. In the author’s valuation, he identifies Burlington’s expected improvements and assesses the risks generated by them in a way that could facilitate post-acquisition value realization, which may prove useful to private equity investors.

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