Image Credit: Christophe Vorlet
By Jason Zweig | Aug. 11, 2017 9:28 am ET
How’s this for an investing optical illusion?
As of June 30, according to S&P Dow Jones Indices, the stocks in the S&P 500 index traded at a price/earnings ratio of 23.56 — meaning that their combined price was almost 24 times the net earnings all those companies had generated over the past year.
Three ETFs holding those same stocks claim to have significantly different P/Es.
On their websites, based on June 30 data, the iShares Core S&P 500 ETF recently reported that its portfolio was valued at 21.69 times earnings; the Vanguard S&P 500 ETF, 21.5 times; and the SPDR S&P 500 ETF, 18.65 times.
All three portfolios are indistinguishable from each other and from the index they seek to replicate.
These ETFs seem to be at a discount to the index of stocks they hold. That could make them look attractively cheap in a market that many analysts regard as overvalued. But the apparent bargain is an illusion.
Stock indexes, and by extension the funds that are based on them, are averages. You can calculate an average in many different ways, and deciding which method to use is part science, part art and part opinion. Investment regulators say that fund companies are free to calculate and report an average valuation any way they wish, so long as it doesn’t mislead or deceive investors.
So you should pay attention to how these funds report valuations.
State Street Global Advisors, which manages the SPDR S&P 500 ETF, bases its P/E ratio not on the profits companies have earned over the past 12 months, but on the earnings that analysts estimate will roll in over the year to come.
Matthew Bartolini, head of SPDR Americas research, says the firm uses that multiple of estimated profits because “the market is forward looking” and the projected P/E “tells investors how much they’re paying for forthcoming earnings.”
State Street doesn’t ignore money-losing companies, but it does lessen their impact by adjusting how it calculates average valuation. Including “massive outliers,” a few companies with huge profits or monstrous negative earnings, can severely distort the P/E of an index, Mr. Bartolini says.
PowerShares, too, adjusts its calculations of average values to lessen the impact of extreme results. That, says John Frank, a product strategist at the firm, “provides a cleaner result not distorted by earnings.”
Depending on how you calculate the average, subtracting the large losses of a few companies from the combined profits of the others can leave a much smaller total of net earnings to go around. That can make the index look more expensive than it effectively is.
The iShares and Vanguard ETFs also exclude unprofitable companies, giving more weight to money-making firms in calculating average valuation ratios, those firms say.
S&P Dow Jones Indices, which calculates the S&P 500 index, doesn’t do that. “These earnings reflect what companies actually did make or did not make,” says Howard Silverblatt, a senior index analyst there. “If earnings are distorted to some degree by negative earnings from some companies, well, maybe that needs to be taken into account. It’s in there.”
Fidelity uses an independent firm to calculate the valuation ratios on its own ETFs and on those it offers from other managers, so different ETFs investing in the same index display highly similar valuation ratios on Fidelity’s website. That provides “a consistent apples-to-apples comparison,” says spokeswoman Nicole Goodnow.
Rich Powers, head of ETF product management at Vanguard Group, says it uses FactSet, an independent research firm, to calculate measures like P/E, eliminating negative earnings from the average.
Still, “using different methodologies may be introducing a level of noise,” says Dorothy Lariviere, a product consultant at iShares. “Having more standardization would be helpful to investors evaluating ETF portfolios tracking the same benchmark.”
Until that happens, don’t let yourself imagine that one ETF is “cheaper” than another that follows the same index — or that either is cheaper than the index itself.
CORRECTION: State Street Global Advisors accounts for money-losing companies when calculating average valuation at its exchange-traded funds. The original version of this column incorrectly said it ignores such firms in the calculation.
Source: The Wall Street Journal, http://on.wsj.com/2vpBS0M
For further reading:
Definitions of EXCHANGE-TRADED FUND, INDEX, and INDEX FUND in The Devil’s Financial Dictionary
Murray Stahl, “It’s One Thing to Not Know, It’s Another to Be Told What Isn’t So” (Horizon Kinetics, 2nd quarter 2017 commentary)