Archive for October, 2012

Why focus on ETFs?

As long time visitors to our site will note, we have gradually shifted our focus from mutual funds to Exchange Traded Funds (ETFs) as the latter product has gained very broad acceptance in the marketplace.

I was reminded of just how fast ETFs have gained acceptance after attending a series of meetings and conferences in Hong Kong around the subject of ETFs. As the product is relatively new to the Asian markets, ETF sponsors found it necessary to take a few steps back in their presentations. The concepts that are taken for granted in the relatively mature US and European markets are relatively novel ones in Asia. Going back to first principles can often help clarify one’s thinking.

Exchange Traded Funds

Broadly speaking, ETFs offer almost all of the benefits of traditional open ended mutual funds but add attractive features like lower management fees, trading throughout the day, fairly tight bid offer spreads, good liquidity and no penalties for early withdrawal. Some of these features have been available for decades with closed ended mutual funds (sometimes referred to as Unit Trusts) but the closed ended funds often trade at premiums and discounts to Net Asset Value which are orders of magnitude larger than any potential cost savings or trading benefits to investors.

Fund Management Company vs. Individual Investor

While certainly not the intention, the investor and the fund management company end up on opposite sides of a transaction. In an open ended fund, units are created and redeemed when an investor sends money to the fund management company or redeems his or her units in the fund. While there might be an intermediary, the transaction effectively has only two parties: the fund management company and the investor. Given that most fund management companies have significantly bigger financial muscle than the average mutual fund investor, it should come as no surprise that the fund manager controls the terms of these transactions and is therefore at an advantage.

Unit Trusts suffer from closed structure

In a closed ended fund, units are created once at launch in a process similar to an Initial Public Offering (IPO) for a newly listed company. Like a listed company, a closed ended fund can issue new units in a secondary offering. But once the units are created, they trade on an exchange like any other equity. So again, the transaction has two parties: the fund management company and the investor when the fund is launched and investor vs. an on-market counterparty when the fund is traded on the exchange. As a result, the only time an investor is certain to get a value close to the NAV of the fund is when it when the shares are issued and when the fund is liquidated (or converted to an open ended structure). In between those two events the units can trade at a discount or a premium to the NAV. Since the level and direction of that premium or discount is dependent upon market forces which could be unrelated to the underlying assets, an investor has two elements of uncertainty to contend with when calculating potential returns: returns from the fund’s investment performance and any changes in the discount/premium in the market.

The Third Party makes ETFs work

The difference between mutual funds (open and closed ended) and ETFs is the introduction of third parties to the process of creating and redeeming units in the fund.

The third party consists of one or more institutional investors (often referred to as Authorized Participant or AP) who are able to create and redeem units directly with the fund manager (often referred to as the Sponsor). And behind the APs are the institutional customers and counterparties of the APs who collectively make up 80-90% of the trading in most developed markets.

The third party brings access to a pool of liquidity far greater than the assets in the ETF. As a result, premiums and discounts are quickly arbitraged away as ETFs represent just another tool in the institutional trading toolbox alongside swaps and futures.

How do institutions use ETFs?

Remember that the institutions managing money are not just researching and trading assets. On a day to day basis, fund managers have to contend with cash flows (subscriptions and redemptions), asset allocation changes from Chief Investment Officers, Index rebalancing, tax harvesting, liquidity management, tracking error and client movements (in and out). In short, institutions aren’t just buying an asset because they love it or selling it because they hate it. Most of the trading is actually geared towards balancing the overall portfolio, dealing with inflows and outflows and managing risks.

Why does Institutional participation in ETFs matter?

Institutions dominate trading in almost every asset class. While long term asset prices are decided by the fundamentals, in the short term, institutions call the shots with their overwhelming buying power.

In the case where there are only two parties to a transaction, yourself and an institution, it is fair to say that the player with the greater buying power is very likely to gain the upper hand most of the time. A mutual fund company can stipulate a fee for redemption within 30 days, for example. With a closed ended fund, your sell order has to be matched with a buyer who is more likely than not a professional market participant. Furthermore, the liquidity of a closed ended fund is constrained by the number of units listed. If there are no willing sellers, you might buy at a big premium. If there are no willing buyers, you might end up selling at a steep discount. The net result is “friction” which causes more investment dollars than you might like to disappear in extra fees and wider than expected spreads.

In the case of three parties, the ETF investor is playing alongside two or more institutions each of which have their own agendas and a suite of alternative investment solutions competing for their investment dollars. That competitive tension between the institutions is something that one can “free ride” as an individual investor. Selling an ETF is no longer an administrative event for the fund manager or a trade that needs to be matched by an investor with an alternative view. Trading liquidity arises from institutions arbitraging small differences in asset prices, completing portfolio allocations, changing credit and duration profiles, adjusting beta measures, rebalancing portfolios and a host of other activities. The result? Your trade becomes part of the institutional order flow. Often, that will translate into better pricing for your ETF assets. Better pricing means that more money is left over to boost investment performance.

In the long term investment game maximizing your investment performance so that it can compound to meet your long term investment goals is the only way to play.

ETF Trading Strategies

What are ETFs?
ETFs are “Exchange Traded Funds”. From an economic perspective they are identical to mutual funds, with a few wrinkles. The “Exchange Traded” part of the name means just that – they trade on an exchange. So rather than buying directly from the fund company, you the investor buys units in the fund from another investor on the stock exchange. In all other respects, an ETF is basically identical to a mutual fund.

How are ETFs different than Mutual Funds? Than Closed End Funds?
The primary difference between the Vanguard S&P 500 Index fund (VFINX) and the Vanguard S&P 500 ETF (VOO) is that you buy the ETF on the stock exchange when you want to buy VOO, whereas to buy VFINX, you have to buy directly from Vanguard. In both cases, the number of shares in the funds can expand to meet demand, and can contract if there is net selling. The price of the fund will, because of arbitrage pricing, always equal that of the underlying index, eventually. If the index was $100, and the ETF was $110, an ETF trader would 1) sell short the ETF, 2) buy the shares that comprise the index, 3) tell Vanguard they want to issue new VOO shares, 4) Vanguard would deliver VOO shares to the ETF Trader’s account and 5) The ETF Trader would deliver these new VOO ETFs to cover their short position created in #1. The net would be $10 – buy at $100 and sell at $110. 
This exact same mechanism is why closed end funds often trade at significant premiums or discounts. The fund manager will not issue new shares. As above, 1) the ETF trader would sell at $110, and then 2) buy the underlying shares that make up the portfolio. However, when it comes to step 3, asking the fund manager to issue more shares, the ETF trader will politely be told, “No”. So there is no market mechanism by which closed end funds can see their premiums and discounts arbitraged away. 
Be very careful when buying a listed fund. A closed end fund might behave like an ETF, until something goes wrong. Then you compound your market risk with the risk of everybody else wanting to get out.

How should I buy ETFs?
ETF Trading can be executed with any online broker. Be aware that many online brokers have a variety of agendas. Some try to get you to pay extra commissions for their, “cutting edge research”, some take the informational value of your order and sell this information (i.e. Allow other traders to know that you will be buying, so that these other traders’ computers can trade ahead of you), some try to make it easy to invest.
One of the cheapest and most scalable ETF trading platforms for individuals is www.ShareBuilder.com. They charge $4 to buy, and allow you to purchase fractional shares. If you want to invest $1000/quarter, and the ETF you want to buy is $33.25, they will credit your account with $1000/$33.25 = 30.0751 shares. You will also receive your dividends as additional fractional shares. So you can have all the advantages of an index fund – reinvested dividends, fractional shares – while being allowed to make your ETF trading decisions outside the confines of the “no active trading” policies of most index mutual funds.

Should I pursue a “Buy & Hold” strategy with ETFs?
As with most investment strategies, it depends on you. If you want to know that you will absolutely never be doing worse than the markets, then a Buy & Hold ETF Trading strategy works best. It ensures you will have the lowest costs, the lowest expenses and the “purest” market exposure. It also means you surrender all chances to improve your odds, take more risk for more reward, and requires the most patience. This final point is significant – most investors bailout out of long-term winning strategies only when they are performing at their worst. 
An alternative ETF Trading Strategy would involve varying weightings in various sectors, depending on market conditions. This, “Modified Indexing Strategy” has the advantage that 1) your are always invested (just as with Buy & Hold) and you can avoid the worst performing sectors at the worst times e.g. Tech 2000-’03. Ten years ago, adjusting your portfolio with this strategy in mind would have been prohibitively expensive. Commissions were north of $50/trade, and there were not enough ETFs to meet your diversification goals. Now, commissions are less than $5/trade, and ETFs exist in size and market depth to accommodate investors of any size.

What other ETF Trading strategies should I pursue with ETFs?
With the wide array of ETFs available, “modified indexing” can now be widely practiced by any investor. Whereas in the past, “buying the index” was all but impossible for individual investors, ETFs have made investing in almost any market sector easy and cost effective.
One of the primary tenets that used to favor Buy & Hold strategies over asset allocation strategies was transaction costs. Broker commissions were $75 in the US, and the bid-ask spread was wide enough to add an additional 1% to costs. Try doing that 500 times to mimic the S&P 500. When Vanguard introduced their S&P500 Index fund, they limited short term trading for 2 reasons. The first was that the buyers and sellers impose costs on those remaining in the funds. So this conflict is most easily resolved by adding a 1% backend load to those who hold less than 90 days to discourage this active trading. Fair enough. But the other reason is, Vanguard does not want you to take your money out. They get paid only when you have your money in their funds. Any thing short of this, and their paycheck declines. So even a firm as transparent and investor-oriented as Vanguard still has conflicts of interest. This does not mean they are a bad firm, out to get you. But they do have their own agenda.

What about leveraged ETFS, or other strategies?
There is a long list of articles explaining why ETF trading strategies using leveraged ETFs will not improve your returns, and will, in fact, significantly reduce any gains you might hope to earn in many cases. Further, day trading ETFs in general is a losing game. In addition, if you bought the S&P 500 Index ETF (SPY) at the open of every market day, and sold at the close, assuming zero transaction costs, you would have lost +50% over the past 20 years. If you had bought at the close every day, and sold at the open the following day, you would have made +700%, or almost twice the returns of buying 20 years ago and holding.
Short terms gimmicks for quick profits are in fact just that – gimmicks, like “7 Minute Abs” designed to relieve you of your money. There are many ETF trading strategies that use inappropriate securities, or churn your portfolio.

In general, the simpler the ETF trading strategy you employ, the more reliable your returns will be. The most reliable is Buy & Hold. Indeed, this is the standard to which the entire investment industry is held. There exist strategies such as Modified Indexing which can enhance returns. However, as with any strategy, when comparing one ETF trading strategy to another, there will always be periods where one outperforms another. If, however, the strategy is built on solid ground, the goals of capital preservation with upside participation will be met. 

Of you have any questions or comments, please write us at admin@fundlogik.com 

Automated Trading Systems – What are they, and why you need one.

What is an automated trading system?

An automated trade system is any approach to trading whereby you use rules – rather than discretion, instinct or, “gut” – to make investment decisions. When we read about most successful investors, we hear stories of their investment acumen, and how they were able to find the best investments using their own instincts and research. However, these individuals represent a small fraction of all investors. The odds are heavily against you winning the investment game if you try to rely on your own instincts and luck.
This is where automated trading systems come into play, and serve their usefulness. An automated trading system looks at past market behavior (which is actually human behavior) and makes recommendations, based on this recurring behavior. It is much like Arctic explorers 100 years ago. Byrd did not know where he was going, but he had a compass, which proved to be enough. Approaching markets these days without your own automated trading systems can be like venturing into the cold Arctic wilderness without even a compass.

Why do I need an automatic trading system?
We need systems – or methods – because we need filters. In almost every line of work, there is a deluge of information. We could spend our entire day, every day, reading new information and still be no better informed than when we started. So an automated trade system will enable you the investor to filter information, and make timely decisions regarding your investment portfolio, rather than being subject to, “paralysis by analysis”.

How can automated trading systems help me?
Automated trading systems help to relieve us of the anxiety of making blind decisions. When the market has been languishing for a few months, and many seasoned professionals are on the media outlets calling for further downside, it is very easy to feel fear, and ignore signs that the market is coming alive again. An automated trade system will give an unambiguous, unemotional signal to buy or sell, even if the majority of the press is calling for the contrary. An automated trading system will measure how market participants are voting with their dollars, rather than what they are saying on television.

Who can benefit from systems?
Everybody can benefit from automated trading systems. All investors – even professionals – have a finite amount of time to allocate to decision making. With an automatic trade system, all investors can streamline their investment process so they can focus on other tasks – work, social, and family.

How can you implement a trading system?
Aside from fund-logik.com, there are many methods by which to implement an automatic trading system. One of the simplest can be found at
www.DogsoftheDow.com. The advantage of these and other automatic trading systems is that they can be implemented by people who are not programmers, and who are not day trading. Investors can reap above average returns through a careful, disciplined approach to investing. This discipline is most easily implemented with the help of automated trading systems.

If you have any questions, please do not hesitate to write admin@fundlogik.com