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 

Selecting an Asset Universe

The Fund King System is all about promoting systematic investment as a way to reduce the emotional component of investing that so often ends up hurting out portfolio’s performance.

This week, in response to several users’ comments, I am going to outline how to construct an Asset Universe that will suit my needs and also work well in the Fund King System. I fully expect that someone else would follow the same process and come up with a different mix at the end of the process.

I approach the process in a top down manner because my role is to be the Asset Allocator for my investment funds. Other people are going to execute trades, hold the securities and decide which securities will meet their obligations to me. By leveraging off of that expertise (which I am already paying for in commissions, custodian charges and management fees), I can invest in a broad range of asset classes without having to visit a single factory.

To do “top down” correctly, I need to start broadly and then trim down my options to get a portfolio.

The first question to start with is: What do I know? Am I stronger in equities, bonds, commodities, currencies or real estate?

The second question is: What can I learn about? Are there any areas that I could expand into with a reasonable amount of effort?

Third, check for holes. Going forward it is reasonable to expect periods where developed market stocks and bonds may be stuck in a downtrend. At that point, I want to have some commodities, metals and/or currency opportunities to continue making money while more traditional asset classes sit on the sidelines.

This should give us a good list of sectors from which we can build up a shopping list of mutual funds, ETFs and/or ETNs.

Investing in what you know

Most of us have grown up with equity investment but some have cut their teeth on the bond market over the last three decades of almost uninterrupted bull market. Perhaps you have a strong feeling about precious metals as a hedge against paper money. You might think that the world is going to end up paying much more for foodstuffs or maybe you want to buy into real estate.

As an economic participant in the markets every day, you actually have access to a tremendous amount of information. Start building up your universe of investment opportunities with ones that you know well. If the universe starts to get too crowded or you find something more exciting in the next two steps, you can always substitute.

Try to keep things as broad as possible. You may be tempted to start picking individual ETFs or fund families but you will end up with a stronger universe and a better refresh process if you take the time to evaluate a broad spectrum of products, ideas and opportunities.

Investing in what you can learn about

It is unlikely that any one of us will possess enough information to feel equally comfortable with every asset class. However, since we are looking at funds (mutual funds and ETFs) a lot of the nitty gritty details are dealt with by the fund manager whom we are paying with a management fee.

This is where most of us have to step outside our comfort zone. But it is important to remember that we are not going to be auditing Eastern European bank balance sheets, Asian petrochemical refineries and South American airframe manufacturers. The idea here is to find assets that may grow in the coming few years. The emphasis is on “may”. If we pick one or two dud assets in our universe, it will not matter overly much because our trading system will keep us invested in the most promising assets. But we do not want to get too complacent. If we pick too many similar or underperforming assets, the system will just be choosing between mediocre investments. As any chef will tell you, no amount of culinary skill will make a great meal out of lousy ingredients.

If we have been primarily US bond investors, it is time to venture into equities (domestic and foreign), emerging market debt, commodities and perhaps even currencies.

What if I don’t like junk bonds?

I don’t like JNK…do I have to include it? No. In fact, decide to actively exclude it. What do I mean by actively? Just admit you don’t like JNK and move on. When your neighbor brags about how he made money one week in the future trading JNK on margin, you can nod politely and imagine all the loss making positions that he neglected to bring up with you. The idea is to make money on the whole portfolio. The actual assets are just tools towards that goal.

If you have a bag of preconceptions that you have brought to the investment process, this is the one place where you can unpack and use them. It may make sense for you to include Russian Equities or a soft commodity ETF in your universe from a pure asset allocation point of view. However, if the idea of dabbling in commodities or investing in Russia makes you uncomfortable for whatever reason (logical or otherwise), then it makes sense to exclude them from consideration at this point in the process.

As a live example, I included home builders (XHB) and Spain (EWP) in my universe as the Global Financial Crisis started on the logic that they would fall sharply and then have some sort of recovery. Both eventually staged rebounds significant enough to be ranked in my System. But because I had strong negative feelings about the underlying assets, I not once but twice (because the rebounds happened at different times) hesitated to buy when the signal came up, kicked myself and bought just as each was peaking and did not cut my losses immediately when they fell back into the general pool. As a result, I allowed my emotions to interfere with what was otherwise a pretty decent investment strategy designed to capture a meaningful rebound in two bombed out assets. After these two helpings of humble pie, I decided to eject the offending ETFs from my universe. There was nothing wrong with the ETFs or the way they performed. The problem was me. So, with plenty of other investment fish in the sea, I took my lumps and moved on.

Leveraged ETNs may be a good category to exclude in the beginning. The reason leveraged ETFs cause trouble is not because they are inherently bad investments but because most retail investors do not understand how to use them and do not have the time (or inclination) to watch them throughout the trading session.

Where are the holes?

We have all heard about diversification and its benefits. Those benefits exist but they were a bit oversold during the “Great Moderation” in the 80s and 90s when most asset classes were in a bull market. We approach diversification in a different way. Rather than holding a diverse basket of assets, we concentrate our investment dollars on the assets that look the most promising. However, to do that, we must consider a broad range of assets in the first place, rerank our universe regularly and invest according to the system (ie. do not let “gut feelings” intervene). Diversification for us means having enough different assets to prepare for the different market conditions that are likely to crop up over the medium term (3-5 years).

So, look for holes in your list of potential assets. You do not need to add a lot of currencies but if you are US based, why not add the Japanese Yen or Euro? You do not need to aspire to becoming a pit trader in Chicago to include some precious metals , industrial metals or a soft commodity basket. And, although you may fancy yourself as a risk taking equity person, there is no reason not to include some short and medium term government bond funds for those times when no one is making money in equities no matter how aggressive your trading stance. Also, you might want to consider some sector funds. While the market has been volatile, the overall direction has been neither particularly positive nor negative over the last decade. Investment flows have become “rotational” as professional investors seek to eke out performance by chasing down the next hot sector.

OK, now that you know where to look, how do you find the funds and ETFs that meet your criteria?

The first place to look is your online broker. TD Ameritrade, Schwab, Fidelity, Vanguard and all the other providers all have excellent tools which can help you zero in on funds and ETFs that match your shopping list.

You want to check beta vs. the index, and if you can see it, the top 10 holdings (just to make sure that what you read on the label of the fund is what you think should be inside). For ETFs, you should check the daily volume. If you are going to be a major (over 5% of daily volume) trader by placing a buy or sell order, you might want to look for a more liquid alternative. ETFs have a bid-ask spread which can get unacceptably wide if the Similarly, you should also make sure that any mutual fund you invest in has a decent amount of Assets under Management (AUM). You do not want AUM to drop to a point that the fund manager decides to close the fund or merge it with another. Nor do you want to be in a position where one large redemption will impact your interest.

ETNs have one more level of due diligence since they are senior obligations of the bank/sponsor that issues them. Whereas the assets in a fund belong to the share or unit holders even if the management company goes under, the assets of an ETN are part of the bank balance sheet that has to satisfy all creditors. If we had not just gone through the Global Financial Crisis, most people would not care about the difference. Now that we know better, just make sure that you are comfortable with the counter-party risk. If in doubt, leave the ETN on the cutting floor and move on.

How many assets to you want to watch?

Try to whittle the list down to 20. Why 20? Because this is an active process and trimming the list to just 20 assets will force you to think carefully about each one. What if you chose a mid cap value ETF over a mid cap growth? If the equity markets are not in a cooperative mood, the System will tell you not to hold either.

Remember, more does not always equal better. If you have 5 tech funds in your universe, they will all move pretty much together relative to non-correlated assets like Silver or Treasuries.

If you are stuck for ideas, ETFdb.com has just put out a page with a number of useful sources that can help you. Check out this page of 50 free ETF tools.

So what is the final result?

For my “Seeking Alpha” Portfolio, I have come up with this. Is this the end of the process? Hardly. I plan to review this list once a quarter to fill holes and make sure that I have all of my investment bases covered. For example, I might want to drop one of my developed and one of my emerging markets and replace them with a Real Estate and another Fixed Income choice. That would add better balance to the universe.

Equities

Developed Markets
SPY – US Equity Market
FEZ – European Equity Market
EWH – Hong Kong Equity Market
EWY – Korean Equity Market
EWT – Taiwan Equity Market
Sectors
IXC – Global Energy Sector
IXG – Global Financial Sector
XPH – Pharmaceutical Sector
Emerging Markets
EWZ – Brazilian Equity Market
RSX – Russian Equity Market
EPI – Indian Equity Market
FXI – Chinese Equity Market
EWW – Mexican Equity Market
TUR – Turkish Equity Market

Fixed Income

TLT – 20+ Year US Treasuries

Currencies

FXY – Japanese Yen
FXE – European Euro
FXA – Australian Dollar

Commodities

DBA – Agricultural Futures
GLD – Gold
Weekly Ranking of the Seeking Alpha Universe

The Seeking Alpha Portfolio

As mentioned in last week’s post, we switched out of 370 shares of EPI (Indian Equities) to invest in 320 shares of DBA (Agricultural Commodities Basket). The EPI netted us $9190.25 (and a short term capital loss of $710.95) and we bought the DBA for $9371.15. Our cash balance falls to $345.95.

Last week, we participated in the general rebound to the tune of +4.11%. Overall, we are still down 3.53% from our starting point on November 15th.

There are no changes in the ranking this week so we will see how our portfolio of Hong Kong, Turkey and Agriculture fares in the choppy markets that seem destined to persist for the foreseeable future.

One final note

Just to follow up on an issue we explored earlier, it seems that hedge fund performance has generally not lived up to expectations (Bloomberg article). This might lead to some sell off in some of the favorite names. One of the biggest, AAPL, may be in for a bit of profit taking as the year closes and redemptions need to be paid out. We do not hold AAPL (long or short) nor are we suggesting that you should take any action. We are using the stock simply as an indication of the magnitude of the Hedge Fund redemptions.

The SPDR Page

In an overall trendless market, you can still make money by trading the sub-sectors within a given market. This video shows you how we apply the Fund King System to the 15 Sector ETFs (and their underlying stocks) that make up the S&P500.

Watch this week’s Video Review to see what we are talking about. Click the full screen icon to the right of the volume controls if you want to see a larger version.