Tag Archives: etf

An ETF Primer

Via Robert Sinche at Amherst Pierpont Securities: Every once in a while a topic, usually the media coverage of a topic, creates a burr in my saddle, as they say. While that has taken place less frequently as I age, the coverage of the ETF market, and particularly the High Yield ETF market, has now reached that level. To be sure, the detailed operation of the ETF market is complicated and I have benefitted significantly from a dialogue with my former colleague and BlackRock Chief FI Investment Strategist Jeff Rosenberg. What I present below, however, are my views and may or may not represent his views. So, there seems to be the view that the creation of ETFs have brought capital into various market segments and, somehow, have added to risk and volatility in those markets. High yield bond ETFs currently are the target of many. But to argue that somehow the money that flowed into ETFs is now creating forced selling and excessive volatility reflects what I think is a lack of understanding on how ETF construction takes place . To be sure, the process IS very complicated and I can understand the misconceptions, and hopefully this note may add some information to the discussion. Jeff forwarded a 2012 paper (pdf attached) by Downing and Lyuee, and for those who want to go through the detailed analysis feel free to do so. What I am more interested in is their excellent discussion of the ETF creation process on pages 3-4. The key quote from the paper is below. As I understand the issue, the selling of ETFs generally only leads to the selling of the underlying assets when there is an arbitrage opportunity for the APs (see below) to buy the ETF and sell the underlying if the price of the ETF falls too far below the NAV of the underlying securities. But it also can work the opposite way – if the underlying securities get too cheap relative to the ETF price, the APs can buy the underlying securities and sell the ETF in the market. It is in this context that ETFs could trade huge volumes at prices set in the open market between buyers and sellers without having to transact ANY underlying securities. In other words, transactions in the underlying securities will take place because of arbitrage opportunities, not simply because investors are selling the ETF . In this context, it does seem to me that ETFs can increase market liquidity and price discovery, not exacerbate the situation in illiquid underlying markets. This is actually different than the open-end MF market – if investors sell their positions in open-end funds the fund company must liquidate underlying securities (unless they already were holding cash positions,), a much bigger problem for the underlying market. Comments/feedback/correction appreciated. Exchange-traded funds (ETFs) are investment vehicles that combine the key features of traditional mutual funds and individual stocks. The typical ETF structure is much like a mutual fund in that shares in the fund represent claims on a portfolio of securities. Typically the ETF portfolio is constructed to track a publicly available index such as the S&P 500. Like stocks, shares in an ETF can be bought or sold (long or short) on an exchange throughout the trading day. This is in contrast to mutual funds, where transactions in shares of the fund occur directly with the fund company at the close of each business day. The pricing mechanism of ETFs relies on the so-called “creation/redemption” process. If an ETF is trading at a price that is higher than the sum of its constituents’ prices, i.e. trading at a premium, the Authorized Participants (APs), which are usually market makers, can purchase the underlying securities and exchange them for shares in the ETF with the ETF manager, and immediately sell the ETF shares on the exchange for a quick profit. This creation mechanism ensures that any premium in ETF pricing is arbitraged away by the APs. The redemption process, which eliminates discounts in ETF pricing, works in the reverse direction. The composition of the basket of securities eligible for creation/redemption is published daily by the ETF manager. In practice, ETF managers may not require that the basket of securities to be exchanged for ETF shares perfectly match the published holdings given the liquidity constraints imposed by the underlying market (i.e., not every bond is trading everyday). The manager may decide to accept a basket where some securities are substituted by similar securities if the substitution would not increase tracking error. One common misconception is that ETFs are “forced sellers” of bonds when markets decline. The rationale behind this view is that, as markets fall and investors sell ETF shares, the ETF portfolio manager will be required to sell securities to fund redemptions. This dynamic does in fact occur with traditional open end mutual funds. While open end mutual funds typically carry a cash reserve to help facilitate redemptions, this reserve may be quickly exhausted during periods of larger outflows, resulting in a sale of securities by the mutual fund portfolio manager. In contrast, ETF investors sell shares of their ETFs on exchange. Whether or not an ETF share redemption ultimately occurs will be driven by the relationship between the exchange market price of the ETF and the actionable value of the underlying redemption basket. If it is economically attractive to exchange shares for bonds, APs will likely seek to do so. At the extreme, if bond markets are impaired, ETF investors may still be able to liquidate their shares on exchange, albeit at a market price that could differ appreciably from the NAV and the ETF’s index (both of which may lag given the limited trading activity in the OTC bond market). In this sense, ETFs do have an additional liquidity venue the exchange which may actually serve to reduce the amount of trading activity in the OTC bond market relative to a traditional open end bond mutual fund. Critics often cite the appearance of anomalous premiums or discounts during periods of market volatility as evidence of dysfunctional behavior in the ETF. However, such behavior often reflects elements of price discovery given the gap in liquidity between the ETF and the underlying bond market [Tucker and Laipply (2012)].

Fossil Free ETFs Head To Head: ETHO Vs. SPYX

Pollution and global warming caused by fossil fuel has been on the rise lately. Global superpowers are leaving no stone unturned to restrict greenhouse emissions, protect the climate and go eco-friendly. President Obama has always been active in cleaning up carbon pollution. A proposed Environmental Protection Agency rule even seeks to reduce 30% carbon emission from power plants by 2030, compared to the levels in 2005. China announced its intent to build a pollution-free environment. And as part of this mission, the president of China and the U.S. president Barack Obama struck a deal to lessen carbon emissions (read: Fight Global Warming with These ETFs ). The agreement calls for carbon emission reductions by 26% to 28% in the U.S. by 2025. It also includes the first-ever commitment by China to stop emissions from growing by 2030. Not only from the social perspective, it has also been noticed that fossil fuels cast a dark shadow on economies and the associated stock markets. The latest theory is that this monster can ” cause job losses, recessions and even a tumbling stock market” according to economists. It is perhaps because of this grave concern that we received two fossil-fuel ETFs from issuers, namely, the Etho Climate Leadership U.S. ETF (NYSEARCA: ETHO ) and the SPDR S&P 500 Fossil Fuel Free ETF ( SPYX ) within just one month. Below we detail these two funds and highlight their key differences: ETHO in Focus This new ETF has a 398-stock portfolio having a carbon emissions profile that is 50-70% lower per dollar invested than a conventional broad-based benchmark. The index studies total greenhouse gas emissions from over 5,000 equities to choose ‘climate leaders’ in each industry. No stock accounts for more than 0.63% of the basket. Netflix (NASDAQ: NFLX ), M&T Bank Corp. (NYSE: MTB ) and Universal Display Corp. (NASDAQ: OLED ) are the top three holdings of the fund, which charges 75 bps in fees (read: How to Invest ‘Fossil-Free’ with This New ETF? ). Technology is the fund’s top priority with 23% exposure while industrial, consumer cyclical, financial and health care also have sizable weights. The fund puts 41% in mid-cap stocks while large caps rake in about 37% of the basket with the rest going to small-cap stocks. The fund has a tilt toward growth stocks with 57% exposure followed by 22% focus on blend and 21% in value stocks. SPYX in Focus The fund looks to tracks the S&P 500 Fossil Fuel Free Index which measures the performance of companies in the S&P 500 Index that do not own fossil fuel reserves. The 473-stock fund is heavy on Information Technology (22.37%). Financials, Health Care, Consumer Discretionary, Consumer Staples and Industrials have double-digit weight in the fund. No stock accounts for 3.92% of the portfolio. Apple takes the top position followed by Microsoft (2.60%) and General Electric (1.66%). The fund charges 20 bps in fees. Capitalization-wise, the fund puts about 90% in large caps. Here too, growth stocks take about 48% weight followed by value stocks (29%). ETHO SPYX Index The Etho Climate Leadership Index the S&P 500 Fossil Fuel Free Index Expense Ratio 0.75% 0.20% Company concentration risks Extremely low Relatively high Index composition Equal weighted Capitalization-weighted Capitalization Multi-Cap Large-cap Style Blend with a focus on growth (57%) Blend with a focus on growth (48%) Link to the original post on Zacks.com

Why I Will Likely Be A Buyer Of High Yield In 2016

The yield in junk bonds has been steadily rising as the price of the bonds in the underlying portfolio have been falling. The biggest concern in this fixed-income sector has been the decoupling from U.S. equity markets. From a psychological standpoint it seems like we have gone from complacency to extreme fear in a hurry. By now you have probably read everything about the death of high yield bonds, the investor lockup at Third Avenue, and the risk that these “junky” assets pose to exchange-traded funds. Believe me, the financial media is just getting started slicing and dicing this thing up. Everyone loves to sink their teeth into an investment that is tanking. It makes for great headlines and offers a curiously similar effect as gliding by an accident on the freeway. Despite our best intentions, we all slow down to take a peek. As an avid watcher and owner of ETFs , I have been closely monitoring the price action of the iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA: HYG ) and the SPDR Barclays High Yield Bond ETF (NYSEARCA: JNK ) this year. These two ETFs represent the lions share of the below-investment grade fixed-income space, with combined assets of $25 billion. HYG is now down nearly 10% from its 2015 high and currently sports a 30-day SEC yield of 7.20%. That yield has been steadily rising as the price of the bonds in the underlying portfolio have been falling. The biggest concern in this fixed-income sector has been the decoupling from U.S. equity markets. The SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) is 5% off its high and still in the middle of its 52-week trading range, while high yield bonds continue to make new lows. That is uncharacteristic of the typical correlation between these two asset classes and has many wondering if stocks are going to follow lower or junk bonds will ultimately rebound. You would probably be hard pressed to find anyone admitting to owning these investments at this stage of the game. However, there are literally millions of investors who own some form of junk bonds. That may be through direct exposure in a fund such as HYG or indirectly through diversified corporate funds, aggregate indexes, bank loans, or a multi-asset fund structure. It’s become an ubiquitous part of the chase for yield over the last several years and far more common than most investors understand. From a psychological standpoint it seems like we have gone from complacency to extreme fear in a hurry. HYG peaked in April, yet the accelerated nature of the sharp sell off in the last six weeks has investors whipped up into a frenzy. This is the inner monologue that I imagine has taken place in many heads this year: HYG down 2% – “Bit of a sell-off here. Time to add to my holdings.” HYG down 4% – “Spreads are so juicy at these levels. I’ll nibble on a little more” HYG down 6% – “Well this turned ugly quickly. Maybe I bit off more than I can chew.” HYG down 8% – “Get me the hell out. Cash is king.” HYG down 9% – “Haha, who would be dumb enough to still hold this stuff? Glad I sold down here. Now I’m safe”‘ HYG down 10% – “Wow, look at it still cratering. Maybe I should go short….” That last one made me cringe as I saw several probing articles and social media anecdotes pointing out funds that short junk bonds last week. They certainly do exist, although if you are asking about them at this stage of the game, you are probably a little late to that trade. That’s just my personal opinion – things can always get worse, and we may still face a high volume capitulation event before a true bottom is formed. There are two important points that should be understood at this juncture: This whole thing is probably not as bad as everyone has made it out to be. The “bubble has burst” or “high yield is dead” is likely driven more by headline artists than true investors in this space. We see the same type of sentiment and conviction when stocks go through a 10% corrective event. It’s always the end of the world and yet somehow it’s not. The same psychological cycle of greed and fear that we are accustomed to in stocks is going to take place in this fixed-income sector as well. It will seem cataclysmic and disastrous until it reaches a point where everyone who is going to has sold. That will be the inflection point that will ultimately create a sustainable bottom and drive prices higher. It may be in the form of a V-shaped reversal or a more rounded consolidation that takes months to stabilize and swing higher. No one knows for sure when that inflection point may be. However, I’m closely watching technical indicators such as prior support levels, volume, sentiment, high yield spreads, and other key variables. These will be the pieces to the puzzle that give us some indication that junk bonds have turned the corner. Rather than getting overly bearish at this juncture, I’m viewing the sell off as a long-term tactical opportunity. The key is knowing how this sector fits within the context of your diversified income portfolio and sizing your exposure correctly to your risk tolerance . My plan is to purchase an income-generating asset class at attractive levels relative to other bond alternatives. That’s likely a contrarian view right now, but in 2016 it may look quite different. For now, I’m keeping my powder dry and my eyes open. I suggest that other serious income investors do the same and consider scaling into any new positions slowly over time. This will allow you the flexibility to size your holdings appropriately and use time or price to your advantage.