Tag Archives: etfs

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)].

Capturing The Move Higher In 3-Month Deposit Rates

Summary What we’re trading and how. Full disclosure of trade entry, objective and strategy. If the Fed’s expectations for rates are right this position will appreciate from $2,050 at 0.82% to $5,000 at 2.00% by December 19, 2016. Linked is an interactive risk/reward spreadsheet enabling you to experiment with any potential outcome for this trade or your own trading criteria. I’ve included instructions on how to use the interactive risk reward spreadsheet. Three-month deposit rates outside the Treasury system (Eurodollars) are the most liquid futures contract on the board. Open interest (contracts outstanding) is greater than the Dow, S&P, Gold, Silver, Crude Oil, Gasoline, Euro-FX, Yen, Pound, Canadian and Australian dollars combined. (6.9 million versus 11.3 million) Click here if you’re not familiar with what this rate is, how it’s set and the underlying futures contract. Capturing the move higher This simple trade runs through December 19, 2016. Short the December 2016 ( GEZ16 ) 3 month rate futures contract at 99.18, trading this rate higher from 0.82% contract value $2,050. Objective = 98.00, rate 2.00% contract value $5,000 consistent with the lowest of the Fed’s disclosed expectations . Click here to enlarge the rate, price valuation chart below A short 99.18, B objective 98.00. (Video 1:59) Last objective guidance of where Fed Chair Yellen sees the Fed funds rate and when. Source: Federal Reserve Correlation between the Fed funds and 3-month deposit rates (Eurodollars) the average for the 3 month is +.25% to Fed funds. (click to enlarge) Qualify risk/reward by experimenting with any potential outcome for this trade and match it to your current risk investments. Click here and open the December 2016 risk/reward spreadsheet. When the spreadsheet opens enable it. Click here for current quotes and charts (December 2016) enabling you to track this trade or experiment with any potential outcome for this trade using the data on the Exchange’s site. How to use the spreadsheet 1) Entry Price = short December 2016 at 99.18 (B-9) 2) Enter any contract price in cell B-3 3) C-3 Shows the rate the contract price represents 4) D-3 Initial investment 5) E-3 Net profit or loss 6) F-3 Net liquidating value 7) C-4 Deposit per contract Any entries can be changes to experiment with your own criteria. Click to enlarge Click here for the CME Fedwatch for rate expectations

Not Owning Stocks Today Is Risking Dollars To Make Pennies

A recent article posited that owning stocks today is “risking dollars to make pennies.” A review of historical data suggests this is alarmist and statistically unlikely; it also implies an overly narrow definition of risk. Stocks in general are expensive, but they still offer better return potential than bonds over the next decade, and there are plenty of individual stocks that offer low-risk returns. A recent article proclaimed owning stocks today is risking dollars to make pennies . For investors with a sufficiently long time horizon, I believe the truth is the opposite: NOT owning stocks today is risking dollars to make pennies. I’m not advocating being all-in on the S&P 500 or anything like that – I have plenty of cash reserves – but in line with Seeking Alpha’s “read, decide, invest” motto, I think it’s important for investors to understand both sides of the issue. I would recommend you read the linked article (written by Jesse Felder) prior to going any further. Let’s start from a high level: What does “risking dollars to make pennies” mean? Well, according to Jesse, it means stocks are so wildly overvalued that your potential return over the next ten years is miniscule, and your potential downside is massive. I posit this is: A) alarmist and statistically inaccurate; B) overly narrow in its definition of risk; and C) treats “stocks” as some monolithic entity (which devalues the excellent investment ideas posted every month here on Seeking Alpha). Starting with point A: What is the actual likelihood of stocks resulting in a significantly negative 10-year return? Here’s a link to a nice document providing this data from 1926 through 2013 in both tabular and graphical format. Summarily, there were only a very few rolling 10-year periods when investing in the S&P 500 would have resulted in losses in nominal terms. Specifically, you would have had to invest right before the Great Depression or in the late 1990s – two of the larger bubbles of all time. Even on an inflation-adjusted basis, there were not many periods when stocks had negative returns. Most of the time, stocks have had substantially positive 10-year returns, averaging 201.15% across all rolling ten-year periods during those 87 years. The two supporting arguments for the author’s assertion that the 10-year return on stocks will be less than the risk-free rate are: a graph of GDP versus market cap over time, and a graph of household equity ownership. The former is merely one data point that ignores substantial changes in the makeup of the economy. Relative to the past, today it is much more service- and knowledge-oriented – thus, there are higher returns on capital. This statistic also ignores changes in effective tax rates over time, which have benefited reported profitability (and consequently, valuation). As for the latter point of equity ownership, let’s discuss that. Point B: Paraphrasing the original article title, I believe NOT owning stocks today is risking dollars to make pennies. Paltry yields on fixed income mean traditional “your age in bonds” portfolios may no longer achieve the returns they used to, and this is likely one factor driving more investors into equities. The 10-year yield barely exceeds the Fed’s targeted inflation; while there are reasons to believe inflation may be on hold for now, the point remains that you will make no more than pennies by investing in bonds. Moreover, there is more than one definition of “risking dollars” – assuming you have a ten-year or greater time horizon and need to invest to fund long-term liabilities (kids’ college funds, retirement, etc.), then earning near-zero returns by investing exclusively in bonds is just as much of a risk as potential volatility from investing in stocks. Risk, in this context, means you won’t meet your financial goals – and if you don’t invest in any stocks, it’s very hard to see how you will generate sufficient returns with yields on fixed income where they are. Please note that I am not arguing stocks are cheap – in fact, I think most indexes are on the expensive side – I’m just saying that if I had to put all of my money in either stocks or bonds for the next ten years, it would be stocks without a question. Finally, point C: I think it’s unfair to treat “stocks” as a monolithic entity – as if you either own the S&P 500 (NYSEARCA: SPY ) or you do not, and there’s no other alternative. Even if you believe the market as a whole is overvalued, like I do, that doesn’t mean every single component of the market is overvalued. To the contrary, there are plenty of low-risk, high-quality companies with good management teams, conservative balance sheets, and solid future prospects that trade at reasonable multiples of cash flow or earnings. One such company which meets these criteria is Prosperity Bancshares (NYSE: PB ), which I’ve written about here . That is far from your only option, of course – but as long as you stick to those basic criteria, you will certainly be able to identify companies that will outperform 10-year Treasuries or corporate bonds. If you can’t find a single stock which meets these criteria, then you’re not spending enough time on Seeking Alpha! To conclude, there is a charming (if crude) saying about what part of your body opinions are like – the punchline is “they all stink” – and this aphorism applies especially to macro predictions, which almost always end up being wrong. Economists have predicted 12 of the last 2 recessions, etc. The future is obviously unpredictable, so we have to make logical decisions based on the information we have available. Despite the high valuation of most indices, stocks (whether individually or via ETFs or mutual funds) still seem to offer much better prospective returns over the next ten years than fixed income. As such, while it’s obviously the responsibility of every investor to determine their own risk tolerance and investment goals, it seems not owning any stocks is risking (future) dollars to make pennies.