ETF Basics: ETFs are No More Of A 'Derivative' Than Mutual Funds

Dec 28, 2010

We have noticed that there still seems to be a fair bit of misunderstanding among those new to ETFs. While the structure of ETF's is different than you may be used to  -- it is really not that complex.   

Ignoring leveraged and inverse ETFs --- the vast majority of ETF assets are plain vanilla index funds --- they are not derivatives.  

Some people think that since ETFs are only representing shares -- and that they aren't actually the underlying securities--- this therefore makes an ETF a derivative.   But this is simply not true.    The ETF holds the actual shares it represents just as when you buy a mutual fund, you don't get the shares delievered to you --- you get mutual fund shares that represent the underlying securities.    Clearly everyone should understand that mutual funds are not derivatives.   They are classified by the S.E.C. as investment funds --- which is how the S.E.C. categorizes ETF's as well.

In fact, you could argue ETFs are less of a derivative than a mutual fund as in the ETF process, actual shares are passed for any creation/redemption.    This is not true when buying a mutual fund.   If you send $2,000,000 to a mutual fund, they create shares for your purchase -- but they do not necessarily buy anything with that money --- it could just sit in cash, it depends on the decision of the portfolio managers.   During this process, no exchange is necessarily involved.   You can send your money directly to a mutual fund company and no exchange would ever know the difference. There were some scandals on this topic in the early 2000's that you may remember regarding late-trading and manipulation --- this was only possible because there was little transparency of this off-exchange activity.   

To better understand how simple this really is, below is an image of the basic mechanics.    Note that in reality there are actually custodians, index information providers, authorized participants and market makers involved ----   but those are all peripheral considerations.


Note also that because the shares are created behind the scenes and the shares traded are on an exchange, this opens up a few new markets.   Now you can sell ETFs short and/or you can trade options on these exchange products.   Neither of these are possible when the creation occurs directly to the investor. Even if you never sell short or trade options, this activity is actually good for you --- as all this incremental trading volume created by options participants allows the ETF provider to cycle out lower-cost shares in the tax-free exchange between the exchange and the ETF provider. You can see in the diagram above how this is only possible because the exchange sits BETWEEN you and the fund provider.




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Vinik ETF Holdings & $1 Trillion In Assets

Dec 18, 2010 in Hedge Funds
Two interesting news items this week:

U.S. ETF assets broke through $1 Trillion in assets for the first time this past week. Global Head of ETF Research and Implementation Strategy at BlackRock Deborah Fuhr said in a press release:

“Increasingly both retail and institutional investors are building global, multi-asset portfolios that are designed to capture the performance of key ‘benchmarks’ for attractive market sectors -- an application for which ETFs and ETPs are particularly well suited,” Ms. Fuhr said. 

Dovetailing nicely with Ms. Fuhrs quote above --- there was a report late in the week that highlighted the extensive use of ETF's by former Fidelity Magellan portfolio manager and long-time hedge-fund manager Jeff Vinik.

As an institutional investor, Vinik must disclose holdings and his September 30, 2010 13-F from his SEC filing is summarized below:

Looking over Viniks holdings, the exposures are specific: U.S. sector tilts, U.S. Small Cap, and Emerging Markets exposure.  Note that SPY is the only of Viniks ETF holdings that is a diversified U.S. large cap index. 10 of the 11 other ETFs represent targeted exposures. 

In the grand scheme of things, $1 trillion in assets is still a drop in the bucket --- ETF/ETN assets are poised to head dramatically higher over the next 3-5 years. 

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ETF Screener Feature Added

Dec 14, 2010 in Screener

Screenshot of ability to combine multiple ETF portfolios into a single list on the ETF screener.    This example takes a list of 25 commodity ETN's (tracking the underlying commodity) and combines this list with 25 commodity stock ETF's.   You can combine as many lists as you would like and/or 'Select All.'



ETF Strategy Focus: Small & Midcap Stocks

Dec 12, 2010
When we launched the ETF Relative Strength Reader module on November 17th, we used a current example of a market rotation toward mid-cap stocks within the introduction video (the video is here: RS Reader Tools Page ).   Since then, this mid-cap ETF segment has shown strong continuation upward, consistent with the relative strength concepts on which our site is focused.  

Owning small companies is a classic strategy that is implemented not to reduce risk – but to enhance overall portfolio return.   The argument goes that small cap companies are generally more dynamic than large cap companies --- with greater growth rates and generally in less mature sectors.   

The story you don’t hear as often is that small cap companies can also be quite fragile.    With the higher growth-rates also comes higher execution risks.   Thus, small cap investing is an information-intensive business.   Hedge funds and large institutions have dramatically better resources to gain an information edge.   However, there is a catch-22 for the investment manager --- success in small cap investing bloats your asset base and then you can no longer be nimble enough to take advantage of your information edge.  

Small cap indexes are higher beta (more aggressive) strategies by their nature.    You don’t need to buy leveraged funds (ie the 2x and 3x funds) that suffer from very significant structural flaws --- instead of such funds, if you want to express more aggressive views, you can do so simply with more aggressive, unlevered strategies.   One such is small cap.   Think of small cap not as ‘your permanent strategy’ --- but one of many return-enhancing strategies at your disposal.   

I find this idea of international small cap investing quite intriguing.   It has simply not been possible to do this kind of thing in the past (at reasonable cost and with such precision).   These ETFs for the most part are not very liquid yet --- and many of these are brand new.   But this is one of 50+ examples of the TYPES of things that ETFs are essentially inventing:  ways for the advisor and sophisticated individuals to pursue ultra low-cost strategies that 1) don’t require stock-picking and yet 2) offer the ability to add significant value over a core allocation.







Note: Ameritrade, Fidelity, Schwab and Vanguard all have one or more small cap ex-US products that are zero commission --- and of course all have extremely low expense ratios. It's quite amazing really when you think about it.


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ETFreplay does not provide investment advice.  All content of this blog refers to past relationships.


Research Links on Relative Strength

Dec 08, 2010 in Relative Strength

Some links to published research on various forms of relative strength concepts. The concept is over a century old. (I am not aware of any studies that involve ETFs directly -- let us know if you know of one). Copy-paste URL into browser.


Abstract from paper #1 above 'Time Series Momentum':


"We document significant "time series momentum" in equity index, currency, commodity, 

and bond futures for each of the 58 liquid instruments we consider. We find persistence 

in returns for 1 to 12 months that partially reverses over longer horizons, consistent with 

sentiment theories of initial under-reaction and delayed over-reaction. A diversified 

portfolio of time series momentum strategies across all asset classes delivers substantial 

abnormal returns with little exposure to standard asset pricing factors, and performs best 

during extreme markets.  We show that the returns to time series momentum are closely 

linked to the trading activities of speculators and hedgers, where speculators appear to 

profit from it at the expense of hedgers.  "




Tactical Asset-Allocation (TAA) And Core-Satellite ETF Techniques Intro

Dec 02, 2010 in Advanced Relative Strength | Backtest

Charles Schwab recently published some summary statistics on their accounts.   They said that while 90% of accounts own individual stocks – just 15% of accounts hold ETFs.    So while many people may have been using ETFs for many years now – using Schwab as a proxy, about 85% of people still need some introduction to ETFs.

There are 3 basics schools of thought on active management in general:

1) Those that think it’s impossible

2) Those that think it’s easy

3) Those that think it’s a challenge -- but rewarding

For those that think passive management is the way to go, your job is still not over.  You will still need to figure out an asset allocation.  “Just buy index funds” actually doesn’t get you far --- there are over 1000 ETFs that follow various indexes and there is no single answer to what exactly constitutes a passive strategy.  I can’t imagine there exists a professionally trained investment advisor who advises putting 100% of money into a S&P 500 index -- but I guess never say never.  So absent that, there are still allocation decisions to be made about stocks vs bonds -- as well as the mix of international stocks and how much to include in alternatives like REITs & Precious Metals.  These are all classic passive indexing discussion points.

For those that think like #2 above – that active management is easy, this crowd is likely just plain dangerous.  They simply ‘don’t know what they don’t know.’      

The third group acknowledges the challenge and comes at the issue with some humility.  We sit firmly in the 3rd camp.   It takes some analysis and testing and hard work to do well in investing.  You don’t need to  just come up with ideas – you need an investment PROCESS.  That is, some type of structured approach.  

So let’s introduce the core-satellite approach.   It’s excellent for its flexibility in balancing return & risk.  Here is a visual that Blackrock has used for this:

Source:  Blackrock

What makes this framework really powerful is that you can pursue more aggressive strategies --- but still rein in the overall risk of a portfolio.   You can stay within your specific risk tolerance but still buy/overweight some attractive (but perhaps more-volatile) segments.    Or perhaps you are an advisor and your clients have different risk appetites.    You can use your same ideas across these different accounts but just change the allocations between the conservative core and the more aggressive satellite strategies to more precisely target the appropriate risk-budget.  

A typical investor thought might be --- I like the idea of investing in Emerging Asia – but how do I do it?  How do I think about the risk involved in the short-run if and when some problem emanates out of South Korea or India or China?      

So for a very basic start, let’s mix the core idea of completely passive-indexing with just 1 or 2 actual ideas.  In this example, rather than invest in just the benchmark S&P 500, we will invest 80% in the S&P 500 and 10% in each of two other market segments --- Real Estate Investment Trusts and Gold.  Below is a look from our free Backtest Portfolio Allocations App to observe how this portfolio looks Year-To-Date (total return):

Note the 3 percentage point pick-up in performance this year for some pretty simple ‘tilts’.   Importantly, note also that there has been some diversification benefit (reduction in volatility).  Other than returns being better, the core-satellite portfolio went down less over the summer.   So it went down less and yet has added 3%.  Your tilts added significant value here.   Not bad for a start.   But we can do better.

If you are a registered user on the site – whether you registered 8 months ago or yesterday – you may have noticed you had 1 starter portfolio we created called ‘Sample Portfolio.’   Rather than use REIT’s and GLD as our satellite strategies, what if we instead used this sample portfolio top relative strength pick as 20% of the portfolio.  Here is that example using our new TAA Application (for members)

Notice that the result here is +14.8% return with even more diversification benefit (it went down even less during the summer correction).  Remember, it is 80% S&P 500 in the first place so this is actually an excellent result.   Standalone, this ‘sample portfolio’ that we created in the Spring time has had a banner year --- see for yourself within the portfolio backtest app.  

As you will see when using the TAA application – and as we will discuss in upcoming blogs, you can change the percentage allocations from the core to the satellite and back to the core and see how it affects the overall results -- not just in returns but in ‘smoothing out the ride’ with lower volatility.   This is the very essence of TAA.

All of this is just a start for those who are new to ETFs.   We have many more options available in this core-satellite framework.   A more conservative investor – perhaps older and less willing to take even average risk --- could start with a bond-only core portfolio and then add equities as satellite strategies.   Or we could start with a more diversified core (say mixing REITS & Gold & Junk Bonds in the core) and then add country or sector funds in the satellite(s).   These and other ideas will be future blog topics.



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Understanding ETF Volatility Part 1

Dec 02, 2010 in Drawdown | Volatility

Volatility is a tough topic to get your hands around.    But one key idea is to think in terms of drawdowns  -- in general, the higher the volatility the higher the drawdown.   What does this mean?   It doesn't mean that volatility is just bad --- it means that with funds like the Russia Fund (RSX) or Brazil (EWZ) or Financial stocks (XLF), your TIMING is more important than with something like a consumer staples ETF (XLP) or an investment grade bond fund (CIU).    Since we've posted this many times this year, it's time to take a look at some actual hard data through the first 11 months of 2010.

The chart below compares the known volatility exiting 2009 with the subsequent drawdown in 2010.   We think this shows the basic idea pretty well.   Its certainly not going to be exact --- but in general, it makes sense.   So we can think about this from a higher level to help us.   If our portfolio were 100% long Brazil (EWZ) all year, then the portfolio value would have moved down -24.7% off its high at one point.   You didn't 'lose' -24.7% vs your starting cost   ---   but you did lose a big % off the high.    A goal in portfolio management is to smooth out the ride a bit.  

Note here that this is just one 11-month period of data.  The concept is solid -- but the future will be different.     The S&P 500 had a -15.6% drawdown during this particular period.  Less volatile ETFs all had lower drawdowns. A few on this list that had significantly higher volatilities had lower drawdowns --- but not by much.   This is for concept and its relative.   If the S&P 500 has a larger drawdown next year, then expect these numbers to all be bigger when we do this again next year.


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