In the first edition of this book, which was published in late 2003, this chapter was six pages long. Based on the profound impact on the investment world of exchange-traded funds (ETFs), this chapter has been greatly expanded. This chapter will provide the basic information to understand ETFs and how to use them. It is not meant to be an exhaustive review of the subject. The Bibliography lists excellent ETF books, Web sites, and other useful resources.
In 2003, only 1.9 percent of investor assets owned ETFs compared with 6.6 percent in 2009. Most of the players are frequent traders, institutions, and hedge funds rather than buy-and-hold investors or the common retail investors. However, as investors, financial advisors, and brokers become more familiar with the advantages of investing in or trading ETFs, these individuals will rely less on conventional mutual funds, sector mutual funds, leveraged mutual funds, and index funds.
In the United States, at year end 2009, there were 797 ETFs valued at $777.1 billion, which comprised 6.6 percent of all investment company assets (includes mutual funds, ETFs, closed-end funds, and unit investment trusts).1 This compares with 102 ETFs valued at $102.1 billion at year end 2002. According to BlackRock and Bloomberg, by October 31, 2010, there were 1,040 ETFs valued at $940 billion. Almost all ETFs are listed on the Nasdaq and New York Stock Exchange (NYSE) Arca. A listing of NYSE-listed ETFs can be found at www.nyse.com/screener/, along with other useful information.
An exchange-traded fund (ETF) is an investment company, typically a mutual fund or unit investment trust, whose shares are traded intraday on stock exchanges, similar to stocks. ETFs are baskets of securities, usually set up as indexes, that trade throughout the day based on the net asset value of their underlying assets. Typical ETFs include major stock indexes, sectors, metals, commodities, international, fixed income, currencies, and other vehicles.
In 1993, the American Stock Exchange (AMEX) listed the first ETF: The Standard & Poor’s Depositary Receipt (SPDR), pronounced “spider.” It exactly mir rors the movement of the Standard & Poor’s (S&P) 500 Index, and its ticker symbol is SPY. There are also ETFs that track the Dow Jones Industrial Average (DJIA), called Diamonds; the Nasdaq 100 (QQQQ), called Cubes; the largest 1,000 U.S. incorporated companies, known as the Russell 1000 (IWB); and many other industry sectors and indexes. For example, there are nine select sector SPDR funds corresponding to specific sector indexes.
ETFs have been developed for the following types of portfolios:
- Broad stock indexes (total stock market, Russell 3000)
- Well-known indexes (DJIA, S&P 500, Nasdaq 100)
- Styles and market capitalization (e.g., small-cap, mid-cap, and large-cap; value, and growth). Table 6-1 lists ETFs with the largest market caps.
- Sectors (e.g., technology, financials, information technology, energy, consumer staples, health care, industrial, telecommunications, and consumer discretionary).
- International and country-specific equity indexes (e..g., Chile, Canada, Sweden, France, Israel, Brazil, China, Russia, and Australia) and international style.
- Fixed-income indexes (e.g., short- and long-term Treasury bonds, corporates, municipals, and Treasury Inflation Protected).
- Specialty indexes (e.g., commodities, currency, real estate).
- Leveraged and inverse (e.g., 2 to 3 leveraged long and short).
MERRILL LYNCH HOLDRS
Another instrument similar to ETFs in most respects, called HOLDRS (Holding Company Depositary Receipts), was created by Merrill Lynch. According to www.holdrs.com, “HOLDRS are securities that represent an investor’s ownership in the common stock or ADRs of specified companies in a particular industry, sector or group. HOLDRS allow investors to own a diversified group of stocks in a single investment that is highly transparent, liquid and efficient.” They have features similar to ETFs. Almost all 18 HOLDRS are either sector funds, concentrated in one industry, or a country— Europe or Spain—and they contain 2 to 54 stocks, with most having an average of 15 stocks. Such a concentration can be risky if you are long a sector when it is declining in price. Of course, if you are short the ETF, you will reap the rewards of a bear ish price trend. Detailed information about HOLDRS and their portfolio composition, performance, and price charts can be found at www.holdrs.com.
The following is a listing of the current HOLDRS with their ticker symbols:
- Biotech (BBH)
- Brazilian Telecom (TBH)
- Broadband (BDH)
- B2B Internet (BHH)
- Europe 2001 (EKH)
- Internet (HHH)
- Internet Architecture (IAH)
- Spain IBEX 35 (IIH)
- Market 2000+ (MKH)
- Oil Services (OIH)
- Pharmaceutical (PPH)
- Regional Bank (RKH)
- Retail (RTH)
- Semiconductor (SMH)
- Software (SWH)
- Telecom (TTH)
- Utilities (UTH)
- Wireless (WMH)
One unusual limitation of HOLDRS is that they can be bought or sold only in 100-share lots, whereas ETFs can be purchased in odd lots. Also, the HOLDRS portfolios never add or delete stocks unless the company disappears in an acquisition or goes bankrupt. This may not con tribute to price stability. The opposite could be true. We need price stability and predictability, not just portfolio stability.
ETFs are viable and useful investment vehicles for the following reasons:
- Transparency. The portfolio composition is known. Since there is no active management (except for a few dozen actively managed ETFs), you always know what you are buying.
- Liquidity. Trades can be made instantaneously any time during the day including pre-market and after-market with small bid-ask spreads. Thus the investor is not at the mercy of the market for the entire day (as is the case with mutual funds) and can liquidate a position at any time for any reason. This flexibility is critical in times of volatile, panicky, or news-driven markets that are more frequent than ever before. Refer to Table 6-2 for ETFs with the largest daily trading volumes.
- Low cost. Annual expense ratios and management fees are much lower than with regular mutual funds and usually a few basis points (0.01 1 basis point) lower than index funds. No analysts or investment managers need to be paid; however, there is a brokerage commission each time an ETF is bought or sold. A discount or online broker can be used to keep the commission well below $10 for each trade. The Standard & Poor’s SPDRs, for example, have an annual expense ratio of just 0.09 percent, and Barclay’s iShares S&P 500 has a ratio of 0.18 percent. The Vanguard 500 Index Fund annual expense ratio is 0.18 per cent per year. On a $10,000 initial investment, that works out to an annual cost of $18. Remember that among mutual-fund families, Vanguard is known to have extremely low fees, whereas other fund families may have significantly higher expense ratios. See Table 6-3 for the least expensive ETFs.
Active traders pay commissions whenever they trade an ETF. Thus, having an index fund with low expenses and the ability to do active trading could be comparatively
cheaper. But most mutual fund families (except Rydex and ProFunds) do not allow more than four exchanges a year. Still, four exchanges could work fine for some of the less active market timing strategies recom mended in Chapters 7 through 11. A number of brokerage firms are offering investors free ETFs with certain restrictions on limited universes of ETFs. These firms include Fidelity (25 ETFs), Vanguard (62), Schwab (11), and TD Ameritrade (100).
- Tax efficiency. ETFs are more tax-efficient than a compa rable mutual fund because they involve lower capital gains and minimal portfolio turnover. With mutual funds, you have to declare capital gains on your tax form whenever they are declared by the fund, even though you may not sell the fund during that year. Owners of ETFs have capital gains or losses only when an ETF is sold. If there are no closing trades, then there are no capital gains or losses to be paid. By contrast, mutual funds pass on the capital gains and losses realized within the fund to their shareholders, who must declare these gains and losses.
- Flexibility for implementing trading strategies. ETFs can be purchased on margin and sold short. And options are available for purchase on many ETFs. Also, the usual types of orders such as limit and stop orders can be placed with your brokerage account. These capabilities are not present with mutual funds. An ETF is considered a passive investment like an index fund. Portfolio turnover is minimal, except when certain issues are replaced when they are replaced in the underlying index. Investors can buy and sell ETFs at any time during trading hours.
A short sale is the opposite of buying a stock or EFT. The seller, in effect, borrows the stock or ETF from the bro – kerage firm, hoping to repurchase it later at a lower price and repaying the broker with the stock purchased at the lower price. The objective in short selling is to make money when the price drops. If a stock sold short drops in price, the shares are bought back at a lower price, generating a profit for the investor. But if the share price rises instead of falls, the investor suffers a loss because he or she has to buy back the shares at a higher price.
For investors who want to short the market, the inverse and leveraged ETFs offered by Rydex SGI, ProShares, and Direxion also can be used. The ETFs are bought long, and no margin is required.
- Diversification. Equity ETFs are composed of a portfolio of stocks. Investing in this type of ETF substantially reduces overall risk compared with buy ing a portfolio of 10 individual stocks. Of course, the specific ETF pur chased may be more risky than another ETF depending on its portfolio mix and volatility.
- Favorable interest income and dividends. Dividends declared on stocks or interest paid on bonds held in the ETF will be passed on to shareholders.
The ETFs with the most assets under management are shown in Table 6-4.
Of course, like any investment, ETFs have specific risks:
- Market risk. Like stocks and mutual funds, the price fluctuates throughout the day, sometimes with wide price swings, depending on many variables.
- Net-asset-value risk. The price may not trade at exactly the net asset value; instead, it may be a bit higher or lower depending on conditions of the market. This is called tracking error. In the case of the most active ETFs, there is a minimal, if any, difference between the net asset value and the market price. Any wide differences would be observed, and big institutional traders and hedgers would step in to take advantage of the situation, thereby rapidly closing any price gap.
- Bid-ask price spread. Depending on the volume of transactions, some ETFs may have higher price spreads between the bid and ask prices, thereby resulting in higher transactions costs. The spread is minimal (e.g., a few
pennies) on the more active ETFs. On the less liquid ETFs, the spreads can be much larger, so make sure that you check the trading volume of any ETFs you plan to purchase and look for at least 100,000 shares a day, and preferably one million shares a day.
- Sector risk. Buying a sector EFT has added risk because any news that affects companies in that sector will affect the ETF’s price, either positively or negatively.
Since the introduction of ETFs, many more players have entered the marketplace. There are currently over a dozen families offering 815 different ETFs. The following is a list of the families, their Web sites, and the number of funds they offer:
- Direxion (www.direxion.com; 38 funds, all of which are 2 and 3 bear and bull)
- First Trust (www.ftportfolio; 43 funds)
- Guggenheim, formerly Claymore (www.guggenheimfunds.com; 38 ETFs)
- HOLDRS (www.holdrs.com; 18 funds)
- iShares (www.us.ishare.com; 218 funds)
- Market Vectors (www.vaneck.com; 29 funds)
- PowerShares (www.invescopowershares.com; 128 funds)
- ProShares (www.proshares.com; 111 funds, many leveraged and inverse)
- Rydex SGI (www.rydex-sgi.com; 19 funds, mostly leveraged and inverse)
- State Street Global Advisors (www.spdrs.com; 93 funds)
- Barclays iPath (www.ipathetn.com; 25 funds)
- Vanguard (www.vanguard.com; 62 funds)
- WisdomTree (www.wisdomtree.com; 44 funds)
Leveraged and Inverse ETFs
Similar to leveraged mutual funds, leveraged ETFs amplify the daily returns of their benchmarks by as much as two to three times (200 to 300 percent), before fees and expenses. They are also referred to as 2.0-beta and 3.0-beta funds. For example, the ProShares Ultra S&P 500 ETF (ticker symbol SSO) doubles the daily price performance of the S&P 500 Index benchmark, so if the latter rises 1 percent today, the SSO rises 2 percent. Of course, the opposite is also true. When the S&P 500 Index falls 1 percent, the SSO will fall twice as fast, or 2 percent. Leveraged funds also have inverse varieties similar to inverse mutual funds, also referred to as bear or short funds. The same principle applies in how returns are calculated for those ETFs that are 3.0 beta. Examples of regular and leveraged ETFs offered by RydexShares™ Exchange Traded Funds and ProShares are listed in Tables 6-5 and 6-6.
Leveraged ETFs can be used by investors for specific purposes:
- To benefit from the beginning of or continuation of a market uptrend or downtrend, investors buy leverage long and short ETFs to provide double or triple the returns in both directions.
- To act as a hedge on an existing portfolio by buying an inverse ETF, where the investor believes that a market correction may be imminent but wants to protect the portfolio’s principal.
- To take a long or short position using less cash than buying a full position. For example, if an investor has only $3,333 to invest but wants to buy $10,000 worth of S&P 500 EFT (SPY ticker symbol), he or she could buy the ProShares Ultra Pro S&P 500 (3.0-Beta) Fund and invest only $3,333 because he or she will be obtaining the same performance as if he or she had invested $10,000.
Compounding of Daily Returns Needs to Be Understood
Investors need to be extremely careful using leveraged products because they can move very quickly in either direction. They have higher than normal volatility, and some may not have adequate daily volume to keep the spread between the bid and ask prices reasonable. They are more complex than traditional mutual funds in their portfolio composition because a certain percentage of the underlying stocks are purchased along with index futures contracts and equity index swap agreements to obtain the compounding.
Each day the price of each leveraged ETF is reset so that it tracks its benchmark index. Over time, the ETF may drift in price owing to the impact of compounding from its benchmark, especially when there is abnormally high volatility. Let’s use two examples to show how compounding affects the price of an unleveraged ETF and a leveraged ETF with a beta of 2.0 under normal circumstances.
- Example 1: In a bull market, assume an investor owns an ETF valued at $100 a share (with no leverage) that increased 10 percent each day for two consecutive days. At the end of the second day, the share price is $121 ($100 1.1 $110; $110 1.1 $121).
- Example 2: Now take the same scenario, but assume that the investor owns a double-beta fund (200 percent). At the end of day 1, it is worth $120 a share, and at the end of day 2, it is worth $144 a share, which is greater than the expected $142.
When the stock market has high volatility with swings of 500 points or more a day in the DJIA, then the leveraged ETFs can get out of whack with their benchmark owing to the compounding effect. This is why ProShare and Rydex Shares™ ETF shares warn investors about this situation on their Web sites and indicate that investors and traders need to completely understand how these ETFs work and the risks involved.
FINRA Warning Buy-and-Hold Investors on Use of Leveraged and Inverse ETFs
The Financial Industry Regulatory Authority (FINRA) is the largest independent regulator for all securities firms doing business in the United States. FINRA’s mission is to protect America’s investors by making sure the securities industry operates fairly and honestly. FINRA has evaluated leveraged and inverse ETFs for buy-andhold investors and has made the following comment:
The best form of investor protection is to clearly understand leveraged or inverse ETFs before investing in them. No matter how you initially hear about them, it’s important to read the prospectus, which provides detailed information related to the ETFs’ investment objectives, principal investment strategies, risks, and costs. The SEC’s EDGAR system, as well as search engines, can help you locate a specific ETF prospectus. You can also find the prospectuses on the websites of the financial firms that issue a given ETF, as well as through your broker.
You should also consider seeking the advice of an investment professional. Be sure to work with someone who understands your investment objectives and tolerance for risk. Your investment professional should understand these complex products, be able to explain whether or how they fit with your objectives, and be willing to monitor your investment.
For complete information on the FINRA warning, visit www.finra.org/Investors/ProtectYourself/InvestorAlerts/Mutual Funds/P119778.
WHERE TO PURCHASE ETFs
You can open a brokerage account with any discount broker to buy and sell ETFs or any other vehicles of your choice. The commission varies from $1.00 to $9.95 per trade depending on whom you choose. During the 2009–2010 period, four firms began offering free ETF trades on a select ETF universe of their choosing. None of the firms has placed leverage or inverse ETFs in its program. The firms offering free trades include Fidelity Investments (25 ETFs; see Table 6-7 for a listing), TD Ameritrade (100 ETFs, which must be held 30 days or $19.95 commission is charged), Vanguard (62 Vanguard ETFs), and Charles Schwab (11 Schwab ETFs). Full information is provided on their Web sites.
If you buy and sell the same Vanguard ETF in a Vanguard brokerage account more than 25 times in a 12-month period, you may be restricted from purchasing that Vanguard ETF through your Vanguard brokerage account for 60 days.
MARKET TIMING WITH ETFs
The many advantages of ETFs over index and active mutual funds make them much more attractive for a market timing approach. With the availability of inverse ETFs, there is no need to use margin and pay margin interest. Moreover, with the wide choices of leveraged ETFs, investors can get a bigger bang for their buck.
The most popular ETFs to use for market timing are those with huge volume (millions of shares a day), low bid-ask spreads ($0.02 or less), and have a big following, such as QQQQ, SPY, DIA, IWM, and leveraged ETFs such as QLD, QID, SDS, FAS, and many others.
if you are going short with inverse ETFs. Alternatively, you can invest in ETFs with one or more of the strategies in Chapters 7 to 11. In all cases, make sure that you have the proper stop-limit orders in place to protect your capital, and use trailing stop-limits to protect your profits. To eliminate the cost of your ETF brokerage commissions, consider using one of the previously mentioned firms, after determining which firm offers the most suitable ETF choices.
The current array of ETFs offers outstanding flexibility and wideranging investment options. Market timing strategies can be easily implemented with these vehicles. Best of all, ETFs can be bought and sold any time throughout the day, and they can be easily shorted using the inverse funds without the need for a margin account. ETFs have greatly expanded the universe of investment choices for market-timers, who should take advantage of this opportunity, but only after examining the details of each ETF available and all the risks involved, especially with commodity and leveraged ETFs. Never invest in any ETF that you don’t fully understand. The Bibliography at the end of this book provides recommended ETF books, Web sites, and other resources. Make sure to check them out because they will speed your learning process and provide useful information on ETFs.