“Exchange Traded Funds” – Look Before You Leap
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. The Basics of Exchange Traded Funds (ETFs)
2. ETF Advantages & Disadvantages
3. Just Another Form Of Index Investing?
4. Conclusions: As Usual, Be Informed
In last week’s E-Letter, I discussed the excitement surrounding the upcoming launch of a new Exchange-Traded Fund (ETF) tracking the spot price of silver, as well as an existing gold ETF that has now been trading for over one year. I received many responses from readers – some thanking me for the information and, as always, others offering additional points of view.
I also received a number of responses that asked various questions about ETFs in general. Such as: What are ETFs; how do they work; and whether ETFs may be superior to individual stocks or index mutual funds. As is the case in the financial services industry, the marketing of new forms of investment often outpaces the explanation. Some investors rush into the latest “hot” investments without knowing exactly how they work, or under what conditions they are best used.
Believe it or not, the first exchange-traded ETF was launched in 1993 on the American Stock Exchange (AMEX), and was based on the S&P 500 Index. From this humble beginning, the total number of ETFs worldwide has now grown to approximately 400, and the list just keeps growing. It is reported that ETF trading now accounts for over 60% of the trading volume on the AMEX. Yet even today there are still many investors who are not very familiar with how ETFs work.
Because of your response to last week’s E-Letter on the new silver ETF, I thought it would be beneficial to discuss the rise of ETFs in the marketplace in this week’s E-Letter. In this issue, I’ll talk about how ETFs work, their advantages and disadvantages, and in what investment scenarios they are likely to work the best.
We have a lot to cover, so let’s jump right in.
ETFs – The Basics
An Exchange-Traded Fund (ETF for short) can probably best be defined as a low-cost index fund that trades on an exchange like a stock. In essence, ETFs are hybrid entities, in that they contain a number of stocks like a mutual fund, but they can be traded at any time the market is open, just like an individual stock. Using these investments, an investor has the potential to capture the performance of a selected stock index, bond index or commodity index using a single trade. Sounds good so far. The ability to trade any time the market is open makes ETFs an extremely flexible way to gain exposure to the growing number of market indexes now represented by ETFs.
As noted above, the very first ETF was rolled out in 1993 in the form of the S&P Depositary Receipts ETF, more commonly known as the “SPIDER,” designed to track the performance of the S&P 500 Index. SPIDERS were very popular, so several new ETFs were soon launched to track the performance of other major stock indexes. Some of the more commonly known ETFs are as follows:
Given the popularity of these early ETFs, it is virtually assured that more will follow in the months and years ahead.
Understanding The Basics Of ETFs
While all of the various instruments discussed above are sponsored by different financial services companies, they are all basically baskets of stocks, bonds or commodities based on an underlying market index or spot price of a selected financial market or commodity index. Investors purchasing an ETF are, in essence, buying a proportional share of the individual securities making up the index or sector targeted by the ETF.
One of the early concerns with the ETF market was whether there would be sufficient trading volume of ETF shares for them to track closely to their target index. While volume did take a while to get up to speed, the ETF market is now very liquid, with millions of shares trading on a daily basis. Much of this volume is from institutional investors who see ETFs as a very cost-effective way to gain exposure to various market indexes.
Pricing of ETF shares is based on a fraction of the underlying index or indexes. Take the “Diamonds” ETF, for example, which is pegged to the Dow Jones Industrial Average. With the Dow over 11,000, it wouldn’t make much sense to base the Diamond share price on the full price of the index, since the ETF would then be priced at over $11,000 per share. Instead, the Diamond ETF share price is pegged at 1/100 of the overall Dow Jones Industrial Index price, which puts the share price at a more reasonable price of approximately $110.00. ETFs tracking other indexes have different proportionate shares, such as the SPIDER, priced at 1/10th of the S&P 500 Index and the QUBES that are priced at 1/40th of the Nasdaq 100 Index.
The legal structure of an ETF is that of an “open-ended Registered Investment Company” under the Investment Act of 1940, with a special exemption from the SEC allowing them to be traded like stocks on an exchange. Shares are created in large blocks by the sponsoring financial and brokerage firms, so that investor demand can be met on a continuous basis, usually without pushing the ETF share price beyond that of the underlying index or sector.
The first and most obvious advantage of ETFs is the ability to gain exposure to an entire index, sector or commodity in one single transaction, and at any time during the trading day. Index mutual funds can offer the same exposure, but can generally only be bought or sold once per day. The increased liquidity of the ETF allows for much more flexibility for the investor, especially in extremely short-term hedging transactions that might be bought and sold during the same day.
ETFs also enjoy the following additional benefits:
This list of advantages has been recognized by many analysts, but especially institutional investors that employ sophisticated strategies such as hedging and net short positions. The instant liquidity available in ETFs allows these institutional investors to “turn on a dime” during the day when their strategies call for such quick action.
These professional investors also use ETFs to “park” excess cash in certain situations. Since ETFs offer a high degree of liquidity, some professional money managers will use ETFs instead of moving to cash so they can maintain exposure to the overall markets while waiting for their strategy to generate another buy signal. As time goes by, I expect more and more individual investors will learn to use these potential advantages.
Some Disadvantages of ETFs
As always, new financial products like ETFs also have disadvantages that may offset some or all of the advantages listed above. One such disadvantage is that ETFs must be bought or sold on a stock exchange, which means paying a brokerage commission. While there are various discount brokerage firms available, frequent trading of ETFs could result in commissions that outweigh some or all of the popular advantages that ETFs offer.
This disadvantage is probably most pronounced for investors who want to use “dollar-cost averaging,” an investment strategy where small periodic (usually monthly) contributions are made to an investment. With commissions charged for each purchase transaction, ETFs may not be the best alternative for such investors.
Some of the other disadvantages associated with ETFs are as follows:
The Perils Of Index Investing
In my December 6, 2005 E-Letter, I outlined the problems associated with “index investing,” which is defined as making long-term bets on the overall markets by investing in securities that track the values of one or more market indexes. With the arrival of ETFs, the financial media and Wall Street firms are claiming a new era of index investing has arrived, but is index investing using ETFs any better than doing so with index mutual funds?
In my opinion, the answer is “No.”
While I don’t have the space to reproduce all of the information in my December 6th E-Letter, I think a brief review is certainly appropriate in regard to index investing using ETFs. As I noted in my previous article, the primary notion behind index investing is the idea that investors cannot do better than the market indexes over long periods of time, so why try?
To prove their point, some proponents of index investing trot out charts and graphs showing various time periods over which the market indexes outperformed traditional mutual funds. In addition, adherents of index investing point out how fees for index funds and ETFs are usually a fraction of actively managed alternatives, in an effort to equate high fees with poor performance. These and other arguments are presented to support the idea that trying to beat the market indexes is futile. As usual, I beg to differ.
I do not believe that a buy-and-hold investment strategy using index mutual funds or ETFs is always the best alternative for an investor. While the financial media is fond of showing graphs over periods of time as long as 75 years as proof of the value of index investing, few, if any investors have the luxury of that amount of time. Most investors have much shorter time horizons, and a quick review of market indexes over shorter time horizons can cast a very different light on index investing.
There is also the issue of risk management. Over the 10-year period ending on March 31, 2006, the S&P 500 Index posted an average annualized return of 8.95%. This sounds pretty good, until you see that during this same 10-year period, there was also a –44.73% drawdown in value in the S&P 500 Index that is yet to be fully recouped. Can such a large drawdown occur again? Probably. What we do know is that market indexes are passively managed, and cannot get out of the way of a market downturn.
Thus, index investing – even with ETFs – is in some cases like buying a car without a steering wheel. It will generally go straight, but you won’t be able to steer around curves and obstructions (ie –recessions or major market corrections) in the road.
I encourage you to go back and read my December 6th E-Letter again to get a full picture of the limitations of index investing. Even if you have a long-term time horizon and think that index investing might be best for you, I encourage you to consider putting at least part of your portfolio in “actively managed” investment programs that have the flexibility to hedge positions or move to cash as market conditions warrant. In this way, you are not only diversifying among asset classes through index investing, but also among investment strategies by including both active and passive management.
Exchange Traded Funds have already made a big impact in the investment marketplace, even though they are a relatively recent phenomenon. The ability to gain access to a wide variety of stock market indexes, sectors and even commodities, with the liquidity of an individual stock, makes ETFs a highly sought-after investment.
One of the benefits of the ETF structure is that they are not limited to stock or bond securities, but have also been adapted to track the prices of physical commodities. I have previously written about ETFs that are designed to track the price of silver and gold, but there is also a new ETF that tracks the price of crude oil, and even one launched last December that tracks the price of companies involved in fresh water purification.
However, some of the very features that make ETFs so attractive also have the potential to lead to large losses in the hands of the unwary investor. The primary advantage of ETF investing is that they offer a highly liquid exposure to a large number of market indexes, but this can also be a disadvantage as I pointed out briefly above, and in more detail in my December 6, 2005 E-Letter.
Even so, I think the development of ETFs has been a positive thing, but primarily in relation to professional Investment Advisors who manage portfolios of index mutual funds. The flexibility inherent in an ETF allows these Advisors to have the same exposure to selected market indexes and sectors, but with added liquidity should the market turn downward over the course of a trading day. They also allow Advisors to trade on an unlimited basis, and without the fear of early redemption fees.
We have spoken to a number of Advisors who actively manage portfolios of mutual funds, and who are now investigating ETFs as a possible alternative to index funds. Some have even started to run parallel test accounts to see how their strategy fares using ETFs as compared to their mutual fund track record. If they are successful, I hope to be able to recommend some of their strategies to my clients in the future through our AdvisorLink® Program.
The one area where I do see a great deal of promise for individual investors is in the area of commodities exposure, specifically in those ETFs that track the price of gold, silver and oil. These commodity-based ETFs offer investors the ability to have exposure to markets that were once only available via stocks or mutual funds in mining or production, or the purchase of physical metals, coins or bullion, or by trading futures and options. ETFs also hold the potential to solve the storage and safekeeping problems usually associated with holding physical gold, silver or oil.
The bottom line is that we live in exciting times where we can look forward to even more specialized investment opportunities in the future. Unfortunately, the proliferation of investment options often creates a greater amount of confusion as to which investment alternatives are the best. Sometimes the most popular investment alternatives are not those that are best for an investor’s needs, but are the ones with the best advertising and promotion, or the most convincing sales representative. So, beware and be informed.
While it is a temptation to rush out and be the first to own some of these new “sexy” ETF investments as soon as they become available, I think the words of Alexander Pope may offer the best counsel:
“Be not the first by whom the new are tried, nor yet the last to lay the old aside.”
As always, we are happy to help you make these decisions, with no pressure or obligation.
Very best regards,
Gary D. Halbert
Why are ETFs more tax-efficient?
Why America's Generals Are Out For Revenge
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.