Search Results for “ETF”

ETFs Increase Correlations, but not Overall Amplitude

Posted on 5 October 20196 October 2019 by David Merkel

Photo Credit: Steve @ the alligator farm

Recently in a tweet, I said:

Index Fund Investment Strategy: Michael Burry Warns of Bubble @Bloomberg https://bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos? The most this would do is increase the correlation of the movements. Unit creation & liquidation serve the same role as futures arbitrage programs that have existed since the mid-80s
https://twitter.com/AlephBlog/status/1179927420884983809

I am not in the crowd that thinks that indexing or ETFs will create a crisis. As I have said before, long-term performance of assets relies on the underlying productivity of the businesses issuing the assets. Short-term performance is also affected by the behavior of secondary market traders, but those effects get eventually washed out by the underlying productivity of the businesses issuing the assets.

And there you have it in slightly different garb: Ben Graham’s weighing machine versus the voting machine. The voting machine is transitory. The weighing machine is permanent. After all, think of a private business — it only has the weighing machine, and it does well enough producing cash flow for the owners, creditors, etc., without the sideshow of the price of its stock and bonds being publicly estimated each day.

In this case, the voting machine has people buying and selling bundles of stocks. But what does that replace? People owning equivalent amounts of individual stocks. People have varying propensities toward panic and greed. Those who would have sold their stocks in a panic or bought stocks in a bullish frenzy will do the same with the ETFs that they hold. It will be the same amount of selling pressure in aggregate.

Now, it is possible that some stocks are misrepresented in the ETFs in which they reside. My favorite example is refiners in the Energy Select Sector SPDR Fund (XLE) . The economics of most stocks in XLE are positively geared off of crude oil and natural gas prices. Refiners, unless they are gambling on their hedges, usually don’t hedge fully, and the economics are negatively geared to energy prices. Ever since XLE became popular, the refiners often trade in tandem in the short run with the rest of the Energy stock complex.

So what happens? Refiners then correct after a bull run of energy prices when their earnings don’t reflect the stock price. Vice-versa for positive earnings surprises in a bear phase for energy prices.

Summary

ETFs do present some anomalies for the markets, but they are localized to the sectors or strategies that are being pursued. For the market as a whole, they are simply pass-through vehicles that have little to no macro effects, aside from increasing short-run price correlation between stocks in the largest ETFs.

Why I Like Foreign Small Cap ETFs

Posted on 15 March 2018 by David Merkel

Photo Credit: amanda tipton || It may not be foreign, and not an ETF, but it IS a small cap

======================

This should be a short post.? When I like a foreign market because it seems cheap (blood running in the streets), I sometimes buy a small cap ETF or closed-end fund rather than the cheaper large cap version.? Why?

They diversify a US-centric portfolio better.? There are several reasons for that:
a) the large companies of many countries are often concentrated in the industries that the nation specializes in, and are not diversified of themselves
b) the large companies are typically exporters, and the smaller companies are typically not exporters.?Another way to look at it is that you are getting exposure to the local economy with the small caps, versus the global economy for the large caps.
They are often cheaper than the large caps.
Institutional interest in the small caps is smaller.
They have more room to grow.
Less government meddling risk.? Typically not regarded as national treasures.

Now, the disadvantages are they are typically less liquid, and carry higher fees than the large cap funds.? There is an additional countervailing advantage that I think is overlooked in the quest for lower fees: portfolio composition is important.? If an ETF does the job better than another ETF, you should be willing to pay more for it.

At present I have two of these in my portfolios for clients: one for Russia and one for Brazil.? Overall portfolio composition is around 40% foreign stocks 40% US stocks, 15% ultrashort bonds, and 5% cash.? The US market is high, and I am leaning against that in countries where valuations are lower, and growth prospects are on average better.

Full disclosure: long BRF and RSXJ, together comprising about 4-5% of the weight of the portfolios for me and my broad equity clients.? (Our portfolios all have the same composition.)

Ten Questions and Answers on ETFs and Other Topics

Posted on 3 December 2015 by David Merkel

I was asked to participate with 57 other bloggers in a post that was entitled?101 ETF Investing Tips. ?It’s a pretty good article, and I felt the tips numbered?2, 15, 18, 23, 29, 35, 44, 48, 53, 68, 85, 96, and 98 were particularly good, while?10, 39, 40, 45, 65, 67, 74, 77, 80, and 88 should have been omitted. ?The rest were okay.

One consensus finding was that Abnormal Returns was a “go to” site on the internet for finance. ?I think so too.

Below were the answers that I gave to the questions. ?I hope you enjoy them.

1) What is the one piece of advice you?d give to an investor just starting to build a long-term portfolio?

You need to have reasonable goals.? You also have to have enough investing knowledge to know whether advice that you receive is reasonable.? Finally, when you have a reasonable overall plan, you need to stick with it.

2) What is one mistake you see investors make over and over?

They think investment markets are magic. They don?t save/invest anywhere near enough, and they think that somehow magically the markets will bail out their woeful lack of planning.? They also panic and get greedy at the wrong times.

3) In 20 years, _____. (this can be a prediction about anything — investing-related or otherwise)

In 20 years, most long-term public entitlement and private employee benefit schemes that promised fixed payments/reimbursement will be scaled back dramatically, and most retirees will be very disappointed.? The investment math doesn?t work here ? if anything, the politicians were more prone to magical thinking than na?ve investors.

4) Buy-and-hold investing is _____.

Buy-and-hold investing is the second-best strategy that average people can apply to markets, if done with sufficient diversification. It is a simple strategy, available to everyone, and it generally beats the performance of average investors who buy and sell out of greed and panic.

5) One book I wish every investor would read is _____. (note that non-investing books are OK!)

One book I wish every investor would read is the Bible. The Bible eliminates magical thinking, commends hard work and saving, and tells people that their treasure should be in Heaven, and not on Earth.? If you are placing your future hope in a worry-free, well-off retirement, the odds are high that you will be disappointed.? But if you trust in Jesus, He will never leave you nor forsake you.

6) The one site / Twitter account / newsletter that I can?t do without is _____.

Abnormal Returns provides the best summary of the top writing on finance and investing every day.? There is no better place to get your information each day, and it comes from a wide array of sources that you could not find on your own.? Credit Tadas Viskanta for his excellent work.

7) The biggest misconception about investing via ETFs is_____.

The biggest misconception about investing via ETFs is that they are all created equal.? They have different expenses and structures, some of which harm their investors.? Simplicity is best ? read my article, ?The Good ETF? for more.

8 ) Over a 20-year time horizon, I’m bullish on _____. (this can be an asset class, fund, technology, person — anything really!)

Over 20 years, I am bullish on stocks, America, and emerging markets.? Of the developed nations, America has the best combination of attributes to thrive.? The emerging markets offer the best possibility of significant growth.? Stocks may have a rough time in the next five years, but in an environment where demographic and technological change is favoring corporate profits, stocks will do better than other asset classes over 20 years.

9) The one site / Twitter account / newsletter that I can?t do without is _____.

Since you asked twice, the Aleph Blog is one of the best investing blogs on the internet, together with its Twitter feed.? It has written about most of the hard questions on investing in a relatively simple way, and is not generally marketing services to readers.? For the simple stuff, go to the personal finance category at the blog.

10) Any other ETF-related investing tips or advice?

For a fuller view of my ETF-related advice, go to Aleph Blog, and read here.? Briefly, be careful with any ETF that is esoteric, or that you can?t draw a simple diagram to explain how it works.? Also realize that traders of ETFs tend to do worse than those that buy and hold.

Possible Bond ETF Problems

Posted on 2 October 2014 by David Merkel

There have been a few parties worrying about crises stemming from ETFs, because they make it too easy for people to sell a lot of assets?in a crisis.

I think that fear is overblown, but I don’t think it is non-existent, and I would like to use a bond ETF as an example of what could be possible.

Most bonds don’t trade every day. ?Only the most liquid bond issues trade every day, and they form the backbone for pricing the bonds that don’t trade.

But how do you price a bond when it doesn’t trade? ?It’s complicated, but let me try to explain…

When a less liquid bond actually has a trade, the bond pricing services take note of it. ?They calculate the yield spread of the less liquid bond versus similar bonds (similar in industry, rating, maturity, currency, domicile, other features) that are liquid, and compare it to:

where that yield spread was in the past
where the yield spread is relative to other similar?less?liquid bonds that have recently traded
where models might imply the yield spread should be, given other securities related to it (stock, preferred stock, junior debt, other bonds in the same securitization, etc.)
where investment banks that make a market in the bonds are indicating they would buy or sell.

Now consider that the bond pricing services are doing this for all the bonds they cover every day, and in real time when?the NAVs are made available for ETFs. ?The bond pricing services attempt to create a set of prices for all securities that they cover that is consistent with the market activity in aggregate, adjusting at a reasonable speed to changing market conditions. ?It’s complex, but it allows investors to have a reasonable estimate of the value of their bonds.

(Note: the same thing is done with illiquid stocks as a result of the late trading scandal in mutual funds back in the early 2000s for setting the NAV of mutual funds — ?less liquid?stocks have the same problem in a lesser way than bonds.)

The technical name for this is matrix pricing, which is a bit of a misnomer — multifactor pricing would have been a better name. ?It works pretty well, but it’s not perfect by any means — as an example, you can’t take the calculated price and trade at that level — it is only indicative of where an uncoerced buyer and seller might trade on a normal day. ?It may be a useful guide, though your broker making a market may disagree, which is part of the art of understanding value in the bond markets.

The Possible Problem

Now imagine an ETF with a relatively large amount of less liquid bonds in it, and a market environment where yield spreads are relatively tight, as it is now. ?In such an environment, even the less liquid bonds may have their yield spreads relatively tight?versus their more liquid cousins. ?Now imagine that a relatively violent selloff starts in the bond market over credit issues.

If you were a bond manager at such a time, surprised at the move, but thought it would go further, and you wanted to lighten up on some of your positions, would you try to sell your liquid or less liquid bonds first? ?Most of the time, you would sell the liquid ones, because it is relatively easy to get the trades done. ?If the selloff is bad enough, it will be impossible to sell the less liquid bonds — practically, that market shuts down for a time.

But if there are very few trades of the less liquid bonds, what does the pricing service do? ?Initially, it might rely on the old spread relationships, leaving the less liquid bonds with higher prices than they should have. ?But with enough time, a few trades will transpire, and then the?multifactor models will catch up “all at once” with where the pricing should have been.

For a time, the NAVs would be high relative to where the bonds actually should trade. ?The unit creation/liquidiation process might not catch up with it, because the less liquid bonds are difficult to source, and there is often a cash payment in lieu of the less liquid bonds. ?That cash payment figure could be too high in my scenario, leading to a rush to liquidate by clever investors sensing an arbitrage opportunity.

Now, would this be a catastrophe for the markets as a whole? ?I don’t think so, but some investors could find the NAVs of their bond ETFs move harder than they would expect in a bear market. ?That might cause some to sell more aggressively, but remember, for every seller, there is a buyer. ?Someone outside the ETF processes with a strong balance sheet will be willing to buy when the price is right, because they typically aren’t forced sellers, even in a crisis.

Practical Advice

If you own bond ETFs, know what you own, and how much of the portfolio is less liquid. ?Have a passing familiarity with how the NAV is calculated, and how units get created and liquidated. ?Try to have a sense as to how “jumpy” investors are in the asset sub-class you are investing in, to know whether your fellow investors are likely to chase market momentum. ?They may cause prices of the ETFs to vary considerably versus NAVs if a large number of them take the same action at the same time.

Know yourself and your limits, and be willing to hold or add when others are panicking, and hold or sell when others are too optimistic. ?If you can’t do that, maybe hand it over to a financial advisor who?stays calm when markets are not calm.

Till next time…

The Good ETF, Part 2 (sort of)

Posted on 18 April 2014 by David Merkel

About 4.5 years ago, I wrote a short piece called?The Good ETF. ?I’ll quote the summary:

Good ETFs are:

Small compared to the pool that they fish in

Follow broad themes

Do not rely on irreplicable assets

Storable, they do not require a ?roll? or some replication strategy.

Not affected by unexpected credit events.

Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

Though I said ETFs, I really meant ETPs, which included Exchange Traded Notes, and other structures. ?I remain concerned that people get deluded by the idea that if it trades as a stock, it will behave like a stock, or a spot commodity, or an index.

What triggered this article was reading the following article:?How a 56-Year-Old Engineer?s $45,000 Loss Spurred SEC Probe. ?Quoting from the beginning of the article:

Jeff Steckbeck?didn’t?read the prospectus. He?didn’t?realize the price was inflated. He?didn’t?even know the security he?read?about?online was something other than an exchange-traded fund.

The 56-year-old civil engineer ultimately lost $45,000 on the wrong end of a?volatility?bet, or about 80 percent of his investment, after a?Credit Suisse Group AG (CSGN)?note known as TVIX crashed a week after he bought it in March 2012 and never recovered. Now Steckbeck says he wishes he?d been aware of the perils of bank securities known as exchange-traded notes that use derivatives to mimic assets from natural gas to stocks.

?In theory, everybody?s supposed to read everything right to the bottom line and you take all the risks associated with it if you don?t,? he said this month by phone from Lebanon,?Pennsylvania. ?But in reality, you gotta trust that these people are operating within what they generally say, you know??

No, you don’t have to trust people blindly. ?Reagan said, “Trust, but verify.” ?Anytime you enter into a contract, you need to know the major features of the contract, or have trusted expert advisers who do know, and assure you that things are fine.

After all, these are financial markets. ?In any business deal, you may run into someone who offers you something that sounds attractive until you read the fine print. ?You need to read the fine print.? Now, fraud can be alleged to those who actively dissuade people from reading the fine print, but not to those who offer the prospectus where all of the risks are disclosed. ?Again, quoting from the article:

Some fail to adequately explain that banks can bet against the very notes they?re selling or suspend new offerings or take other actions that can affect their value, according to the letter.

[snip]

?My experience with ETN prospectuses is that they?re very clear about the fees and the risks and the transparency,? Styrcula said. ?Any investor who invests without reading the prospectus does so at his or her own peril, and that?s the way it should be.?

[snip]

The offering documents for the VelocityShares Daily 2x?VIX (VIX)?Short Term ETN, the TVIX, says on the first page that the security is intended for ?sophisticated investors.? The note ?is likely to be close to zero after 20 years and we do not intend or expect any investor to hold the ETNs from inception to maturity,? according to the prospectus.

While Steckbeck said a supervisor at Clermont Wealth Strategies advised him against investing in TVIX in February 2012, he bought 4,000 shares the next month from his self-managed brokerage account. The adviser, whom Steckbeck declined to name,?didn’t?say that the price had become unmoored from the index it was supposed to track.

David Campbell, president of Clermont Wealth Strategies, declined to comment.

Steckbeck, who found the TVIX on the Yahoo Finance website, doesn?t have time to comb through dozens of pages every time he makes an investment, he said.

?Engineers — we?re not dumb,? said Steckbeck, who founded his own consulting company in 1990. ?We?re good with math, good with numbers. We read and understand stuff fairly quickly, but we also have our jobs to perform. We can?t sit there and read prospectuses all day.?

If you are investing, you need to read prospectuses. ?No ifs, ands, or buts. ?I’m sorry, Mr. Steckbeck, you’re not dumb, but you are foolish. ?Being bright with math and science is not enough for investing if you can’t be bothered to read the legal documents for the complex contract/security that you bought. ?I read every prospectus for every security that I buy if it is unusual. ?I read prospectuses and 10-Ks for many simple securities like stocks — the managements must “spill the beans” in the “risk factors” because if they don’t, and something bad happens that they didn’t talk about, they will be sued.

In general I am not a fan of a “liberal arts” education. ?I am a fan of math and science. ?But truly, I want both. ?We homeschool, and our eight kids are “all arounds.” ?They aren’t all smart, but they tend to be equal with verbal and quantitative reasoning. ?Truly bright people are good with both math and language. ?Final quotation from the article:

?The whole point of making these things exchange-traded was to make them accessible to retail investors,? said?Colbrin Wright, assistant professor at?Brigham Young University?in Provo,?Utah, who has written academic articles on the indicative values of ETNs. ?The majority of ETNs are overpriced, and about a third of them are statistically significant in their overpricing.?

So, I contacted Colby Wright, and we had a short e-mail exchange, where he pointed me to the paper that he co-wrote. ?Interesting paper, and it makes me want to do more research to see how great ETN prices can be versus their net asset values [NAVs]. ?That said, end of the paper errs when it concludes:

We assert that the frequent and persistent negative WDFDs [DM: NAV premiums] that appear to be driven by?uninformed return chasing investors would not exist to the conspicuous degree that we observe if ETNs?offered a more investor-driven and fluid system for share creation. We believe the system for share?creation is ineffective in mitigating the asymmetric mispricing investigated in our study. Hence, we?recommend that ETN issuers reformulate the share creation system related to their securities.?Specifically, we recommend the ETN share creation process be structured to mirror that of ETFs. At a?minimum, the share creation process should be initiated by investors, rather than by the ETN issuers?themselves, as we believe profit-motivated investors will be more diligent and responsive in creating?ETN shares when severe mispricing arises.

Here’s the problem: ETNs are debt, not equity. ?To have the same share creation system means that the debtor must be willing to take on what could be an unlimited amount of debt. ?In most cases, that doesn’t work.

So I come back to where I started. ?Be skeptical of complexity in exchange traded products. ?Avoid complexity. ?Complexity works in favor of the one offering the deal, not the one accepting the deal. ?I have only bought one structured note in my life, and that was one that I was allowed to structure. ?As Buffett once said (something like this), “My terms, your price.”

To close, here are four valuable articles on this topic:

So avoid complexity in investing. ?Do due diligence in all investing, and more when the investments are complex. ?I am astounded at how much money has been lost in exchange traded investments that are designed to lose money over the long term. ?You might be able to avoid it, but someone has to hold every “asset,” so losses will come to those who hold investments long term that were designed to last for a day.

Eliminate Leveraged ETFs

Posted on 29 October 2011 by David Merkel

Have a look at this article.? He makes the case as to why leveraged ETFs should not be held over the long term, as I have argued before.

There is a problem with this.? Imagine for a moment that all users of leveraged ETFs extinguish their positions daily.? There would be no shares to be sold the next morning to those who want to take a position. Where would the shares come from to be bought or sold?

Leveraged ETFs rely on those that will not use them over one day only. They provide the supply/liquidity for everyone else.

Maybe there should be a tiny dividend accrued/paid to holders at the end of each day to equalize for the rebalancing losses.? I don’t know for certain, but I suspect that would ruin the economics of running a leveraged ETF.? It would add to the daily costs of hedging, which are already significant.? But maybe the overall costs would be borne more equitably with dividends corresponding to the hedging interval.? It would also deter paired shorting of leveraged ETFs.

But maybe losses for levered speculators is its own best reward.? The ability to take levered positions shouldn’t be free; someone trying to do it on his own would incur costs.

It’s paternalistic, but maybe these products should be barred on public policy grounds.? On net, they guarantee losses to holders.?? If people want to construct these strategies themselves, and bear the costs explicitly, fine.? But to have the costs borne implicitly by fools is another matter.

We limit market leverage partly for systemic reasons, but also because it prevents people from harming themselves.? As for me, I would not object if the regulators eliminated leveraged ETFs.? They serve no long-term useful purpose.

On the Percentage of Market Cap held by Domestic Stock ETFs

Posted on 12 February 201113 February 2011 by David Merkel

I don’t have all the resources that I would want in order to do complex analyses.? Give me the database, and the right software, and I can do amazing things.

Even with limited data, and cruddy software, I still have something interesting this evening.? On January 21st, I made measurements of domestic equity ETFs to try to analyze what percentage of domestic equities were held by ETFs.

In order to limit my efforts, I polled the largest 61 domestic stock ETFs, excluding funds that are leveraged or inverse.? (those don’t buy/sell the equities directly, but use derivatives.? Granted, the derivative seller has to hedge, but he very well may cross hedge, messing up the estimates.)? That accounted for 90% of the markets cap of ETFs.? I then took the actual stock holdings of the ETFs and aggregated them, and then compared those holdings to the market capitalizations of the underlying stocks themselves, ending with a percentage of each stock held by the top 90% of ETFs.

I then ran a regression of that variable on several other variables.

SUMMARY OUTPUT

Regression Statistics
Multiple R	0.655372491
R Square	0.429513102
Adjusted R Square	0.428951442
Standard Error	0.013189645
Observations	7,118.000000000

ANOVA
	df	SS	MS	F	Significance F
Regression	7.000000000	0.931250612	0.133035802	764.719743739	–
Residual	7,110.000000000	1.236903529	0.000173967
Total	7,117.000000000	2.168154141

	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%
Intercept	0.002247578	0.000264739	8.489772940	0.000000000	0.001728610	0.002766546
shr insd	(0.000086814)	0.000017370	(4.997942180)	0.000000593	(0.000120865)	(0.000052764)
beta	0.001683951	0.000182311	9.236686447	0.000000000	0.001326567	0.002041335
shr inst	0.000292763	0.000005154	56.804885114	–	0.000282660	0.000302866
mktcap	(0.000000003)	0.000000018	(0.151538794)	0.879555010	(0.000000039)	0.000000033
3m avg volume	(0.000000002)	0.000000002	(1.282295801)	0.199780706	(0.000000006)	0.000000001
3m realized volatility	0.000076315	0.000005765	13.237614053	0.000000000	0.000065014	0.000087616
Float/Shs	0.000001184	0.000002810	0.421210862	0.673613846	(0.000004325)	0.000006693

In short, I learned that ETF holdings of stocks were:

Inversely proportional insider holdings
Proportional to the stock’s beta, realized volatility, and amount held by institutions, and
Seemingly not related to market cap, trading volume or float.

Even the intercept term has some value as it is near the actual average percentage of market cap held by the top 90% of ETFs, which was 2.15%.? Assuming the same proportion applies to the last 10% that would mean that domestic stock ETFs own 2.39% of domestic stocks.? That’s enough to affect pricing at the margin.

Now, that percentage held by the top 90% of domestic ETFs in any common stock was as high as 17.9%, and as low as zero.? In terms of percentage of market capitalization held by the top 90% of domestic ETFs, we hit zero at stock 2912.

Implications

Domestic stock ETFs tend to pick more volatile stocks.
Domestic stock ETFs tend to pick stocks held by major institutions.
Domestic stock ETFs tend to pick stocks less held by insiders.? (They tend to be more boring.)

My summary is that those who create ETFs, even the big successful ones, tend to follow trends.? By their nature, they are extrapolating from what worked in the past, but in the process of doing so, end up overchoosing some names, and in the process add to their volatility.

That’s all for now, I still don’t feel well.

On Bond Investing, ETFs, Indexes, and the Current Market Environment

Posted on 29 October 2009 by David Merkel

Bond indexes are what they are.? They represent the average dollar invested in the bond markets.? Those that say that the indexes are flawed miss the point.? Indexes represent the average return of an asset class, with all of its warts and wrinkles.? That is the nature of an index; it earns what the asset class as a whole earns.

So what if big issuers dominate the index?? The average dollar in bonds reflects that.? Do you want to take a bet against the average?? You probably do, and I do as well.? But it is not the purpose of an index to make that bet, so much as to facilitate that bet for active managers.

I appreciated the book The Fundamental Index ? Arnott did us a favor by writing it.? The book shows how to do enhanced indexing off of fundamental factors.? (A pity that the book went public at the point where most of those factors were overpriced.)

The trouble with enhanced indexing is scalability.? Suppose Arnott?s fund and those like it grew large relative to the market as a whole.? The components of his strategy that are smallest relative to their total market size will get bid up disproportionately.? Eventually they will not be a favored investment of the strategy, and as they move to sell, they will find that they are large holders of something the market is not so ready to buy.? As the price goes down, perhaps it becomes attractive again. Perhaps an equilibrium will be reached.

One thing is certain, though.? The non-enhanced index can be held be everyone.? The enhanced index will run into size limits.

What then for bond ETFs?? Are they chained to inferior indexes? ?No.? By their nature, bond indexes are almost impossible to replicate perfectly because of liquidity constraints. Many institutional bond investors buy and hold, particularly for unique issues.? That?s why indexes are constructed out of liquid issues which will have adequate tradability.? Who issues those bonds?? The big issuers.? It is not possible to create a scalable bond index in any other way, and even then, there will always be some bonds in the index that are impossible to find, and/or, because they are index bonds, they trade artificially rich to similar bonds that are not in the index.

Almost all bond indexers are enhanced indexers, because they don?t have enough liquidity to exactly replicate the index.? Instead, bond indexers try to replicate the factors that drive the index, with better performance if they can manage it.? That?s where choosing non-index bonds that are similar in characteristics, but have better yields comes in.? That is the value of active bond management; it does not mean that the indexes are flawed, but that there are ways for clever investors to systematically do better, that is, until there are too many clever investors.

Pricing Issues

Morningstar prepared this piece on pricing difficulties with bond ETFs and open-ended bond funds.? Yes, it is true that many bonds don?t trade regularly, and that matrix pricing gives estimates for prices on bonds that have not traded near the close, where an asset value must be calculated.

Remember the scandal over mutual fund front-running?? In that case, stale pricing off of last trades enabled clever connected ?investors? to place late trades where the calculated NAV was far away from the theoretically correct NAV (if assets traded continuously).? In order to calculate the theoretically correct NAV (which the late traders did in order to make money), the mutual funds had to engage in a form of matrix pricing, adjusting the last trades to reflect changes in the market since each last trade until the close.? Far from being inaccurate, matrix pricing is far superior to using the last trade.

I will take the opposite side of the trade from the Morningstar piece.? Markets are not rational, especially bond ETF investors.? I trust the NAV more than the current price; matrix pricing is complex, but it is pretty accurate.? Yes, for some really illiquid, unique issues, it will get prices wrong, but that is a tiny fraction of the bond universe.? We can ignore that.

Rationality comes to bond ETFs when sophisticated investors do the arbitrage, and create new ETF units when there is a premium to the NAV, or melt ETF units into their constituent parts when there is a discount to NAV.? That pressure places bounds on how large premiums and discounts can become.

The more specific the bonds must be to create a new unit, the harder it is to do the arbitrage, and the higher the level of premium can become before an arbitrage can occur.? If a less specific group of bonds can be delivered to create a new unit, i.e., the bonds must satisfy certain constraints on issuer percentages, issue sizes, duration [interest rate sensitivity], convexity [sensitivity to interest rate sensitivity], sector percentages, option-adjusted spread/yield, etc., then arbitrage can proceed more rapidly, and premiums over NAV should be smaller.

So, when there are large premiums to NAV, it is better to sell.? Large discounts, better to buy.? Of course, take into account that short bond funds should never get large premiums or discounts.? If they do, something weird is going on.? Long bond funds can get larger premiums and discounts because their prices vary more.? It takes a wider price gap versus NAV before arbitrage can occur.

As for cash creations, those that run the ETF could publish a shadow ETF price, which would represent the price that they could create new units themselves, taking into account how they would like to change the ETF?s positions in order to better outperform while matching the underlying characteristics of the index.? That shadow ETF price could not be a fixed percentage of the existing NAV.? It would have to vary based on the cost of sourcing the needed bonds.? This would run in reverse for cash-based redemptions, which would only likely be asked for when the ETF was at a discount.? Better for the fund to do some modified ?in-kind? distribution, agreed to in advance by the sophisticated unit liquidator.

Derivative Issues

Well, if there?s not enough liquidity in the bond market to accommodate our desired investment, why not create it synthetically through credit default swaps?? That might work, but if the bonds are illiquid, often the derivatives are as well, or, the derivatives trade rich to where an identical bond would trade in the cash market.? There is also credit risk from the party buying protection on the default swap; if he goes broke, your extra yield goes away, at least in part.

I don?t see derivatives as being a solution here, though they might be helpful in the short-run while waiting to source a bond that can?t be found.? Derivatives aren?t magic; liquidity comes at a cost, and some of those costs aren?t obvious until a market event hits.

Also, I would argue that the rating agencies are better judges of creditworthiness on average than the prices of credit default swaps.? Though rating agencies should be examined for their conduct in structured securities, their record with corporates is pretty good.? The rating agencies do fundamental research; yields do reflect riskiness, but markets sometimes wander away from their fundamental moorings.? Derivatives can trade rich or cheap to the cash market for their own unique reasons.? Same for bond spreads ? just because one bond has a higher spread than another similar bond, it does not mean that that bond is necessarily more risky.

When I was a corporate bond manager, I would occasionally find bonds that yielded considerably more than others of a given class.? My job, and the job of my analyst was to find out why. ?Often the bond was not well known, or was a better quality name in a bad industry.? On average, spreads reflect riskiness, but in individual situations, I would rather trust the judgments of fundamental analysts, including the rating agencies, though private analysts are better still.

So what should I do in the Current Environment?

I don?t think we are being paid to take credit risk at present, so stay conservative in bonds for now.? Specifically:

Underweight credit risk.
With equities, stress high-quality balance sheets, and stable industries.
Underweight financials, particularly banks and names that are related to commercial real estate.
GSE-related residential mortgages look okay.
TIPS don?t look good on the short end, but look okay on the long end.
Be wary of paying premiums on bond ETFs? and maybe look at some closed-end funds that trade at discounts.
The yield curve is steep, but that is ahead of a lot of long supply coming from the US Treasury.? Stick to short-to-intermediate debt, and wait for supply to be digested.? After that, maybe some long maturity positions can be taken as rentals, so long as inflation does not take off.
Diversify into foreign bonds, but don?t go crazy here. ?The Dollar has run down hard, and opportunities are fewer.? (I will have a deeper piece on this in time, I hope.)

This is a time to preserve capital, not reach for gains.? Don?t grasp for yields that cannot be maintained.

PS — Thanks to the guys at Index Universe and Morningstar for the articles; they stimulated my thinking.? I like both sites a lot, and recommend them to my readers.? The articles that I cited had many good things in them, I just wanted to take issue with some of their points.

The Good ETF

Posted on 9 October 2009 by David Merkel

What makes a good ETF in the long term?? My, what a question, driven by the ETFs challenging the limits of what is prudent.? Maybe it is easier to start with what makes a bad ETF, then:

Headline risk can be eclipsed by credit risk.? All ETNs, Currency ETFs, and ETFs that use non-exchange-traded swaps, sometimes for commodity funds, take credit risk.? Did you know you were taking credit risk?
Roll risk — for commodity funds, trying to replicate the returns of the spot market using the futures market works only when there aren’t a ton of funds trying to do so.? The flood of funds into front month futures contracts incites other funds to front-run the activity, capturing the profits that the commodity funds were trying to make.? (For storable commodities, better to take delivery and store.)
Market size risk — an ETF can become too large relative to liquidity or regulatory constraints of the market, and it no longer tracks its benchmark well — again, mainly a commodity fund problem.
Irreplication risk — This is mainly a bond market theme, but once the ETF defines the index, only index bonds can be bought in proportion to the index.? I ran into this personally in 2002, when I ask ed why a certain bond traded rich.? The answer came that it was in a common index, but it was a small bond issue in proportion to its weight in the index.? Many investment banks were short the note to provide liquidity, but could not source the bonds to cover the short because most were in index funds.? I would keep an eye out for those bonds, and would sell them to those short for a small markup when I found them.? For ETFs, the trouble is that arbitrage can’t take place, because bond buyers can’t find certain rare bonds in order to create new units in exchange for expensive ETF shares.? That is one reason whey NAVs get stretched versus market prices.
Abnormal or faddish theme — the risk is that they become too dominant in the trading of less liquid companies in their ETFs.? But away from structural risks is the faddish investment risk.? The ETF only gets created as the fad is about to go into decline.

In one sense, the market can reward non-consensus views, particularly when they are small compared to their relative advantage in their sub-markets.? In the same way, the market can punish those that become too large for the pond that they swim in.? Growth will be limited or negative.? Even the efforts to create more capacity, create it at the cost of credit risk.

Good ETFs are:

Small compared to the pool that they fish in
Follow broad themes
Do not rely on irreplicable assets
Storable, they do not require a “roll” or some replication strategy.
not affected by unexpected credit events.
Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

Fusion Solution: The Stable Value Fund Guide to Commodity ETF Management

Posted on 21 August 200920 June 2017 by David Merkel

This piece is one of my experiments where I try to straddle two different investment worlds in an effort to bring more understanding.? The two world are stable value funds and commodity ETFs.

Commodity ETFs have a hard job, in that they are supposed to replicate the returns on spot commodities.? Given the difficulty of storage, only a few commodities — gold and silver, can be physically stored — they don’t deteriorate.? Unlike government promises, they are uniquely suitable for being money.? (Sorry, had to say that.)

Other commodities require futures markets or off-exchange markets where swaps get traded.? The swaps introduce counterparty risk, which is a common risk in many currency and commodity-linked funds.? I’ve written about that before, along with criticisms of exchange-traded notes.

One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple.? “Buy the front month futures contract, and roll to the second month contract before the front month expires.”? Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy.

So, what do the other investors do?? They take the opposite side of the trade early, in order to make it more expensive to do the roll.? Buy the second month contract, and short the first.? As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract.? What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market.

Compounding Money Slowly

If you want to keep your money safe, and earn a little bit, what should you do?? Invest in a money market fund.? “Wait a minute,” some intrepid investor would say, “I can do better than that.? I don’t need all of my money for immediate liquidity.? I can ladder my funds out over a longer period.? I can invest surplus funds out to the end of my period, and earn a better yield, and over time, my funds will mature bit by bit.? I will have liquidity in a regular basis, and I will get a higher yield because yield curves slope up on average.”

Leaving aside the wrap agreements that a stable value fund buys, stable value funds build a bond ladder with and average maturity of 1.0 to 4.5 years.? Commonly, it averages around 2.0 years.

The funds could invest everything short and give up yield.? That would give them certainty, but lose yield.? That is what the commodity funds are doing.

What could go wrong?? There could be a large demand to withdraw funds when longer-dated contracts are priced below amortized cost, and the fund might not be able to meet all withdrawal requests.? So far that has not happened with stable value funds.

The Fusion Solution

Whether in war or in business, it is not wise to be too predictable; opponents will take advantage of you.? In this particular example, I would urge commodity funds to look at their liquidity needs over the next month, and leave an amount maturing in the next three months equal to 4-6x that amount.? Then spread the remainder of funds according to advantage, looking at the tradeoff of time into the future versus yield of the futures contracts versus spot.? Longer dated futures do not move as tightly with the spot markets, but they often offer more yield.

Ideally, a commodity fund ends up looking like a bond ladder, and as excess funds mature, they don’t get invested in the new front month contract, instead, they get invested in the longer dated contracts, near the end of the ladder, as a stable value fund would do.

This maximizes returns for the bond/stable value funds, and I believe it would work for commodity funds as well.? Please pass this on to those who might benefit from it.

A Closing Aside:

Back in the late 90s, I ran one of my interest rate models to try to determine what the best investment strategy would be.? I found that the humble bond ladder was almost always the second best strategy, regardless of the scenario, because it was always throwing off cash that could be reinvested out to the end of the ladder.

Again, please pass this along, and commodity fund managers that don’t get this, please e-mail me.? I will help you.