Kyle Waller and Casey T Smith explore the world of opportunities and access created Exchange Traded Funds.

Exchange-Traded Funds (ETFs) have become popular throughout the globe, and are used by institutional, professional, and individual traders and investors. ETFs allow investors to gain precise, razor-sharp access to diverse parts of the market cheaply and efficiently.

Structure

ETFs are versatile because of their structure. Although traditional ETFs are passive investments, tracking an index, alternative active ETFs have been developed recently. The objective of the traditional ETF is to track its index precisely. In this way an investor can know, intraday, the value of the underlying holdings, called the Net Asset Value (NAV).

Stocks or funds?

ETFs trade on an exchange throughout the day in the same way as stocks, while having other characteristics that are like mutual funds. Since the underlying holdings can be determined exactly throughout each day, they can be traded and valued extremely efficiently. In some cases, trading the basket of securities is much more efficient than trading individual holdings. For instance, trading a diverse group of commodities may be more efficient than managing a dozen rolling futures contracts in a futures exchange.

Arbitrage

Since ETFs trade throughout the day on an exchange and track a market index, they have a built-in arbitrage feature. Unlike an open-ended mutual fund, where investors can buy and sell at the NAV, ETFs trade at market prices rather than at NAV. This is similar to a closed-end fund, where the fund may trade at a premium or discount to the NAV or the value of the underlying security.

The built-in arbitrage feature of ETFs allows market makers, called ‘authorised participants’, to buy shares in the basket of underlying ETF holdings on the open market, and to exchange those shares for ETF shares, profiting from the premium in the ETF market. In the same way, when ETF shares are trading at a discount to the underlying holdings, market makers can receive the value of the basket of the ETF’s underlying holdings, paying the discounted price by giving the ETF firm the price that is represented in the discounted ETF market. Transactions between the market maker and the firm issuing the ETF are done in kind. ‘In kind’ means that the transactions are done through exchanging goods: no money is transferred, so the fund does not incur any tax- or income-related problems. During these transactions, tax consequences are minimised by allowing low-basis shares to be transferred out and high-basis shares to be transferred in.

ETF efficiency

It is important to consider the efficiency of the underlying market when you put money into a vehicle that invests passively in an index of underlying securities, without a manager making decisions. A less efficient market may be more suitable for active managers and for actively selecting individual securities. Beyond traditional approaches, ETFs empower an investor to reach into an inefficient market in many different ways, ultimately giving the active investor control, while using passive instruments.

Structural efficiency should be a main concern of any ETF investor. An ETF’s sole objective is to track an index. ‘Tracking error’ is a measure of how well an ETF tracks an index. Indexes, by nature, are difficult to track. Indexes are strict price followers. There is no allowance for any transaction costs, which would occur from rebalancing the index. Indexes in both the stock and bond markets often account only for the closing value of securities; and it may be difficult or inefficient to invest in them at that price. ETFs, by following the index’s moves exactly, incur transaction costs from rebalances and also have problems matching the closing price on market exchanges. ETFs also charge (often extremely low) expense ratios that are priced into the performance. The handling of income from coupon payments or dividends may also cause some tracking error. Despite these issues, ETFs are, by and large, efficient index trackers. In some cases the performance difference between NAV and the index is less than the annual expense ratio.

Tracking error can come in many forms and is measured in different ways. ETFs often hold global assets and those assets may trade on markets that are open during different hours, causing what may seem to be tracking error. But it is really the ETF acting as a price discovery mechanism for the market, as it is the only way for investors to enact new prices in foreign markets. That more efficient pricing will be reflected in the premium/discount of the fund, in which the price of the fund deviates from that of the index. ETF managers in the foreign market space often use foreign depository receipts in the underlying basket. These are not included in the index. When analysing the fund it may appear the fund has more holdings then the index does, as ETFs split holdings between foreign securities and the identical DR. In this way, higher tracking error may not represent inefficiencies; greater efficiencies can sometimes create small losses. In this way the ETF market reflects the actual value of the underlying basket.

As the use of ETFs, tracking a wide variety of indexes, grows globally, the need for ETF managers to optimise the index their ETF tracks also grows. There are often limits to how much optimising can be done; further, not all ETF issuers optimise indexes (and some do it poorly). Optimising is a form of index sampling by which the managers of the ETF attempt to construct a smaller creation unit, or basket of securities, either to allow for more efficient creations and redemptions or to cut significant costs to the ETF by excluding extremely small holdings. It is very common for emerging market and bond ETFs to sample their indexes because holdings are either costly to buy or have an extremely high number of index components.

Exchange-Traded Notes, ETNs, are a variation of the ETF. They are debt notes issued by investment banks that track an assigned index. ETNs have no underlying holdings and promise perfect tracking. ETNs are useful for investing in commodities and currencies that may have tax consequences in an ETF structure. Buyer beware: unlike ETFs, ETNs have counterparty risks, just as any debt instrument does.

Leveraged ETFs

Leveraged ETFs are a misunderstood subset of the ETF market. These vehicles can be triple or double long the index or triple, double, or -1 times the inverse of an index. The popularity of these types of fund has grown greatly. However, a real danger exists in that all these funds have tracking the daily leverage value of the index as an objective. Over a single day these funds have good tracking error; but over any longer period the tracking error varies, sometimes by extreme amounts.

The naïve expectation is that these funds will offer a long-term leveraged position. During 2008, a popular -2 times leverage fund tracked an index that was down more than 50 per cent during the year. The naïve expectation was that the leveraged fund would be up 100 per cent. The leveraged fund was down over 50 per cent; extremely close to the index it was tracking. The reason was a compounding effect and the way the funds must re-leverage each day. In the United States the Financial Industry Regulatory Authority (FINRA), the main broker regulatory agency, has made it clear that these investments are not suitable for clients beyond one trading day, unless as part of a complex trading strategy.

Bond ETFs

ETFs are price followers. Their market price is constantly following the intraday indicative value, which is tracking the underlying index. ETFs are also subject to any risks and structural problems in the asset class they represent. During the credit crisis of 2008, bond ETFs emerged as the hero for the bond market. Some issues with the structure of ETFs were also uncovered.

During the fourth quarter of 2008, the global bond markets began to freeze. Significant discounts were seen in late September and October 2008 for the selected bond ETF. This was a common occurrence during this time for many bond ETFs. Bonds, which do not trade over a central exchange as do stocks, lacked any real trading volume during the credit crisis. In many cases bonds have low volume and are priced in indexes based on mark-to-market prices. That pricing is done by specialists. When volume freezes in these markets there is no way to effectively price the bonds. Bond traders knew during that period that the prices were poor reflections of value. True value was much lower. Since there were no buyers at any price and sellers were not able to enact any transaction, prices remained on the books at an artificial high. The NAVs of ETFs, being price followers, reflected the high valuation.

However, market participants were able to reflect the lower true value of bond baskets through the only liquid bond market – ETFs. This led to major discounts as the bond ETFs reflected the lower value that was not reflected in the underlying bond holdings. In the same way, premiums were created during the first quarter of 2009, as values needed to be higher, but volume was still low, reflecting stale prices. During normal periods, bond ETFs can also be efficient; however, analysis of any asset class should include issues in the marketplace that might create problems in the use of ETFs.

Volume

A major misconception among ETF investors relates to the importance of volume. ETF volume matters most in regard to bid/ask spreads. Many ETFs, having low volume, may make trading costly. That is something long-term investors may not be greatly concerned with. However, there are many ETFs that have efficient and tight spreads for the short- and long-term investor.

The volume of underlying holdings should be considered. An ETF can have low volume but may represent an index which has holdings that are frequently traded and has high volume. When you purchase ETF shares it is important to note whether you are purchasing a low volume instrument representing a highly liquid investment in the underlying. New units of the ETF can be created at any time – large orders will not necessary create premiums or discounts. So the use of limit orders is necessary.

For these reasons investors should be most concerned with the liquidity of the underlying holdings, since efficient prices can be had through limit orders when liquidity is low in the ETF marketplace.

Strategies

Strategies involving ETFs can aid traditional stock and bond strategies. Other strategies are exclusive to ETFs and Exchange-Traded Products (ETPs). Since there is a great variety of ETFs, the strategies best suited to them are also diverse. Some ETFs offer built-in strategies and can be used for allocations to hedge fund replication and long or short managed commodity futures.

Conventionally, ETFs and ETPs are used in two types of investment strategies: strategic and tactical. The strategic use of ETFs involves, in general, a broadly based asset allocation approach or broad-based macro viewpoints. This strategy involves taking broad-based approaches to asset classes and styles, formatting portfolios based on market direction, style drifts, and other broadly based decisions in the market. These could include country or region exposure, or specific exposure to long-only commodity ETFs and ETNS.

Strategic ETF techniques allow investors to play long or short directions in nearly any global market, in bonds, and in alternative asset classes.

Core satellite

A popular strategic use of ETFs is termed ‘core satellite’. Investors have a core portfolio of passive ETFs to which they add satellite positions in active funds, or actively invest in individual securities. This technique can be used in many ways, including having a core of individual securities and a satellite position of passive ETFs. In another variation, ETFs can be used as both the core and the satellite. Investors can use plain-vanilla ETFs that are market cap weighted as the core position and add fundamentally weighted ETFs from the same category as satellite positions.

In general, a core satellite strategy is useful for investors who are conscious of benchmarks but who also want to attempt to outpace the benchmark, while still remaining tied to the general risk and return characteristics of that benchmark.

Asset allocation

A frequent strategy using ETFs involves the development of dense, highly diversified portfolios with assets throughout the globe. ETFs make this strategy simple and highly cost effective. Building these kinds of portfolios can even involve a tactical-, style-, or themed-based strategy while, broadly, remaining completely invested. Investors constructing asset allocation portfolios may use different analytical styles, but traditionally make allocation decisions using different Modern Portfolio Theory techniques, including correlation, standard deviation, and expected return.

Tactical

Many different varieties of tactical investing can be used. They can be as diverse as the ETF market. Mixed with other investment vehicles or using ETFs only, tactical ETF investing is a strategy that highlights what powerful and precise tools ETFs are. Using ETFs, investors can express thematic viewpoints in a global market.

Such viewpoints may include dividend weighting or tilting, or the use of alternative asset classes such as hedge funds and emerging markets. Tactically, investors could shift assets extremely quickly between styles, moving from growth to value in different market caps, in some cases by country, or globally. Sector rotation, using ETFs to move in and out of sectors, has become very popular. Technical or fundamental analysis determines whether sectors are overweighted or underweighted. Some tactics can be carried over into the bond market, where investors can rapidly shift between time periods, and in credit quality. Careful analysis of bond ETFs can allow investors to shift among categories. For example, the choice of different durations and other characteristics inside high-yield bonds is made easy by the wide selection of ETFs available.

In summary

ETF analysis can be carried out using many different techniques, including fundamental and technical analysis. ETF investors, whatever strategy they use, must understand the underlying index. Understanding the structure of, and ways to use, ETFs and other ETPs is only part of what makes ETF strategies effective. Efficient portfolios and trading strategies are created through the sum of an investor’s knowledge of the structure and features of the underlying asset classes and markets. ETFs offer investors access to asset classes, sectors, countries, currencies, and select strategies within a tight, cheap, and tax efficient structure. These passive investments can be used by both the passive and active trader and investor.

This article was originally published in the Nov/Dec 2009 issue of YourTradingEdge magazine. All rights reserved. © Copyright 2011, Your Media Edge Pty Ltd.

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