Taxes, like hemorrhoids, are annoying ETFs can provide relief

People don’t like to talk about them and they are decidedly a pain . . . but taxes are the bane of an investor’s existence.

Investment professionals know that three key characteristics make exchange–traded funds (ETFs) tax efficient:

1. Index-based ETFs have extremely low turnover. Transactions trigger gains taxable in the hands of unit holders.

2. The redemption of ETFs allows for in-kind transfers, allowing sponsors to transfer out the lowest cost shares without incurring tax. This maintains the adjusted-cost base closer to the market value. Unit holders pay most taxes when they sell the ETF, effectively deferring taxes until realized.

3. The creation method and exchange-traded nature of ETFs means that supply and demand are balanced in the marketplace and units do not have to be sold (incurring a possible tax liability) to meet redemption requirements as mutual funds do. As a consequence, ETFs hold less cash to earn taxable income. (albeit not much lately given low interest rates).

These tax minimizing characteristics are a big relief for taxable investors. Had they owned mutual funds, they could be subjected to big taxes unrelated to their actual investment results. Paying for the capital gains or income received by others is just silly.

Tax losses

ETFs are ideally suited for capturing tax losses. The conventional way is to replace a losing stock position with an ETF. Example: sell Research in Motion (RIM) at a loss to buy iShares Canadian Tech Sector ETF (XIT). The loss in the stock position is captured, to be used to offset capital gains in the current year, back three years or carried forward indefinitely. The portfolio exposure, to the technology sector in this case, is maintained.

Another effective tactic is to swap between ETFs with similar underlying risk. An example is iShares S&P 500(IVV) and SPDR 500(SPY). Both have the S&P 500 as their underlying index but because the ETFs have different sponsors, BlackRock and State Street Global Advisors respectively, they are considered different securities for tax purposes. Therefore, they may be traded simultaneously to capture a loss. The 30 day waiting period to avoid a superficial loss is not required.

Holding a core portfolio of ETFs and owning a satellite portfolio of individual stocks is a good way to protect capital gains generated by the stock portfolio by applying tax losses generated from the core. Some firms may offer a tax-loss-capture module, like PŮR Investing’s, that does this automatically.

Caution

Ms. Ioulia Tretiakova, Director of Quantitative Strategies for PŮR Investing, says that while ETFs have tax efficient characteristics, some have shocked investors at tax time.

The 2008 experience with some leveraged Rydex Inverse sector series ETFs is shown here.

ETF	Gain
Rydex Inverse 2x Sector Energy	86.61%
Rydex Inverse 2x Sector Technology	59.46%
Rydex Inverse 2x Sector Financial	42.35%

Ms Tretiakova explains that inverse, leveraged long and leveraged inverse ETFs use swaps and derivative instruments rather than securities that can be transferred in-kind. This creates potential tax liability when the contracts are closed out. Capital gains, influenced by volatility and the expiration of futures contracts related to the underlying sectors on January 1, 2009, were huge for several Rydex ETFs. In Canada, a similar situation is not expected although in 2012 the Horizons Beta Pro’s leveraged ETF products listed below have OTC derivative contracts maturing. A different Canadian structure, unavailable in the U.S., allows sponsors to better minimize taxes. At any rate, leveraged ETFs should always be watched carefully.

ETF	Date	Symbol
HBP S&P/TSX Financials Bull Plus ETF HBP S&P/TSX Financials Bear Plus ETF	June 11, 2012 June 11, 2012	HFU HFD
HBP S&P/TSX Energy Bull Plus ETF HBP S&P/TSX Energy Bear Plus ETF	June 18, 2012 June 18, 2012	HEU HED
HBP S&P/TSX Global Gold Bull Plus ETF HBP S&P/TSX Global Gold Bear Plus ETF	June 25, 2012 June 25, 2012	HGU HGD

Screening ETFs for tax efficiency

While it should be clear by now that taxable investors should always use ETFs rather than mutual funds, differences in the tax efficiency of ETFs bears some attention. Like other forms of investing, “tax” should never be the prime reason to make an investment, however, it is common sense to be mindful of an instrument’s tax impact.

Screening ETFs by the proportional size of their historical distributions is a fair way to assess their tax efficiency. It is these distributions that incur the tax that investors seek to avoid. To be fair, indexes that change their components or are in start-up mode, may incur more transactions and more taxable activity. This should diminish over time.

When choosing between similar ETFs, picking the one with better tax efficiency may improve your after tax return. To see the tax efficiency of ETFs trading in Canada, check the free screener at: http://purinvesting.com/demo/Screen.htm

Picking the right ETF: Liquidity

Lack of liquidity is treacherous for everyone.

Catastrophe in capital markets is always characterized by a lack of liquidity. Significant imbalances between buyers and sellers (widened bid-ask spreads) can create market “gaps”. Occasionally this happens to the upside but predominately it occurs on the downside. Examples: October 1987, September 2001, Q4 2008. Liquidity is important for investors, but a lack of liquidity is treacherous for everyone.


Liquidity of underlying securities

Since the 1990 launch of the first exchange-traded fund (ETF), the Toronto Index Participation Securities (TIPS), liquidity has been important. Originally developed for retail investors, TIPS became popular among institutional investors seeking broad market access in part because of the liquidity of the 35 stocks underlying TIPS. It follows that ETFs with illiquid holdings should be watched carefully. Fixed income ETFs can fall into this category.

Theoretically, trading volume and liquidity for today’s ETFs is not a problem with the creation/redemption mechanism. This structure authorizes designated brokers to create additional units if demand exceeds supply, and conversely, remove units when supply exceeds demand. But there are differences in bid-ask spreads impacting every investor’s bottom line that require explanation.


Timing and volume

“An ETF manager may be doing a terrific job of tracking an index,” says Ioulia Tretiakova, Director of Quantitative Strategies for PŮR Investing, “but the retail investor may still be impacted by liquidity costs, paying a hefty price in the form of wide bid-ask spreads or volatile premiums/discounts to net asset value (NAV), all resulting in less than stellar market liquidity.

“Transacting before a holiday or at other times when volume is expected to be low, can be expensive and should be avoided. For example the closing bid-ask spread for actively traded iShares CDN S&P/TSX 60 (XIU), as of Friday, October 9, 2009 (Thanksgiving weekend) was $17.08-17.10 or 11.7 bps (normally about 5.8 bps) and for less actively traded Claymore Canadian Fundamental Index ETF (CRQ), was $10.85-10.99 or 129 bps (normally about 28 bps). Bid-ask spreads are generally correlated with trading volume and tend to be tighter for ETFs with more assets under management as the examples above demonstrate. 3 month average trading volume: XIU 17.6 million shares vs. CRQ 35,632 shares. The chart below demonstrates that trading volume and bid-ask spreads are correlated. This is not a surprise. More activity reflects popularity which suggests better arbitrage opportunities to keep spreads narrow and ETF values close to NAV.

“Poor liquidity can cost investors money. Most ETF prices oscillate around their NAV. The absolute level of premium/discount and its standard deviation, a measure of how far, on average, the market price of an ETF tends to deviate from the NAV, warrants scrutiny. Some ETFs, primarily fixed income, trade mostly at a premium. For these ETFs, the magnitude of the average premium depends on the liquidity of the underlying assets, a good example being iShares Canadian Real Return Bond ETF, (XRB). Due to the limited depth of the Canadian real return bond market, this ETF tends to trade at a premium to NAV, closing at $20 on October 9, 2009 with a NAV of only $19.75, or a 1.27% premium.”

The daily historical premium/discount to NAV for the XRB is shown below.


Conclusion

The overall measure of ETF liquidity is a combination of factors; bid-ask spreads, fund assets, trading volume, premium-discount and last, but not least, the liquidity of the underlying assets. Imbalances can lead to tracking error that can distort strategies (to be covered in a future article).

If investors intend to hold positions for longer than 6 months, liquidity may be less of an issue, but larger spreads can be costly over time to frequent traders. A rule of thumb for liquidity is that if the securities underlying the ETF are popular, the ETF’s construction is transparent, and trading is active, liquidity should be pretty good.

PŮR Investing Inc. offers a free ETF screener on their website that includes liquidity: www.purinvesting.com.

Picking the right ETF: Diversification

PICKING THE RIGHT ETF: Diversification

First of a series of articles exploring how to sort and evaluate exchange traded funds.


The need

Exchange-trade funds (ETFs) have had the most profound impact on personal investing since the introduction of the modern mutual fund in 1924. To the advantages that drove mutual fund growth; diversification, professional management, and shared expenses, ETFs have added low costs, transparency, market access throughout the trading day and tax efficiency.

Institutions lead the use of ETFs for effective acquisition and hedging of portfolio positions. In 2008, the ability to short financial ETFs while shorting individual financial company shares was banned is only one example of the value of these instruments.

With over 100 ETFs trading in Canada, over 800 in the U.S., and over 500 more in registration, this rapidly expanding universe demands better selection tools.

These articles will explore key factors for evaluating ETFs beyond simple categorization and screening. Diversification, liquidity, cost, tax efficiency and tracking error will be examined for their impact on portfolio construction.



DIVERSIFICATION


Definition

Diversification is a method to control risk by limiting exposure to any one holding. Institutions typically diversify by:

 asset class (stocks, bonds, cash, real estate, commodities, currency)
 region (domestic, foreign, emerging markets)
 style (value, growth, core)
 size (large cap, mid-cap, small cap)
 sector (financials, materials, technology, energy)

All of these are available via ETFs. Individual investors no longer need millions of dollars to get broad exposure.


How to measure it

The quantitative way to measure diversification is by measuring the specific (idiosyncratic) risk in a portfolio. The less specific risk there is, the better the diversification. Specific risk is the risk "specific" to a security, not explained by systematic market factors (such as energy prices, interest rates, etc).

Specific risk is a metric routinely calculated by risk models. Investors without access to risk models can use PŮR’s “rule of thumb” approach:

 total number of securities (PŮR recommends at least 50),
 weight represented by the top 10 holdings (PŮR recommends under 30%)
 weight of maximum individual holdings (PŮR recommends 10%).


Why it is important

According to capital market theory, specific risk is not rewarded. That's why minimizing exposure to this risk by increasing diversification makes sense. Better diversification can mean less variability in a portfolio’s value. Professionals call this “risk management”, investors call it “sleeping at night”.


How it works

The principle is based on the idea that prices of selected assets can move independently from one another (uncorrelated). Good diversification means lots of different risks not lots of different assets, as many investors often forget. ETFs’ risk is more reliable than that of individual securities because it is dampened by the variety and number of their holdings. The result offers a more effective approach to portfolio construction.


What are you trying to do?

Are you an investor or a trader? This will impact how you choose ETFs.

Investor: Your investing horizon is 5 years plus and you’re looking to overweight areas of the economy that will outperform. You need to manage risk, so diversification is important. Selecting the more diversified ETFs from different asset classes, regions, styles, sizes and sectors is a good way to succeed.

Trader: Your investing horizon is lunchtime tomorrow (maybe up to one year). All you need to predict price movements is in price, volume and trading statistics. You gain by exploiting volatility and you trade frequently. Ironically, ETFs dampen volatility! Nevertheless, it may be easier to make a call on a sector (like financials) rather than a single security (like TD Bank ). Diversification is a two-edged sword for you, but is useful in assessing broad or specific exposure to underlying indices.

Examples

An ETF’s diversification is a function of the number, concentration and nature of its holdings.

iShares CDN Large Cap 60 Index Fund (Symbol: XIU) with 60 holdings vs. iShares CDN Composite Index Fund (Symbol: XIC), with 220 holdings, illustrates similar ETFs with different diversification. While similar, the XIC is somewhat better. This doesn’t necessarily mean that XIC is the better choice however. As we will see in a future article, cost is a very important factor.

The iShares CDN Tech Sector Index Fund (Symbol: XIT) with only 5 holdings is a very concentrated ETF that would score low on diversification but may be interest traders.

Single commodity-based ETFs represent pure systematic risk. They are asset classes by themselves. Some U.S. ETFs track commodity indices that have different sector concentrations. Look before leaping.


Summary

Diversification is one the most important factors in ETF evaluation. It is central to portfolio construction and an important reason for ETF popularity today. In the next issue, we will discuss liquidity, important for when the $%^t hits the fan as it did in 2008.

PŮR Investing Inc. is a registered portfolio manager specializing in risk managment using exchange traded funds. PŮR’s free ETF screener is available at: http://purinvesting.com/demo/Screen.htm

Goals-based asset allocation: Part B

Using the right tool for the job is fundamental in many disciplines. To drive a nail one needs a hammer, to insert a screw, a screwdriver, to screw unsuspecting investors , Goldman Sachs (http://www.rollingstone.com/politics/story/28816321/the_great_american_bubble_machine/print) But I digress! Actually, from the viewpoint of many investors, all advisors, not just the ones at GS were guilty last year.

"If your only tool is a hammer, every problem looks like a nail." I love that phrase and it applies well to the investment business. Investment advisors too often believe that making as much money as possible is everyone's goal all of the time. Is that equally the case for a 26 year old investment banker and a 68 year old retired school teacher? Maybe, but not likely. So why do advisors push similar solutions for each client?

Whoa! You may argue that giving the retiree a conservative balanced or all fixed income portfolio and the banker an all equities or emerging markets portfolio is providing different solutions. But neither solution was likely constructed based upon that investor's needs only their perceived risk tolerance. What's the difference? Sometimes not much, but usually quite a bit!

If you ask a prospective investor to mentally divide their pool of investment capital into three buckets:
1. Basic needs: food clothing and shelter
2. Enhanced lifestyle: cottage, vacations, French rather than Chilean wine
3. Legacy: grandchildren's education, philanthropy.
a typical split may be 1.(60%) 2.(25%) 3.(15%).

Now assign risks to each bucket.
Bucket 1 is pretty important so you can't take much risk with that one. Perhaps you buy all bonds with this portion.
Bucket 2 gives you more flexibility. Perhaps a 60% equity 40% bond portfolio will address this need.
Bucket three is a long time horizon goal so perhaps 80% equities and 20% bonds works for this piece.

Now you have addressed client goals but investing time horizon needs to be accommodated. More on this in the next installment.

Goals-based asset allocation: Part A

There is not much new in the world of asset allocation despite the drubbing portfolios sustained last year. The best and the brightest minds and the most researched and supported techniques failed to save Humpty Dumpty from shattering on impact as he fell from that wall.

The Harvard and Yale Endowments, and in Canada, the Ontario Teachers' Pension Plan and le Caisse de depot et placements with extensive risk budgeting tools and an enviable record of success, succumbed to the same gap in the system that eliminated 30-40% of the value of stock portfolios globally. Capital markets went into "rectal lock" and values plummeted in the ensuing vacuum.

What were the goals of these institutions? Did they achieve what they set out to achieve? What could have been done differently? All these questions are being asked and the industry, its observers and consultants have been offering opinions. The "finger pointing" has been extraordinary. The only question that is meaningful for most of us is: what can investors and investment professionals learn from this experience?

Asset allocation describes the strategy investors follow to divide their money between different assets like stocks, bonds and cash. The underlying principle is that the prices of different assets move in different (uncorrelated) ways leading to the idea that "diversification" protects against risk, as defined as volatility.

The obvious problem is that this approach says little about the objectives of the investor. Volatility is an abstract concept for most retail investors. After the extreme volatility of capital markets last year, I suspect it is a more distant concept for many professionals also.

Goals-based asset allocation attempts to match the volatility of a group of assets to the broad goals of an investor. I'll explore how to do this in future posts.

Leveraged and inverse ETFs

The controversy over ETFs that offer 2 or 3 times the daily price movement of an index (up or down) is rooted in the wonky returns from an unprecedented period of volatility in capital markets in 2008 and early 2009.

The Foundation for Advancement of Investor Rights (FAIR) executive director Ermanno Pascutto has been clear in criticizing these products as misleading. His statement in the May 15, 2009 Jonathan Chevreau Financial Post article "Investor group blasts makers of leveraged ETFs" could be, with respect for the goals of the organization, better informed.

"There's a lot of detailed disclosure in the prospectus about risk but nowhere does it bluntly tell you you could be completely right in your selection of an ETF and find out that despite being right, you lose money". He goes on to say "In several cases, no matter which way you bet over the past year, you would have lost money."

One of the examples cited is the case of the Horizon BetaPro Global Gold + ETF. The underlying index, the S&P/TSX Gold Mining Index was up 0.9% for the year ending March 31, 2009 while the Bull + (2X) ETF was down 46.4% and the Bear + (-2X) was down 86.7%. At first glance this doesn't seem right. The fact is that each ETF delivered pretty much what they said they would, 2X the daily price movement of the index. The issue is the difference between arithmetic daily returns and geometric compounded returns.

It doesn't take much volatility to get these two different returns out of alignment. When volatility is as wild as it was for the 12 months ending March 31, 2009, the extreme results mentioned earlier are possible.

A way to estimate the impact of volatility on the returns of leveraged ETFs is as follows:

daily geometric return = daily arithmetic return - (0.50 X SD^2)

In the case of the S&P/TSX Gold Mining Index, the daily volatility was 5% and that of the HBP Bull and Bear + ETFs was 10%! Working through the above formula one derives an estimate of 0.50% per day. This translate into 72% per annum of volatility drag. In other words, assuming zero index movement for a year, an investor could expect a -72% return from volatility in this ETF. The investment strategy is very clear, if an investor expects a high level of volatility to persist; short the ETF.

If FAIR wanted to help the broadest base of individual investors, they would be doing better to demand that Canadian mutual fund prospectuses display costs on the front page in a type size that everyone can read so that Canadian investors would know that they are being charged the highest mutual fund fees in the world.

Canada Cup of Investment Management 2009

This two day event, held in Toronto, has just ended. It was a subdued gathering compared to similar events several years ago when capital markets were more sanguine. The bloodied financial system and subsequent economic consternation has left investment professionals bewildered and chastened. This is quite significant when considering few stadiums could accommodate their collective egos in better times.

The presentations were good. Even mine, I am told! But most surprising was the attention attendees paid to the messages from sessions titled: Critical issues facing pension funds for the next year/Global economic crisis and its impacts on investment and risk management decisions. In better times, one can't tell portfolio managers anything. They are gods in bull markets! Today, gods in training.

The double barreled kick off speakers were Dwight Duncan, Finance Minister, Ontario followed by Iris Evans, Finance Minister, Alberta. We were reminded why we all should live in Alberta. One could conclude from this small sample of two people that there seems to be some intelligent life among politicians in that province.

Big public sector pension money was represented. Ontario and Alberta Teachers Pension funds, Hospitals of Ontario Pension Plan, OMERS, OPSEU, and others. Folks were in shock that their well constructed portfolios designed for diversification all took a bath. "Correlations all rose" they complained. The tools failed, VaR failed, alternatives failed, leveraged and inverse ETFs disappointed and the only way back is if the markets float funds into solvency. In other words, their is no resolution.

Everyone shuffled through the sessions looking for answers finding solace only in group commiseration.

The best hope for salvation was mentioned several times but usually out of context. It was as if nobody wanted to admit they were spooked by volatility and that it was too early after the disaster to face the perpetrator. Consultants failed to boost spirits with predictions of a long and uncertain road back. (Check this space in the future for more about the "answer").

The only bright event was the announcement that the Bank of Montreal had listed four exchange traded funds on the TSX Thursday. Their first. This is important because it marks a validation of this lower cost alternative to mutual funds. The mutual fund industry was only muddling along in Canada until 1990 when the banks entered the market that they now dominate, and validated that product. How many other banks will follow suit by January 2010?