“Experienced investors understand four wonderfully powerful truths about investing, and wise investors govern their investing by adhering to these four great truths:
1. The dominant reality is that the most important decision is your long term mix of assets; how much in stocks, real estate, bonds, or cash.
2. The mix should be determined by the real purpose and time of use of money.
3. Diversify within each asset class – and between asset classes. Bad things do happen – usually as surprises.
4. Be patient and persistent. Good things come in spurts – usually when least expected – and fidgety investors fare badly. “Plan your play and play your plan,” say the great coaches. “Stay the course” is also wise. So is setting the right course – which takes you back to great truth number 1.”
— Charles D. Ellis, 2007
Charles Ellis is a dean of institutional investing. The founder and managing partner for 30 years of respected consulting firm Greenwich Associates, he pioneered the systematic application of measurable investing activity. Supported by the 1986 research of Gary Brinson, L. Randolph Hood, and Gilbert Beebower, and follow on work by Jahnke, Ibbotson and others, the important role of asset allocation in the investment process developed.
In 2008-2009, extreme volatility, caused by the financial crisis, repealed the laws of asset allocation. Everything went down. Judicious choice of non-correlated assets was meant to invoke the protective properties of diversification. But correlations, based on historical relationship, have always wavered in the face of crisis. Yet advisors and professional investors alike embrace the tenets articulated by Ellis above.
It is not that these platitudes are wrong. There aren’t many absolutes in the investment world after all (except, perhaps, that costs detract from returns). Rather, there should be a fifth truth:
“The risk of assets selected for a portfolio should not only be consistent with the goals, time horizon, and risk tolerance of the investor or mandate, but should be kept consistent particularly when market risk rises and falls.”
Risk is like the temperature of bath water, some like it hotter than others, some cooler. If the temperature is too hot, add some cool. Conversely for a cooler bath, remove some cool and add some hot. Portfolios can be managed the same way.
If you would like to follow our ongoing research, please leave your email address and we’ll keep you apprised as we progress over the next several quarters.
Thursday, May 20, 2010
Thursday, April 15, 2010
Bird-brained stock picking
Less guesswork with exchange-traded funds
Every week at home, as a keen young portfolio manager, I would pour over the charts of all the stocks traded on the New York and American Stock Exchanges that were included in a binder with 12 charts to the page, 24 in total when open.
My pet cockatiel, named Dow Jones, would fly around the room as I worked. One day, he landed on my shoulder and walked down my arm onto the chart book. He shuffled around and pecked showed his displeasure in a unique bird-like way on one of the charts. The next day that stock went down sharply! A humorous coincidence!
He did it the next week and the next. Each stock that received a “deposit” went down in price. Still a humorous coincidence, but I realized it represented a random key to how many people make investment decisions.
People are notoriously random when it comes to making investment decisions. They base them on conversations overheard in the office bathroom, or relatives who’ve seen big returns on their investments, or the sound bites of investment journalists. And then they pray. People do what they think worked for them in the past regardless of the method’s randomness. Sometimes their lottery ticket selection strategy is more systematic. No wonder so many investors end up with a portfolio of random securities with no plan or purpose.
But when it comes to exchange-traded funds, there is no guesswork. There is less guesswork with exchange-traded funds (ETFs). These securities track an broad indicies, a commodities, currencies, sectors and industries and allow investors to take leveraged long and short positions. a grouping of assets like an index fund, or a trade like a stock on an exchange. They offer diversification, and the ability to sell short, buy on margin, and purchase as little as one share and trade like a stock during regular exchange hours.
There are only three basic ways to build portfolios with them, all others are variations. Over the next three issues, I will examine each of these.
Here is a brief overview of how ETFs portfolio construction works:
Fundamental approaches
The fundamental approaches use some form of “top down” or “bottom up” analysis. Assessing views of global, regional and local economies and their impact on sectors, industries and companies, ETFs lend themselves nicely to these strategies because they make country, regional, sector and industry investing simple.
Institutional managers can use ETFs to establish broad exposure before making specific securities investments and they can hedge existing exposure by shorting the relevant ETF. Portfolios for individual investors can similarly benefit from diversified exposure to elements identified by the portfolio manager.
“Bottom up” managers, or stock pickers who screen for superior growth, value a combination of both or other factors, have style ETFs as well as large, mid-cap, and small capitalization alternatives in different regions and sectors to choose from.
Many large portfolios and pension schemes employ “core” plus “satellite” or “tactical” approaches. They create a passive core cheaply and select active alpha-seeking strategies around that core.
ETFs offer flexibility and choice at a low cost so these traditional approaches can be applied to private client portfolios effectively. The tax efficiency of separately managed accounts combines nicely with ETFs so many firms will be encouraged to transition pooled and mutual fund assets to this format. Indeed, low costs contribute to better performance, so complacent product vendors should pay attention.
Market timing
Today, there are 1,000 ETFs available worldwide, with another 500 or so in registration, a fact attractive to many. Include currency; commodity; leveraged or enhanced; long and short; so-called “fundamental” and even Chinese real estate ETFs; and the possibilities grow.
Traders feed on volatility. So it’s good news that the dampened relative volatility of groups of securities, which counters traders’ need for action, is offset by better liquidity from the ETF structure.
Leveraged ETFs that offer the holder two times the daily price movement of an index are available; inverse versions go up two times the daily fall in price of an index. This is the type of action that traders want. But leveraged ETFs are not just for traders.
Trading has done much to democratize capital markets for individual investors; specialized education in financial analysis is not required. Technical analysis, the trader’s discipline, doesn’t care about companies, products, margins or market share. All that matters is price movement.
Within the movement of prices (and sometimes trading volume) lies all the necessary information needed to make buy and sell decisions. Anybody can apply these methods to the price of anything. This is pure market timing.
SIDEBAR
Risk management
The low cost and tax efficiency of ETFs are what individual investors should exploit. However, there are many other perks to using ETF products:
1. A free lunch: Lowering risk by using levered ETFs : If achieved, investors benefit from the higher return potential from leverage without assuming additional risk.
2. Risk budgeting through sophisticated portfolio construction: Only the most sophisticated institutions use this approach that optimizes diversification by assigning weights by risk.
3. Constant volatility: Consistent risk exposure for individuals can help avoid sharp market declines.
ETFs are neat little packages of diversified risk that make effective building blocks for many kinds of portfolios. Next month: ETFs in greater detail.
Every week at home, as a keen young portfolio manager, I would pour over the charts of all the stocks traded on the New York and American Stock Exchanges that were included in a binder with 12 charts to the page, 24 in total when open.
My pet cockatiel, named Dow Jones, would fly around the room as I worked. One day, he landed on my shoulder and walked down my arm onto the chart book. He shuffled around and pecked showed his displeasure in a unique bird-like way on one of the charts. The next day that stock went down sharply! A humorous coincidence!
He did it the next week and the next. Each stock that received a “deposit” went down in price. Still a humorous coincidence, but I realized it represented a random key to how many people make investment decisions.
People are notoriously random when it comes to making investment decisions. They base them on conversations overheard in the office bathroom, or relatives who’ve seen big returns on their investments, or the sound bites of investment journalists. And then they pray. People do what they think worked for them in the past regardless of the method’s randomness. Sometimes their lottery ticket selection strategy is more systematic. No wonder so many investors end up with a portfolio of random securities with no plan or purpose.
But when it comes to exchange-traded funds, there is no guesswork. There is less guesswork with exchange-traded funds (ETFs). These securities track an broad indicies, a commodities, currencies, sectors and industries and allow investors to take leveraged long and short positions. a grouping of assets like an index fund, or a trade like a stock on an exchange. They offer diversification, and the ability to sell short, buy on margin, and purchase as little as one share and trade like a stock during regular exchange hours.
There are only three basic ways to build portfolios with them, all others are variations. Over the next three issues, I will examine each of these.
Here is a brief overview of how ETFs portfolio construction works:
Fundamental approaches
The fundamental approaches use some form of “top down” or “bottom up” analysis. Assessing views of global, regional and local economies and their impact on sectors, industries and companies, ETFs lend themselves nicely to these strategies because they make country, regional, sector and industry investing simple.
Institutional managers can use ETFs to establish broad exposure before making specific securities investments and they can hedge existing exposure by shorting the relevant ETF. Portfolios for individual investors can similarly benefit from diversified exposure to elements identified by the portfolio manager.
“Bottom up” managers, or stock pickers who screen for superior growth, value a combination of both or other factors, have style ETFs as well as large, mid-cap, and small capitalization alternatives in different regions and sectors to choose from.
Many large portfolios and pension schemes employ “core” plus “satellite” or “tactical” approaches. They create a passive core cheaply and select active alpha-seeking strategies around that core.
ETFs offer flexibility and choice at a low cost so these traditional approaches can be applied to private client portfolios effectively. The tax efficiency of separately managed accounts combines nicely with ETFs so many firms will be encouraged to transition pooled and mutual fund assets to this format. Indeed, low costs contribute to better performance, so complacent product vendors should pay attention.
Market timing
Today, there are 1,000 ETFs available worldwide, with another 500 or so in registration, a fact attractive to many. Include currency; commodity; leveraged or enhanced; long and short; so-called “fundamental” and even Chinese real estate ETFs; and the possibilities grow.
Traders feed on volatility. So it’s good news that the dampened relative volatility of groups of securities, which counters traders’ need for action, is offset by better liquidity from the ETF structure.
Leveraged ETFs that offer the holder two times the daily price movement of an index are available; inverse versions go up two times the daily fall in price of an index. This is the type of action that traders want. But leveraged ETFs are not just for traders.
Trading has done much to democratize capital markets for individual investors; specialized education in financial analysis is not required. Technical analysis, the trader’s discipline, doesn’t care about companies, products, margins or market share. All that matters is price movement.
Within the movement of prices (and sometimes trading volume) lies all the necessary information needed to make buy and sell decisions. Anybody can apply these methods to the price of anything. This is pure market timing.
SIDEBAR
Risk management
The low cost and tax efficiency of ETFs are what individual investors should exploit. However, there are many other perks to using ETF products:
1. A free lunch: Lowering risk by using levered ETFs : If achieved, investors benefit from the higher return potential from leverage without assuming additional risk.
2. Risk budgeting through sophisticated portfolio construction: Only the most sophisticated institutions use this approach that optimizes diversification by assigning weights by risk.
3. Constant volatility: Consistent risk exposure for individuals can help avoid sharp market declines.
ETFs are neat little packages of diversified risk that make effective building blocks for many kinds of portfolios. Next month: ETFs in greater detail.
Thursday, February 18, 2010
ETF Tracking Error: Where's the beef?
The 1 kg of stewing beef I bought ended up tasting like pork. When confronted, the butcher retorted “Well buddy, it’s meat isn’t it?” Most consumers would be incensed at this response, but for some reason, investors are far more tolerant. It may be that mutual funds have dulled our expectations by underperforming their benchmarks for decades.
But for exchange-traded funds (ETFs), the standards should be higher.
They should be higher because their benchmarks are transparent indices (for the most part) and the goal is replication.
Tracking error, what is it and why is it important
Mathematically, tracking error is the standard deviation of the difference between index and ETF returns. Example: 4% tracking error means that annual ETF returns will be within ±4% of index return, two times out of three.
Ioulia Tretiakova, Director of Quantitative Strategies, PŮR Investing Inc., affirms that while tracking error can be important if ETFs are used to hedge a portfolio, understanding tracking error helps individual investors employ these vehicles more effectively.
Causes of tracking error
There are three ways to replicate an index:
Stratified sampling: buy only some of the underlying securities: you order a chicken and get 1 wing, 1 breast, 1 leg, 1 thigh.
Optimization: use underlying securities and/or derivative instruments to mimic an index’s return: chicken fingers!
Full replication: buying all the components of an index is the most effective way to minimize tracking error. You order a chicken and get the whole bird.
Ordering a chicken and getting chicken fingers may not bother some investors, but understanding the possibility is important. To be fair, stratified sampling and optimization can be the only practical approaches given size and liquidity considerations. The DEX Universe Bond Index has 1,058 holdings while the popular iShares CDN Bond Index Fund (XBB) that mirrors it, holds only 301 issues.
Ms. Tretiakova observes, “Regulation has an impact. There is no maximum security weight for ETFs in Canada, but in the U.S. there is a 19.99% cap. Hence the return of Vanguard’s Information Technology ETF (VGT) lagged its benchmark MSCI U.S. Investable Market Information Technology Index, by 50% since inception (1/26/2004 to 1/3/2010) in part because the index weight of AT&T was 49% and only 19.99% for VGT.” This is like ordering three chickens and getting the two-bird maximum.
Should daily returns be used to calculate tracking error?
The index underlying the iShares MSCI EAFE Index Fund (EFA) and its “Loonie-hedged” cousin, XIN, does not have a contemporaneous closing time, so using daily closing NAVs and index values for tracking error calculations makes little sense; like roosters crowing dawn in each time zone.
On the other hand, the tracking error of leveraged ETFs (in Canada, the Horizon BetaPro series) should be calculated using periods no longer than daily. Over the longer term, daily rebalancing will cause divergence made all the greater by volatility; like ordering an egg and getting a two egg omelette.
Leveraged ETF tracking error
The multiple-of-daily-index-return objective of leveraged ETFs is not completely accurate, warns Ms. Tretiakova. What actually happens, in the case of a 2X ETF, is that “there is twice the total return minus one times the cost of capital. Currently, this is slightly better for investors than the stated objective of twice the price return because dividend yields are slightly higher than the cost of capital. However, when these two rates vary, the difference may be more significant.”
Leveraged Fund Performance Relative to Stated Objective
and its relationship to dividend yield-interest rate differential
ETFs with unusual tracking error
Some ETFs operate without a specifically stated benchmark, defining only broad asset class exposure. For example, the Claymore Broad Emerging Markets ETF (CWO, launched April 7, 2009) states that “The Manager will select an Emerging Markets Benchmark Index such as the MSCI Emerging Markets Index, the FTSE RAFI Emerging Index or another widely recognized emerging markets index in order to provide such exposure and may change the Emerging Markets Benchmark Index in its discretion without unit-holder approval.” This sounds like advertising chicken while delivering duck. The challenge is trying to determine the tracking error when the target index is changing. One comfort these unit-holders have is that the indicies for groups of emerging markets will likely have similar volatility (risk). This means that the advertised chicken is unlikely end up being pork chops!
Finding tracking error information
Most ETF sponsors offer tracking error information on their websites. Often shown in chart form, price movement of ETFs are easily compared with their underlying index. The actual tracking error of Canadian-traded ETFs and how they compare to others is available at http://purinvesting.com/demo/Screen.htm .
A cost to investors, tracking error is well worth monitoring. It’s one way of keeping ETF sponsors honest and assuring you don’t get salt pork when you expected steak.
Mark Yamada is President of PŮR Investing Inc. a registered portfolio manager specializing in risk management using exchange-traded funds.
But for exchange-traded funds (ETFs), the standards should be higher.
They should be higher because their benchmarks are transparent indices (for the most part) and the goal is replication.
Tracking error, what is it and why is it important
Mathematically, tracking error is the standard deviation of the difference between index and ETF returns. Example: 4% tracking error means that annual ETF returns will be within ±4% of index return, two times out of three.
Ioulia Tretiakova, Director of Quantitative Strategies, PŮR Investing Inc., affirms that while tracking error can be important if ETFs are used to hedge a portfolio, understanding tracking error helps individual investors employ these vehicles more effectively.
Causes of tracking error
There are three ways to replicate an index:
Stratified sampling: buy only some of the underlying securities: you order a chicken and get 1 wing, 1 breast, 1 leg, 1 thigh.
Optimization: use underlying securities and/or derivative instruments to mimic an index’s return: chicken fingers!
Full replication: buying all the components of an index is the most effective way to minimize tracking error. You order a chicken and get the whole bird.
Ordering a chicken and getting chicken fingers may not bother some investors, but understanding the possibility is important. To be fair, stratified sampling and optimization can be the only practical approaches given size and liquidity considerations. The DEX Universe Bond Index has 1,058 holdings while the popular iShares CDN Bond Index Fund (XBB) that mirrors it, holds only 301 issues.
Ms. Tretiakova observes, “Regulation has an impact. There is no maximum security weight for ETFs in Canada, but in the U.S. there is a 19.99% cap. Hence the return of Vanguard’s Information Technology ETF (VGT) lagged its benchmark MSCI U.S. Investable Market Information Technology Index, by 50% since inception (1/26/2004 to 1/3/2010) in part because the index weight of AT&T was 49% and only 19.99% for VGT.” This is like ordering three chickens and getting the two-bird maximum.
Should daily returns be used to calculate tracking error?
The index underlying the iShares MSCI EAFE Index Fund (EFA) and its “Loonie-hedged” cousin, XIN, does not have a contemporaneous closing time, so using daily closing NAVs and index values for tracking error calculations makes little sense; like roosters crowing dawn in each time zone.
On the other hand, the tracking error of leveraged ETFs (in Canada, the Horizon BetaPro series) should be calculated using periods no longer than daily. Over the longer term, daily rebalancing will cause divergence made all the greater by volatility; like ordering an egg and getting a two egg omelette.
Leveraged ETF tracking error
The multiple-of-daily-index-return objective of leveraged ETFs is not completely accurate, warns Ms. Tretiakova. What actually happens, in the case of a 2X ETF, is that “there is twice the total return minus one times the cost of capital. Currently, this is slightly better for investors than the stated objective of twice the price return because dividend yields are slightly higher than the cost of capital. However, when these two rates vary, the difference may be more significant.”
Leveraged Fund Performance Relative to Stated Objective
and its relationship to dividend yield-interest rate differential
ETFs with unusual tracking error
Some ETFs operate without a specifically stated benchmark, defining only broad asset class exposure. For example, the Claymore Broad Emerging Markets ETF (CWO, launched April 7, 2009) states that “The Manager will select an Emerging Markets Benchmark Index such as the MSCI Emerging Markets Index, the FTSE RAFI Emerging Index or another widely recognized emerging markets index in order to provide such exposure and may change the Emerging Markets Benchmark Index in its discretion without unit-holder approval.” This sounds like advertising chicken while delivering duck. The challenge is trying to determine the tracking error when the target index is changing. One comfort these unit-holders have is that the indicies for groups of emerging markets will likely have similar volatility (risk). This means that the advertised chicken is unlikely end up being pork chops!
Finding tracking error information
Most ETF sponsors offer tracking error information on their websites. Often shown in chart form, price movement of ETFs are easily compared with their underlying index. The actual tracking error of Canadian-traded ETFs and how they compare to others is available at http://purinvesting.com/demo/Screen.htm .
A cost to investors, tracking error is well worth monitoring. It’s one way of keeping ETF sponsors honest and assuring you don’t get salt pork when you expected steak.
Mark Yamada is President of PŮR Investing Inc. a registered portfolio manager specializing in risk management using exchange-traded funds.
Tuesday, January 26, 2010
Lower costs, better portfolios (sometimes)
Exchange-traded funds (ETFs) are less expensive than mutual funds by a wide margin. Embedded mutual fund distribution costs, paid to financial advisors for selling them, are most of the difference. Claymore is the only ETF sponsor in Canada paying advisors from a separate ETF series that is 0.50-0.75% more expensive. While brokerage costs must also be considered when acquiring ETFs, improving transparency is helping investors make more informed choices.
Canadian Median Mutual Fund MER vs. ETF MER
Canadian Equities Mutual Fund Median 2.45%
0.16% BMO Dow Jones Canadian Titans 60 (ZCN)
0.17% iShares Large Cap 60 (XIU)
0.25% iShares CDN Composite (XIC)
0.65% Claymore Canadian Fundamental (CRQ)
1.15% HBP S&P TSX 60 Bull Plus (HXU)
Canadian Bonds Mutual Fund Median 1.96%
0.15% Claymore 1-5 yr Laddered Gov’t Bond (CLF)
0.325% BMO Canadian Gov’t Bond Index (ZGB)
0.35% iShares CDN Government Bond (XGB)
Int’l Equities Mutual Fund Median 2.69%
0.455% BMO International Equity Hedged (ZDM)
0.49% iShares MSCI EAFE Hedged (XIN)
0.65% Claymore International Fundamental (CIE)
Emerging Markets Mutual Fund Median 2.93%
0.535% BMO Emerging Mkts Equity Index (ZEM)
0.65% Claymore BRIC (CBQ)
0.82% iShares CDN MSCI Emerging Markets (XEM)
1.15% HBP MSCI Emerging Mkt Bull Plus (HJU)
Commodities Mutual Fund Median 2.60%
0.40% iShares COMEX Gold Trust (IGT)
0.75% HBP COMEX Gold (HUG)
1.15% HBP COMEX Gold Bullion Bull Plus (HBU)
ETF COST DIFFERENCES
Among the Canadian Equity ETFs shown, newcomer Bank of Montreal (BMO) undercut comparable and more established iShares LargeCap 60 by 0.01%. and similarly positioned themselves in bonds, U.S. and international equities, and emerging markets.
Sometimes costs reflect structural differences. Higher-priced iShares CDN Composite at 0.25%, includes a broader holdings base (S&P/TSX Composite’s 204 issues). Claymore’s Canadian Fundamental (0.65%) would appear to be out of step with the group, but includes an “embedded strategy” namely a value bias in the construction of its index. Claymore is actually offering an actively-managed ETF in passive clothing.
PASSIVE OR EMBEDDED STRATEGIES
Distinguishing passive ETFs from those with embedded strategies is a good starting point for portfolio building. One is not better than the other, but those with embedded strategies are usually more expensive. Director of Quantitative Strategies at PŮR Investing, Ioulia Tretiakova, maintains: “You never know what the future return of an ETF is going to be, but you do know its cost.”
Embedded strategies try to offer something in return for their higher cost. In Claymore’s RAFI Fundamental series, it is a tilt towards value stocks. If this is what you want, ETFs can give you effective access. The Horizon BetaPro (HBP) Plus ETF series offers two times the DAILY return for the “Bull” version and two times the inverse DAILY return for the “Bear” series. This powerful leveraging capability comes at a cost of 1.15% but considering the “double exposure” makes the effective MER 0.575%. This appears expensive in the Canadian equity category with offerings at 0.16-0.17%, but in emerging markets, where iShares cost 0.82%, HBP appears more competitive.
TRADING COSTS
While lower cost is a key ETF benefit, management expense ratios tell only part of the story. Studies of U.S. mutual funds showed that annual trading costs were 1.44% per year (Edelin/Evans/Kadlec, 2007). Canadian mutual fund trading costs are not available, but exchange traded fund trading costs are certainly lower than mutual fund costs for two reasons:
1. the index nature of ETFs means little trading is required for rebalancing;
2. market-makers for Canadian ETFs assume the cost and risk of rebalancing including index composition changes. Elsewhere in the world, the cost of an index change is borne by the ETF unit-holder. If the annual trading cost for an active Canadian mutual fund is 1.0%, and the comparable ETF cost is 0.0%, it is little wonder that active funds have so much difficulty beating index and ETF performance.
LOONIE EH?
Canadian investors, like counterparts around the world, focus most investments in their domestic currency. This makes sense because liabilities and expenses are Loonie-centric. Some international ETFs are offered “hedged”. This comes at a cost. Is it better to buy the hedged or unhedged ETF? The answer is related to your expected holding period. Here’s a guideline:
1. The longer the holding period (over 4 years) you may be better off unhedged. The cost of hedging is fixed and compounds over time.
2. If you have a view about the direction of currencies, hedging for protection or unhedging for exposure can become part of your strategy.
ETFs offer an increasing palette of risk shapes and colours giving investors broad scope to construct portfolios that reflect their views and address their needs. Cost is a rare certainty in a financial world filled with unknowns. Consequently, it is one of the most important considerations in building any portfolio.
PŮR Investing Inc. is a registered portfolio manager specializing in risk management using exchange traded funds. PŮR’s free ETF screener is available at: http://purinvesting.com/demo/Screen.htm .
Canadian Median Mutual Fund MER vs. ETF MER
Canadian Equities Mutual Fund Median 2.45%
0.16% BMO Dow Jones Canadian Titans 60 (ZCN)
0.17% iShares Large Cap 60 (XIU)
0.25% iShares CDN Composite (XIC)
0.65% Claymore Canadian Fundamental (CRQ)
1.15% HBP S&P TSX 60 Bull Plus (HXU)
Canadian Bonds Mutual Fund Median 1.96%
0.15% Claymore 1-5 yr Laddered Gov’t Bond (CLF)
0.325% BMO Canadian Gov’t Bond Index (ZGB)
0.35% iShares CDN Government Bond (XGB)
Int’l Equities Mutual Fund Median 2.69%
0.455% BMO International Equity Hedged (ZDM)
0.49% iShares MSCI EAFE Hedged (XIN)
0.65% Claymore International Fundamental (CIE)
Emerging Markets Mutual Fund Median 2.93%
0.535% BMO Emerging Mkts Equity Index (ZEM)
0.65% Claymore BRIC (CBQ)
0.82% iShares CDN MSCI Emerging Markets (XEM)
1.15% HBP MSCI Emerging Mkt Bull Plus (HJU)
Commodities Mutual Fund Median 2.60%
0.40% iShares COMEX Gold Trust (IGT)
0.75% HBP COMEX Gold (HUG)
1.15% HBP COMEX Gold Bullion Bull Plus (HBU)
ETF COST DIFFERENCES
Among the Canadian Equity ETFs shown, newcomer Bank of Montreal (BMO) undercut comparable and more established iShares LargeCap 60 by 0.01%. and similarly positioned themselves in bonds, U.S. and international equities, and emerging markets.
Sometimes costs reflect structural differences. Higher-priced iShares CDN Composite at 0.25%, includes a broader holdings base (S&P/TSX Composite’s 204 issues). Claymore’s Canadian Fundamental (0.65%) would appear to be out of step with the group, but includes an “embedded strategy” namely a value bias in the construction of its index. Claymore is actually offering an actively-managed ETF in passive clothing.
PASSIVE OR EMBEDDED STRATEGIES
Distinguishing passive ETFs from those with embedded strategies is a good starting point for portfolio building. One is not better than the other, but those with embedded strategies are usually more expensive. Director of Quantitative Strategies at PŮR Investing, Ioulia Tretiakova, maintains: “You never know what the future return of an ETF is going to be, but you do know its cost.”
Embedded strategies try to offer something in return for their higher cost. In Claymore’s RAFI Fundamental series, it is a tilt towards value stocks. If this is what you want, ETFs can give you effective access. The Horizon BetaPro (HBP) Plus ETF series offers two times the DAILY return for the “Bull” version and two times the inverse DAILY return for the “Bear” series. This powerful leveraging capability comes at a cost of 1.15% but considering the “double exposure” makes the effective MER 0.575%. This appears expensive in the Canadian equity category with offerings at 0.16-0.17%, but in emerging markets, where iShares cost 0.82%, HBP appears more competitive.
TRADING COSTS
While lower cost is a key ETF benefit, management expense ratios tell only part of the story. Studies of U.S. mutual funds showed that annual trading costs were 1.44% per year (Edelin/Evans/Kadlec, 2007). Canadian mutual fund trading costs are not available, but exchange traded fund trading costs are certainly lower than mutual fund costs for two reasons:
1. the index nature of ETFs means little trading is required for rebalancing;
2. market-makers for Canadian ETFs assume the cost and risk of rebalancing including index composition changes. Elsewhere in the world, the cost of an index change is borne by the ETF unit-holder. If the annual trading cost for an active Canadian mutual fund is 1.0%, and the comparable ETF cost is 0.0%, it is little wonder that active funds have so much difficulty beating index and ETF performance.
LOONIE EH?
Canadian investors, like counterparts around the world, focus most investments in their domestic currency. This makes sense because liabilities and expenses are Loonie-centric. Some international ETFs are offered “hedged”. This comes at a cost. Is it better to buy the hedged or unhedged ETF? The answer is related to your expected holding period. Here’s a guideline:
1. The longer the holding period (over 4 years) you may be better off unhedged. The cost of hedging is fixed and compounds over time.
2. If you have a view about the direction of currencies, hedging for protection or unhedging for exposure can become part of your strategy.
ETFs offer an increasing palette of risk shapes and colours giving investors broad scope to construct portfolios that reflect their views and address their needs. Cost is a rare certainty in a financial world filled with unknowns. Consequently, it is one of the most important considerations in building any portfolio.
PŮR Investing Inc. is a registered portfolio manager specializing in risk management using exchange traded funds. PŮR’s free ETF screener is available at: http://purinvesting.com/demo/Screen.htm .
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:
- Index-based ETFs have extremely low turnover. Transactions trigger gains taxable in the hands of unit holders.
- 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.
- 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
| 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
Friday, October 30, 2009
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.
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
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
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