Category Archives: ETFs Vs. Mutual Funds

synthetic ETFs

July 4, 2011 By in ETFs Vs. Mutual Funds, Portfolio management Tags: , , , , Leave a comment

what they are

They’re ETFs that contain derivative contracts, not by physical securities.

using a subset of an index

Synthetic ETFs are the extension of an idea that’s been around for a long time.  Provides of index-tracking products, like index mutual funds, know that they don’t need to buy and sell every  component of the index they mimic in order to have an acceptable commercial product.  In fact, in the case of broad indicies, like the Russell 2000, the MSCI EAFE, or the S&P 500,results can be improved by transacting only in a subset consisting of the most liquid names.

After all, if an index has 1,000 constituents, the average weighting is .1%; for the bottom 10%, weightings will be much tinier.  So the act of a big index fund buying and selling may move the prices of those small stocks significantly.  The index fund’s tracking error, the difference between the performance of the fund and that of the index may well be smaller by dealing with a more liquid subset than with the entire index.

using futures

It’s also a standard technique for managers of all stripes to use a stock index future overlay on top of physical securities to protect their portfolios against adverse market movements over the time while they’re buying or selling to deal with large inflows or outflows.

combining these ideas

So conceptually it’s not much of a stretch to think of index-tracking products that contain no physical securities, but just derivatives contracts instead.  Voilâ!…synthetic ETFs.

mostly in Europe

So far, synthetic index ETFs are by and large products offered in Europe.

However, just as the concepts behind them are familiar, so too is the main risk associated they entail–namely, counterparty risk.  In the case of a “normal” index ETF, if the fund were to somehow fail, owners would still possess the underlying index securities.  Holders would recover net asset value–or something close to it–by selling the securities and receiving the proceeds.

In the case of a synthetic ETF, it’s possible that the investment bank or other counterparty could fail–as the recent financial crisis amply illustrates.  But this would leave the ETF owners with one side of a contract with a now-defunct entity.  At best, they could face a protracted bankruptcy proceeding before they’d be able to collect anything; at worst, they’d have nothing.

To address this issue, banks have been offering to collateralize their derivatives contracts, arguing that this will safeguard holders against counterparty risk.  But the collateral won’t be shares of the securities underlying the index.  To do this, banks would have to set up the expensive index fund infrastructure they’re trying to avoid by creating the synthetic ETFs in the first place.  Instead, shares in an EU-oriented index might be collateralized by a mortgage on an office building in Tokyo or a project loan to a government in Latin America.

The question is:  is this good enough?  Personally, I’d prefer not to have a “normal,” not a synthetic, ETF.

are South Korea and Taiwan emerging markets?: implications for index mutual funds/ETFs

June 12, 2011 By in Current Market Thoughts, emerging markets, ETFs Vs. Mutual Funds, Purchasing power parity (PPP) Tags: , , , , , , Leave a comment

Korea and Taiwan aren’t emerging economies…

Korea has been a member of the Organization for Economic Co-operation and Development, the association of developed nations, since 1996.  Taiwan would presumably be a member, too, if it were not for China’s insistence that Taiwan is not a separate country, but a prodigal province of the mainland.

On a GDP per capita basis, Korea and Taiwan rank #33 and #37 in the world, respectively, just above the Czech Republic, which is also an OECD member.  On a Purchasing Power Parity basis, the two rank #25 and #20 by their per capita GDP–around the same level as the UK, France and Japan.

Looking at their place in world trade, neither is an exporter of raw materials or agricultural products in the way Australia or New Zealand (both classified by index compiler MSCI as developed countries) are.  Instead, both sell advanced technology and machinery products, like computers and smartphones.

…but their stock markets aren’t well-developed.

My experience is that company financial statements aren’t reliable in either country.  Neither governments nor company managements in either country care to have foreigners as shareholders, and treat them poorly.  There’s also a significant amount of intrusion into market workings by politically powerful entities in both.  The fact of this interference isn’t the issue; that happens everywhere.  It’s the extent–and maybe my lack of familiarity with the local rules–that bothers me.  In this regard, both Taiwan and Korea seem to me like Japan, only on steroids.

Every one of these factors is characteristic of emerging markets, not developed ones.

is MSCI about to reclassify both stock markets as developed?

There’s nothing new about what I’ve written above.  It’s been the situation for at least a decade (in stock market terms, it was worse before).

What is new, however, is that both the Wall Street Journal and the Financial Times have published recent feature articles suggesting that the MSCI will reclassify both Korea and Taiwan as developed markets later this month.

that might be an issue for holders of emerging markets index funds/ETFs

I’m most familiar with these entities in the US, but I think what I’m saying holds true for EU funds/ETFs as well:

Mutual funds/ETFs are both instances of a special type of corporation that is exempt from corporate tax.  It gains this exemption by, among other things, distributing all income (net of expenses) and realized capital gains to shareholders–who must pay tax on them.  Typically, distributions are made once annually, shortly after the tax year for the fund/ETF ends.

Together, Taiwan and Korea make up about a quarter of the MSCI Emerging Markets stock index (the largest other index constituents are China and Brazil).  If both countries are reclassified, index funds/ETFs will be required by their charters to sell all their Taiwanese and Korean holdings and reinvest the proceeds back into the revised Emerging Markets index.  That will presumably generate a large capital gain to be distributed to shareholders.

four quirks about a possible distribution

1.  It’s a fact of life about funds/ETFs that the holder who pays tax on a fund’s capital gain is the person who receives the distribution–not necessarily the person who enjoyed the rise in price of the stock that’s been sold.  If you buy a fund/ETF share today and receive a massive capital gains distribution tomorrow, you’re on the hook for any tax due, not the holder of the share while the capital gain was being amassed.

2.  Any distributions are net of any accumulated realized losses.  In the case of the Vanguard emerging markets index fund, which I hold, it had unrealized gains of $7.5 billion on April 30, 2011, the date of the most recent semi-annual report, but accumulated losses of $2.4 billion.

3.  Distributions are usually made at the same time every year.  For US funds, which typically have an October tax year, distributions come most often in late November or early December.  But a distribution can be made earlier–and often is, if the fund manager fears shareholders intend to sell their holdings to avoid receiving a large taxable distribution.  In other words, a Taiwan/Korea-related distribution could come as early as in July.

4.  Virtually everyone who buys a fund/ETF signs up for automatic reinvestment of distributions, so that the distribution itself results in almost no outflows. Only anticipatory sales, made to avoid a distribution, do that.

fund groups aren’t talking

I called up Vanguard the other day to ask about this issue.  My own back-of-the-envelope reckoning is that a distribution from the Vanguard emerging markets fund, if any, will be small (25% of the accumulated unrealized gains of $7.5 billion would be $1.9 billion, less than the $2.4 billion in accumulated losses).  And I own my fund shares in an IRA, so a distribution doesn’t affect me, in any event.  But I was curious.

My Vanguard representative was aware of the issue, but said everything depended on what MSCI does later this month.  I asked for the April 30th tax situation for the fund, but she wasn’t able to find it.  I looked it up online after I hung up.

relevant tax data are easy to find

Look for the latest annual/semiannual/quarterly report for your fund/ETF.   It will have a list of holdings and their market value (but not their individual cost basis).  At the end of the list, there’ll be aggregate cost and market value data.  In a section following right after that, the fund will show its accumulated realized losses.

2008 is a key year

The emerging markets index lost over half its value that year.  Although there’s no way of being certain with any individual fund, twenty some years of managing this type of money tell me that all the redemptions that created Vanguard’s accumulated losses came at the bottom or shortly after–probably in large part from people who bought shares in 2007.

Any fund/ETF that’s large now but was just getting started in 2008 probably has little in the way of accumulated losses to offset realized capital gains.  Entities like this are where the risk of a large taxable distribution are highest, in my opinion.  We’ll know more on June 21st, when MSCI does its next revision of the index.

 

is a bond fund exodus beginning?

December 23, 2010 By in Current Market Thoughts, ETFs Vs. Mutual Funds, Portfolio management, Shaping a portfolio for 2011, Strategy Tags: , , , , , , , Leave a comment

money is starting to flow out of bond funds

The Investment Company Institute, the trade organization of the the mutual fund industry, reported on Tuesday its weekly estimate of the money flowing in and out of the industry’s products.  The current report covers the week ending December 15th.

The equity news is the same as it has been for a long while–investors are taking $2 billion or so out of domestically-oriented funds each week and putting a somewhat smaller amount into foreign/global funds.

The real changes are coming on the bond side, both taxable and tax-exempt.

Over the past month or so, municipal bond funds have lost a total of $14 billion to net redemptions, presumably on worries about credit quality

For the past two weeks, for the first time since the collapse of Lehman in late 2008, taxable bond funds have had sizable withdrawals–$1.3 billion in the period ending 12/8 and $4.9 billion in the week of 12/15.

Why is this happening?

Bond yields are rising, as investors sense that the worse cyclical effects of the financial crisis are behind us.  Economic indicators and corporate reports are suggesting the US economy is stronger than the consensus had thought.  Markets are concluding that we’re past the cyclical lows for interest rates and that the Fed may begin to restore a normal (read: higher) level of rates sooner rather than later.

This means bond funds are potentially facing a headwind that will likely produce capital losses.

Where is the money going?

That’s not clear.  Some mutual fund consultants, like EFPR of Cambridge, Massachusetts, say the bond fund withdrawal money is going into equity funds.  Others are suggesting that it’s being parked on the sidelines in money market funds.

The ICI data, which cover the entire US mutual fund industry, don’t show either.

The ICI releases a separate weekly report on money market fund assets. That shows money market fund assets as being flat since the beginning of the month.  Assets held by retail investors are actually up slightly.

As mentioned above, the ICI data have shown a continuing small loss of money from equity funds over the past couple of years.  There’s a sharp shift within the equity category from US to non-US, but a net drain nonetheless.  That hasn’t changed.

So where is the money going?

A Bloomberg article that talks about he ICI numbers speculates that some is going into direct purchases of bonds.  This makes some sense:  you avoid the management fee mutual funds charge; and, unlike funds, individual government bonds mature–and you get your principal back.  I  suspect this is being done by individuals, not the institutions the article suggests, however.

I think a large chunk of this “lost” money will eventually end up in the stock market, either through individual equity purchases or stock ETFs.  Why?  Historical patterns suggest stocks are flat to up during a cyclical rise in interest rates, while bonds fall.  Also, to the extent that customers are withdrawing money from load mutual fund organizations–and Bloomberg suggests this is happening at places like Pimco–and forfeiting the sales charges they have paid, this suggests a certain finality to their actions.  My guess is that such investors are taking out a fresh sheet of paper and rethinking their asset allocations.

If so, we should see evidence of a more equity-friendly attitude as the new year begins.  Given that taxable investors typically greet January by selling winners they have nursed into the new tax year, a large inflow of new money should be easy to detect.

 

 

 

 

 

What is fair value pricing?

December 1, 2010 By in ETFs Vs. Mutual Funds, fair value pricing, Vocabulary Tags: , , , , Leave a comment

what it is:  two meanings

The overall idea is to price a mutual fund or an ETF using up-to-date prices.  The two meanings:

1.  The less important:  Mutual funds and ETFs price their holding every day.  If the fund owns a security that hasn’t traded on a given day–maybe it’s highly illiquid, or maybe it’s suspended an hour before the close pending an important announcement–a committee meets to determine, as best it can, what the proper closing price should be.  That’s one kind of fair value pricing.

2.  The more important:  The US stock market is open from 9:30 am until 4:00 pm, Eastern time.  Europe is open from around 4:00am until noon Eastern.  The Pacific opens at around 6:00 pm and closes around 2:00 am Eastern.

International or global mutual funds and ETFs are priced at the New York close at 4:00 pm Eastern time.  But the closing price for the securities it holds may have been at 2 am or at noon Eastern.  A lot of stuff that’s important to a stock’s price may happen between closing in the local market and the New York close, however.

The same is true of the currency of the local country, which probably trades twenty-four hours a day, around the world.

For many years, mutual funds used the local market close and possibly the local market currency value in calculating the daily net asset value of the fund, the figure at which shares are bought and sold through orders placed up until 4pm Eastern that day.

In other words, you could buy stocks at 4 pm whose prices were set at 2 am, without adjustment for any information that might have entered the market in the intervening time.

What kind of information?  …earnings reports from European or American firms, government economic announcements, or the rise or fall of western hemisphere stock, bond or currency markets.

This practice gave rise to a kind of time-zone arbitrage, that was most pronounced in the case of a US-based Pacific Basin fund.  Let’s say the US market was up 2% at 3 pm on a given day.  Chances are high, just on that basis, that Pacific markets would be up significantly that night as well.  But you could still buy shares of the fund at last night’s prices. On the other hand, if the European and American markets tanked, you could sell the Pacific funds you held at yesterday’s higher prices.

But market levels aren’t the only information you’d have access to.  You could see trading of Pacific securities in London and in New York.  You could see currency and interest rate movements.  And you could see the Nikkei futures (Japan) traded in Chicago.  So you could create a relatively sophisticated set of buy/sell signals, all predicated on the idea that you could in effect transact at yesterday’s prices.

As interest in foreign markets rose, and as more people worked out that this arbitrage could be highly profitable, mutual fund organizations began to experience significant numbers of shares being aggressively traded in and out of their foreign-oriented fund.  This created a severe technical problem for a portfolio manager in remaining fully invested, while at the same time raising and investing cash to match the individuals and organizations doing this time zone arbitrage.  More important, the trading activity was highly lucrative, meaning that to some degree these profits were being earned at the expense of the large majority of fund shareholders who were not constantly trading the fund shares, and who were likely unaware that this kind of activity was going on.

No-load funds had this problem before their load brethren.  No-loads pioneered the solution.  They hired third parties–S&P and the Financial Times are two of them–that had developed predictive software that determined what the New York closing price of any foreign security should be if the local market had access to financial information that emerged between the local close and 4pm New York time.  They also developed decisions rules that determined when to use local closing prices and when to use those generated by the third-party.  A typical rule would be that if the S&P 500 closed with up or down .5% vs. the previous close, the third-party implied quotes would be used.

Using fair value pricing has been the norm for US-based funds for years.  True, some fund groups required a nudge from the Attorney General of New York or of Massachusetts before falling in line.  But the “shooting fish in a barrel” arbitrage has been eliminated.

My firm used the FT figures.  In volatile markets, they would be used quite frequently instead of the local close figures.  Although I’ll admit to being skeptical at first, I was pleasantly surprised–maybe shocked is a better word–at how accurately the FT numbers mirrored the opening trade for the securities that night.

why is this important?

I own shares in an international mutual fund in an IRA.  I’ve been gradually selling my position down and replacing it with individual stocks.  I surprised myself on Monday–the US was down sharply when Europe closed but recovered to end just below breakeven at 4pm–by thinking for a minute that I shouldn’t sell shares that day but should wait to see if the better US close caused a sympathetic rebound in Europe on Tuesday.  Then I realized that the potential rebound is already priced in, thanks to fair value pricing.  One more thing neither you nor I have to worry about.

 

 

 

 

ETFs, synthetic reconciliation and counterparty risk

October 17, 2010 By in ETFs Vs. Mutual Funds Tags: , , Leave a comment

the issue…

Most ETFs are index-tracking investments.

A key decision for the ETF’s managers is how they will mimic the index while dealing with inflows and outflows of money.

There are two basic choices:

–physical replication, a strategy followed by US-based ETFs: and

–synthetic replication, favored by Europeans.

The fund’s offering documents will spell out what a given ETF intends to, and is allowed to, do.

Physical replication means mimicking the relevant index by buying the constituent elements. In the simplest case, it means buying and selling all the index constituents, in appropriate amounts, as needed. A modified strategy is to use index futures to allow the manager to control the timing of purchase and sales, while still responding immediately to inflows and outflows.

With an index with a lot of members like the S&P 500, it’s also common to find a subset of the index that tracks the overall index with a high degree of accuracy and use it as a substitute for holding the entire index. The ETF can thereby avoid potential problems with trading in illiquid index constituents. Typically, this strategy will be disclosed to investors in the offering documents.  Differences between ETF and index performance that’s attributable to “tracking error” is a risk shouldered by the ETF holder.

Synthetic replication is an extension of the idea that you can use derivatives to supplement holdings of physical securities that are index constituents. In its extreme form, synthetic replication means that the ETF manager negotiates a derivatives deal with an investment bank. The manager agrees to invest the ETF capital in a specified basket of securities and swaps the return on that basket for the return on the ETF’s index.

Synthetic replication has a number of aspects:

–ETF management is simplified substantially, meaning, among other things, that the ETF manager can concentrate on marketing its investment product rather than managing it,

–control of execution of the investment strategy is, in effect, transferred to the investment bank

–the issue of  tracking error can be negotiated away

–the investment bank typically is able to collect income from lending out the securities held by the ETF (presumably influencing the bank’s position about what securities the ETF should hold).

…is always counterparty risk

Synthetic replication also has consequences you should be aware of before buying.

– The swap arrangement negotiated with the bank by the ETF doing synthetic replication is an OTC derivative. This means it’s a contract whose value depends crucially on the financial soundness of the counterparty.

–In the event that the bank is unable to fulfill its obligations to the ETF, shareholders are left with an interest in the securities held in the ETF portfolio. This may, or may not, be the equivalent of the index. In addition, it’s possible that securities lent out to third parties may be involved in litigation and difficult for the ETF to recover and sell.

The risks inherent in synthetic replication are doubtless disclosed in the offering documents.  I’d characterize the risks as having low probability of actually occurring, but potentially having severe negative effects if they do.  The fact that everything is disclosed in the ETF’s official filings suggests that the holder will have no legal recourse against the ETF manager should the counterparty fail.  In selecting this type of ETF, he has taken the risk on himself.

As is the case with leveraged or inverse ETFs, the unwary buyer may only find out about the product’s characteristics when it’s too late to do anything about them.

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