why September is usually a bad month for US stocks

It has to do with taxes on mutual funds and ETFs, whose tax years normally end in October.

That wasn’t always true.  Up until the late 1980s, the tax year for mutual funds typically ended on December 31st.  That, however, gave the funds no time to close their books and send out the required taxable distributions (basically, all of the income plus realized gains) to shareholders before the end of the calendar year.  Often, preliminary distributions were made in December and supplementary ones in January.  This was expensive   …and the late distributions meant that part of the money owed to the IRS was pushed into the next tax year.

So the rules were changed in the Eighties.  Mutual funds were strongly encouraged to end their tax years in October, and virtually every existing fund made the change.  New ones followed suit.  That gave funds two months to get their accounts in order and send out distributions to shareholders before their customers’ tax year ends.

getting ready to distribute

How do funds–and now ETFs–prepare for yearend distributions?

Although it doesn’t make much economic sense, shareholders like to receive distributions.  They appear to view them as like dividends on stocks, a sign of good management.  They don’t, on the other hand, like distributions that are eitherminiscule or are larger than, say, 5% of the assets.

When September rolls around, management firms begin to look closely at the level of net gains/losses realized so far in the year (the best firms monitor this all the time).  In my experience, the early September figure is rarely at the desired target of 3% or so.  If the number is too high, funds will scour the portfolio to find stocks with losses to sell.  If the number is too low, funds will look for stocks with large gains that can be realized.

In either case, this means selling.

Some years, the selling begins right after Labor Day.  In others, it’s the middle of the month.  The one constant, however, is that the selling dries up in mid-October.  That’s because the funds’ accountants will ask that, if possible,  managers not trade in the last week or so of the year.  They point out that their job is simpler–and their fees smaller–if they do not have to carry unsettled trades into the new tax year.  Although the manager’s job is to make money for clients, not make the accountants happy, my experience is that there’s at least some institutional pressure to abide by their wishes.

Most often, the September-October selling pressure sets the market up for a bounceback rally in November-December.




actively managed ETFs begin to attract investors

About 2 1/2 years ago, I first wrote about actively managed ETFs.

As I mentioned in greater detail then, for buy-and-hold investors ETFs can be substantially cheaper than mutual funds.  That’s because mutual funds maintain their own high-cost distribution and recordkeeping networks, while ETFs use the much larger, and cheaper, infrastructure maintained by Wall Street brokerage firms.  To pluck a number out of the air, the added value of the ETF route could be 50 basis points (0.5%) in annual return.

Active ETFs have never really taken off, though.  That’s partly because start-up active ETFs can be illiquid, and therefore difficult to trade.  And, again because of their small initial size, expense ratios can appear to be very high.  In addition, large mutual fund groups have been reticent to launch active ETF clones of their mutual funds.  Most firms don’t want to be pioneers.  But also, if an associated ETF begins to trigger redemptions of a mutual fund, the fund’s expense ratio will begin to rise–presumably creating more momentum to redeem.  That’s because the costs of distribution will be spread over fewer shares.

This may all be beginning to change.

As Factset reports, actively managed ETFs had large inflows for the first time ever in May.

Two things caught my eye:

–the Principal Financial Group launched an actively-managed, dividend-focused global ETF last month that took in $424 million, and

–ARK Investment Management, a small firm focused on “disruptive innovation”  received $37.3 million in new money in its flagship ARK Innovation ETF (ARKK) + the ARK Industrial Innovation ETF (ARKQ)  (Note:  I’ve owned ARKW, the firm’s internet fund, for a long time).  ARKK and ARKQ together had assets of $53.4 million at the end of April.

My first thought about the strong ARK showing was the attraction could be that the firm has been an early investor in the Bitcoin Investment Trust (GBTC).  But ARKQ doesn’t hold it.

It’s noteworthy, too, that Principal should want to cannibalize its mutual funds–although it’s always better to cannibalize yourself than to have other firms do it.


We may be at a positive inflection point in the development of active ETFs.  Good for innovation, if so.  Bad for stodgy mutual fund complexes, at the same time.


$4.95 trading commissions: a good deal?

Yes, both for you and me and for Fidelity, which initiated the move down from $7.95.  Fidelity has quickly been followed by other discount brokers.

The reason for the reduction is the increasing popularity of ETFs with individuals who have been traditional buyers of no-load mutual funds–and who, because of this, aren’t used to paying commissions.  (Yes, the functional equivalent of trade commissions end up being deducted from mutual fund results through administrative expense charges, but people generally don’t notice this.)   Apparently, though, $4.95 is an acceptable number.

Fidelity, as a market maker in ETFs, will also earn a bid-asked spread on transactions.   In addition, the reports I’ve read suggest that the sponsor of an ETF can earn as much as 0.5% of assets annually through stock lending.  So forfeiting $3 on each trade won’t dent Fidelity’s bottom line, especially if this stimulates sales of in-house ETFs.

I think the main results of the move will be to lower our costs modestly and to hasten a bit the demise of traditional brokers.






what liquidity is to the SEC

As I mentioned in my Windows 10-plagued post yesterday, the SEC is considering new procedural and disclosure rules for ETFs and mutual funds about the liquidity of their positions.  The most controversial, as well as, to my mind, the most reasonable, is the idea of allowing funds to assess a premium to net asset value during times of unusually high purchases and apply a discount when redemptions are running high.


Liquidity itself, on the other hand, is not as straightforward a concept as it appears on the surface.  That’s not a reason for having no disclosure.  But it raises the question of how extensive the disclosure should be.


The definition the SEC appears to be using is how many days it would take for a given fund to sell its entire position in a certain security without having an impact on the security price.  Let’s refine that a bit by saying that having no impact would mean that the stock moves in line with its market over the selling period (as opposed to just doesn’t go down).

Let’s take Exxon (XOM) as an example.  It has 4.2 billion shares outstanding and has been recently trading 17+ million shares daily.

For you and me, selling is a piece of cake.  Our 100 or 200 shares is a miniscule portion of the daily trading volume.  Also, no one on Wall Street knows–or cares–what we’re doing.

Suppose, on the other hand, that we own 1% of the company, or 42 million shares, which amounts to three days’ total trading volume.  What happens then?

Subjectivity and skill/deception come into play.


How much of the daily trading volume can we be before a broker notices that we’re doing unusual selling?  (Once that happens, he/she looks up our position size on a trading machine (mutual fund positions are disclosed quarterly in public filings at the SEC) and assumes we’re selling the whole thing.  The trader then calls his own proprietary trading desk, and all the traders at other firms that he/she’s friendly with.  Then the price moves sharply against us.)

In my working career, I mostly dealt with positions in the $50 – $100 million range, although some of my stocks have been more illiquid than that position size would suggest.  I always thought that I could be 25% – 30% of daily volume without moving the price.  In the XOM example, that would mean my position would take 9 -12 days to sell and would be classified, according to the SEC proposal, as sort of liquid.  A larger or perhaps more cautious manager might think the percentage of daily volume should be capped at 10%.  In this case, the same position would take 30 trading days(six calendar weeks) to unload and would be highly illiquid.


The norm in the US is to separate trading sharply from portfolio management.  I’ve been lucky to have worked mostly with very talented traders, who could conceal their presence in the market.  I can remember one trader, however, that I inherited at a new firm who was almost inconceivably “loud.” Using him, every stock was illiquid (luckily for me a hapless rival headhunted him away after months of ugly trading results).

Organization size, not just portfolio size,  also comes into play.

organization size

Suppose I’m alone as a manager at my firm in having a 1% position in XOM.  That’s one situation. On the other hand, I might be one of five managers with similar-sized portfolios, each with a 1% position.  If we all decide to sell at the same time–perhaps influenced by internal research or by the most senior PM–the firm’s liquidity position in XOM is far different.  The stock is now very, very illiquid.  With conservative daily volume limits, it could take half a year to unload and ostensibly mega-cap liquid stock.


This is a whole other story, one that I don’t know particularly well.  However, corporate bonds, especially low quality bonds, can be extremely hard to sell.

It will be interesting to see what the SEC comes up with.


bond funds when interest rates are rising (ii)

Yesterday I referenced an article in the Wall Street Journal that talked about possible liquidity problems with junk bond funds as rates begin to rise. Based on information provided by Barclays, a huge provider of ETFs, the reporter, Jason Zweig, concluded that junk bond ETFs are a safer alternative to traditional mutual funds.

My comment from yesterday, boiled down perhaps to the length it should have been, was that since the first junk bond crisis in the late 1980s, junk bond funds have adopted very rigorous pricing mechanisms, so the chances a junk bond fund is badly mispriced are very small.  On top of that, mutual fund companies have lots of tools available to deal with high levels of redemptions.


As to ETFs, while as a practical matter it may be that these vehicles themselves may not be subject to the same selling pressures as traditional mutual funds, the way that ETFs insulate themselves can be an issue for you and me.

In the case of traditional mutual funds, we buy and sell directly with the fund, once daily, after the close, at NAV.

ETFs are considerably more complicated.   We deal with broker intermediaries who make a continuous market throughout normal trading hours, though with no guarantee about how closely the bid-asked spread they set will match up to net asset value.  (Authorized participants, who typically deal in minimum blocks of 50,000 shares are the only ones who transact directly with ETFs.)

The tendency of ETF market makers in times of market stress is to widen the bid-asked spread.  This does two good things for the broker.  He gets a higher return for transacting at a risky time.  And the wider spread discourages people from trading.  Translation:  liquidity for you and me dries up.

How bad can it get?  I don’t know.  Several years ago I tried to collect data on the performance of stock ETFs at the market bottom in early 2009.  The only information available then was a comparison of the last trade on  given day with the NAV calculated after the NY close.  In one case, for a foreign stock ETF, the last trade was at a 12% discount to NAV.  The discount may have been considerably wider during the day.  At that time, ETF companies told me they just didn’t know.

I haven’t checked since. I haven’t done this for bond funds.  And one might argue that the 12% discount is an outlier. But the horrible problems ETFs had during the last week of August suggest to me that the situation hasn’t changed for the better.

My experience is that trying to trade during highly emotionally charged times is usually not a good idea.  But it also seems to me that the potential risks inherent in trading in mutual funds at times like this to you and me, not to the fund company, pale in comparison to those involved with ETFs.


This has gotten much longer than I intended.  More tomorrow.




ETF and mutual fund problems last week

Both types of fund, exchange-traded and mutual, had issues throughout last week in calculating their per share net asset values .

For fund management firms, the lack of end-of-day mutual fund pricing was a real pain.  For us as investors, however, the ETF consequences were far worse.

mutual funds

The best feature of mutual funds, in my view, is the guarantee that under all but the most extreme circumstances owners can buy in or cash out every trading day after the close at net asset value.   Last week, because of the computer failure at BNY Mellon, the funds that it prices didn’t have NAV information.  So they had to estimate NAV to do daily transactions.

Once they have precise NAV information, they can adjust the number of shares that buyers from last week actually have.  For people who have cashed out, though, it’s not so easy.  If a fund paid too little in a redemption, it must forward the extra to the seller once it finds out.  If, however, it pays out too much in redemptions, most sellers won’t voluntarily return the excess.  The fund may not even ask, either because it doesn’t want embarrassing publicity or because it knows the cost of suing the seller to get the money back will doubtless exceed the potential return.  The fund will presumably try to get BNY Mellon to make good any losses. Failing that, the fund management company has to pony up.


ETFs are basically mutual funds that let designated brokerage firms handle the buying and selling for them.  This makes ETF expenses noticeably lower than those of a traditional mutual fund.  It also allows the ETF to trade all day, rather than once after the close.  These are the main ETF pluses.  The offset is that potential buyers and sellers have no assurance that brokers will be willing to transact at any given time and in the amounts they wish to.  We also have no guarantee that transactions will be at, or even near, NAV.  For those of us who are long-term holders or who place limit orders, neither shortcoming should be a big worry.

Then there was last week.

Last week, the ETFs normally priced by BNY Mellon had no current NAVs, only guesstimates.  This had two related consequences for investors:

–Brokers became reluctant to trade, since they couldn’t be 100% sure any bid-asked spread they made would be profitable on both sides (for most ETFs, they had to have had a reasonable idea, I think).

–And they widened the market they made from, say, + / – 0.5% around NAV to a lot more.  On Monday, for example, I decided to throw a long-time clunker in my portfolio overboard and replace it with an ETF.  I soon found that I could only buy at NAV +3%.  And even a small transaction at that price took half an hour to complete.

A lot worse than that happened, however.

The Wall Street Journal offers this account of ETFs during trading early Monday of last week:

“…the $2.5 billion Vanguard Consumer Staples Index ETF …plunged 32% within the opening minutes of trading. The Vanguard Consumer Staples ETF was halted six times over the course of 37 minutes early in the day, according to trading records.

The declines…were notable in that they exceeded the declines in the prices of their underlying holdings. In the case of the Vanguard Consumer Staples ETF, the value of the underlying holdings in the fund fell only 9%, according to FactSet. (my emphasis)”

Yes, Monday was a bad day.  But it wasn’t a terrible, horrible, no good, very bad day, of the type that occurs occasionally in a bear market.  This characteristic of ETFs–that market makers swing the bid price waaay down in times of stress–is one that all of us as investors should be aware of.  As far as I can see, it’s also something the ETF industry has deliberately de-emphasized.  I don’t think it’s a reason not to own ETFs in the first place.  But there will surely be times in the future like last Monday where the price for cashing out is 20%+ of the value of your holding.  So I think most people shouldn’t be holding only ETFs.  Trying to sell them in a market downdraft should only be a last resort.





how one China-related ETF has fared

Yesterday I mentioned a Factset article about the trading behavior of China-related ETFs during the current market gyrations in Shanghai and Shenzhen.  It focuses on the Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (ASHS).  Quite a mouthful.

ASHS opened for business last year and has about $41 million in assets.  Its goal is to track the performance of 500 Chinese small caps.  It holds all of the names in the appropriate proportions, to the extent that it can.  Where it can’t, it finds the best proxies available.

Year to date through yesterday, ASHS has risen by 37%+.

The fund melted up in mid-June, however.  Its price rose by 40% from June 8th through June 10th alone, at which time it had y-t-d performance of +113%.

The bottom fell out in the following month, when ASHS lost slightly more than half its value–before bouncing back up by +30% over the past few weeks.

Two points about ASHS:

1.  The fund uses fair value pricing, which is the industry norm in the US.  Fair value pricing, usually performed by a third party the fund hires, does two things:

—-it adjusts the prices of foreign securities in markets that are closed during New York trading for information that has come to light after their last trade, and

—-it gives an estimate for the value of securities that are not trading for one reason or another on a given day.

(Note: in my experience, both types of adjustment are surprisingly reliable.)

This second feature has doubtless come in handy over the past couple of months, since there have been days when as many as half of the Chinese small caps haven’t traded.


2.  A mutual fund transacts once a day, through the management company, after the market close and at Net Asset Value.

In contrast, an ETF like ASHS trades continuously during the day, through a number of broker dealers (Authorized Participants), and not necessarily at NAV.

The idea is that these middlemen will use the very cheap brokerage record systems for fund transactions, thus keeping administrative costs down–and that the brokers will use their market making and inventory capability as a way of minimizing the daily flows in and out of the ETF portfolio.

In June, this worked out in an interesting, and ultimately stabilizing way for ASHS.

As I mentioned above, the market price of ASHS rose by 40% over two days in mid-June.  We know that, according to Chinese trading rules, the stocks in the portfolio itself could rise in value by at most 10% daily, or 21% over two days.  I can’t imagine the ASHS fair value pricing service decided that the portfolio was actually worth 40% more than two days earlier when the market signal was twenty-ish.  If I’m correct, the broker dealers decided to meet (presumably large) demand for ASHS shares by letting the premium to NAV expand substantially  …by 20%?…thereby choking some of the demand off, rather than issue a ton of new ASHS shares at a lower price.

According to Factset, the brokers did create new shares.  But they apparently lent at least some of them to short sellers, who sold them in the market, further tamping down demand.

So the Authorized Participants performed their market-making function admirably–presumably making a boatload of money in the process.   But this situation illustrates that the worst fears of possible ETF illiquidity in crisis times may be overblown.