Tag Archives: ETFs

index funds, passive ETFs and operating leverage

September 17, 2012 By in Industry Analysis, Investment firms Tags: , , , , , Leave a comment

Russell leaves the ETF business

Early this month, the financial press carried stories that Russell Investments, the pension consultant turned money manager, has decided to close its ETF business less than two years after entering the field.

What’s going on?

(By the way, Russell’s is the typical pattern in many commodity-like industries, where latecomers are never able to achieve the scale needed to become profitable.  Presumably, Russell knew this before made its move into ETFs.  It concluded that the possible gains justified the initial outlays.  On the other hand, maybe it didn’t.)

the case for passive products

Arguably, given the repeated failure of active managers in the US equity market to outpace the S&P 500, or other standard benchmarks, passive products are better choices.

At the same time, with passive ETFs or index funds, the possibility–however remote–of market-beating performance is eliminated as a selling point.  Every fund targeting the same benchmark index will have (more or less–a comment on this in a minute or two) the same gross return.  As a result, the only real difference among funds is the size of the fees the fund operator charges.  Lowest fee wins.

basic assumptions

Let’s look at the situation as if we’re a newcomer to the passive fund industry.

We’ll have expenses:

–for a bank to keep custody of assets

–for mathematicians to oversee construction of the portfolio and to monitor the trades the fund makes to deal with purchases and redemptions

–for traders to buy and sell the securities in the fund, and to process customer orders

–for overhead, that is, office space, marketers, boards of directors, lawyers. top management…

To make the numbers easy, let’s say all that costs $1 million a fund a year.  (Unless a firm plans on having a ton of funds, $1 million is going to be much too low.)

Let’s also say that once we have all this infrastructure in place, the variable cost of running a given fund is the electricity needed to power the computers that keep the fund humming.  Call that zero.

charging for our services:  the view from below

Now we’re ready to offer our products to customers.  Customarily we charge a percentage of the assets as our fee.  How do we set that percentage?

well, our fund has to be at least reasonably competitive with other offerings in the market.  Let’s say the most prominent fund among our rivals charges a fee of $.20% of assets.  If we match that fee, then we’ll only achieve breakeven when our assets exceed $500 million.  Until we reach that level, we’ll have to subsidize our operating expenses.

Our other choice is to charge a higher fee, at least initially.  But since low price is the major selling point for the product, it’s not clear that this will be successful.

Worse than that, there’s a second issue with passive products–the question of how faithfully a given index fund or ETF mimics the benchmark it intends to duplicate.  This is called tracking error.  Passive portfolios don’t usually buy and sell tiny bits of all the stocks in their benchmark.  They transact in small, more liquid subsets of the index that their statistical analysis says will mirror the overall index closely.

Assurance that tracking error is low comes partly from the fund promoter’s promises, but mostly from seeing the fund deliver on those promises over long periods of time.  A startup fund only has the first.

It’s going to be hard to attract assets away from the market leader who has a low tracking error by charging more.

the view from the top

Look at the market leader.  He’s getting in new money on a regular basis from IRA or 401k clients.  If the relevant index is up, say, 20% over the past year (the S&P is a tiny bit better than that), his assets under management–and therefor his management fee–have gone up by that amount just by not losing net customers.  So the market leader is making at least 20% more money than he was in 2011.

What’s his best strategy?  Cut his management fee percentage, of course!

If the market leader decreases his management fee to .175% of assets, he’s still making more money than before.  His product looks even more attractive.  And he’s forcing the startup to cut management fees, too–raising the startup’s breakeven to $570 million, thus lowering the chances that the startup will ever reach profitability.

more wrinkles

There are a few.  But I’ve made my main point–that unless the market leader gets piggish and creates a pricing umbrella under which the competition can prosper–it’s tough for a latecomer to gain any market traction.  That’s natural market evolution.  And it’s what has happened to Russell.

That’s it for today.

TVIX: an expensive lesson about an exotic exchange traded note

March 30, 2012 By in Derivative instruments, ETFs Vs. Mutual Funds, Getting financial advice, short selling, Where are the customers' yachts? Tags: , , , , , , , , Leave a comment

TVIX

TVIX is the ticker symbol for “Velocity Shares Daily 2x VIX Short-Term” ETNs (exchange traded notes), sponsored by Credit Suisse.  What a mouthful!

They’ve been in the news recently because of very big losses some buyers of them have suffered.

what it is (hang onto your hat)

An ETN is something like an ETF, except that what the holder is buying is not an ownership interest in a collection of equity securities but rather a piece of a debt security issued by the investment bank that sponsors the ETN.

In the case of TVIX, the debt instrument in question is a promise by Credit Suisse to pay the holder an amount that’s tied to the performance of futures on the CBOE Volatility Index, or VIX.  Although in form the actual note issued by CS is a debt instrument, in function it’s very much like an OTC derivative contract.

The 2x in the name means the ETN is leveraged.  It’s designed to deliver 2x the return on the VIX.

Daily means it’s re-leveraged each day to deliver 2x the return on the VIX.  The significance of this daily recalibration is that the return over longer periods of time can be significantly different than 2x leverage over that span, depending on the sequence of daily gains and losses.

The VIX is a measure of expected volatility, or movement of the S&P 500 index away from the current level–up or down–over the coming 30 days.  It’s calculated based on the prices of near term puts and calls on the S&P.

what happened

ETFs and ETNs typically act like open-end mutual funds.  When new buyers want the securities, the sponsor satisfies demand by issuing more.  When sellers want to redeem, the sponsor cashes them in.

In the case of TVIX, Credit Suisse hedges the risk it takes in issuing the note by maintaining an offsetting position in the actual VIX futures contract. A month or so ago, however,  CS reached the maximum position size allowed by the Chicago Board of Exchange.  When it did, CS stopped issuing new ETN shares.  At that time the net asset value of TVIX was about $15/share.

Over the ensuing weeks, as the S&P 500 meandered, the VIX fell sharply and the NAV of TVIX plunged to about $7 a share.

And here’s the strange part…

…retail buyers didn’t notice. 

They continued to pay $14-$15 a share for TVIX, despite the plunge in value of the underlying note!.   At the worst point investors were paying over 2x NAV!!!   That’s like going to the bank to get change for $20 and being satisfied with $10 in coins.  Who would do that?  From looking at the charts it appears that at least a million shares or so traded at this level of misvaluation.

Then short sellers appeared and the bottom fell out. TVIX, which is trading a bit below $7.50 now, bottomed around $6.

the lesson(s)?

1.  Unlike mutual funds, ETFs and ETNs don’t trade at net asset value.  They trade at whatever price willing buyers and willing sellers meet.

2.  As far as I’m aware there’s no publicly available data on average bid-asked spreads for any ETFs or ETNs.  But the VIX price is available in real time, so it should have been easy to make a rough guess at NAV–and theefore the premium one would be paying.  It’s hard to believe that no buyer did any homework.  The broker acting as an agent in the transaction certainly knew what net asset value was.

3.  The broker you place the order with is an agent.  He has no obligation to tell you you’re doing something incredibly stupid.  (Caveat emptor.  Welcome to Wall Street.)

4.  I wonder who the short sellers were and how they got the idea to sell TVIX short.

5.  Where do you think the stock the short sellers borrowed to sell came from?   …from the accounts of the retail investors who held TVIX and whose brokerage agreements allowed their firms to led out their holdings, that’s where.  Translation:  from just about any retail holder.

According to the Wall Street Journal, which doesn’t seem to get the misvaluation–which I think is the most interesting part of the story–the SEC is investigating.  Why?   …because the shares plunged just before Credit Suisse announced it would begin to issue new TVIX shares.

a price war among ETFs?: implications

March 13, 2012 By in ETFs Vs. Mutual Funds, Industry Analysis, Investment firms, Portfolio management, securities markets, Strategy Tags: , , , , , , , , 2 Comments

the ETF phenomenon

To my mind, the ETF phenomenon is not just a story about price advantage.  I think the popularity of ETFs is an indicator of a fundamental sea change in sentiment on the part of individual investors.  For me,ETFs mark the end of the almost twenty-year love affair of individuals with actively managed mutual funds–and maybe with mutual funds, period–that began after the stock market crash in 1987.

Just as individuals shifted from relying on retail brokers to puting their faith in mutual fund portfolio managers after Black Monday, the trigger for the change in direction has been the Great Recession.  Its cause is the continuing failure of even the most highly publicized active managers to beat their benchmark indices-or, even if they did, to preserve during the downturn of 2007-2009 what their clients thought of as enough of their wealth.

The new trend is for individuals to take responsibility for themselves and to allocate their portfolios by sector through narrowly focused passive vehicles, that is, ETFs.

price war?  yes and no

Exchange traded funds, which now control over $1trillion in assets in the US, appear to be entering a new phase of competition, one marked by sharp reductions in their management fees.  The media are calling this a “price war.”

It’s not a price war in the most dramatic sense–where firms with excess production capacity slash selling prices in a desperate bid to keep their heads above water, or to generate cash flow needed to repay debt.  But it still is one, in the sense of a widespread fall in fee levels.

What do the fee reductions mean? 

Two aspects:

a maturing industry

1.  At one time, ETFs were competing for investor dollars primarily against their cousins, index mutual funds.

During this period, simply having an expense ratio lower that that of an index fund was all an ETF needed to succeed.  Today, despite the fact that their per share expenses are already far below those of index funds, ETF companies are beginning to slash their fees further.

(An aside:  to some extent, the ETF fee advantage is offset by the commission charges that ETF transactions bring with them.  More important, buyers pay more than net asset value at the time of purchase, sellers collect a bit less.  There isn’t enough data available for third parties to determine what this bid-asked spread typically amounts to.  Comparisons of ETFs vs. index funds usually deal with this issue by ignoring it, making ETFs look somewhat more attractive on a cost basis that then actually are.)

That’s because competition between ETFs and index funds is over.  Index funds have been defeated.  The new contest for customers is between one ETF and another.

closing the door to newcomers

2.  Investment products like mutual funds and ETFs have substantial up-front fixed costs, mostly computers and professionals to manage the money and safeguard it.  So they initially run at a loss.  Once a fund gets to the point where fees cover these costs, however, new assets bring almost pure profit.  Margins expand fast.

At some point high margins become a negative, not a positive.  They act as a lure for new competition.  And they allow new entrants to become profitable quickly.

Therefore, lowering fees has a second purpose.  It lengthens, possibly by an enormous amount, the time a potential new entrant must operate at a loss–and increases proportionally the amount of assets he must gather in order to reach profitability.  Naturally, this decreases the attractiveness of the industry to newcomers.  So, as counter-intuitive as it may seem, the fee reductions also serve to preserve the long-term profit profile of at least today’s very largest players.  It makes no economic sense for anyone else to enter the fray.

It’s interesting to note that of the three largest sellers of ETFs in the US, BlackRock, Vanguard and State Street, only Vanguard has a significant actively managed mutual fund complex.  All the other last-generation investment companies have had their heads in the sand.  Internal forces of the status quo have preferred to let assets leave rather than create an ETF divisions that might be headed by a political rival.

portfolio checkup

October 24, 2011 By in Constructing a Portfolio, Current Market Thoughts, Fixing mistakes, Getting financial advice, How often to measure, Keeping Score, Portfolio management, Strategy Tags: , , , , , , , , , , , Leave a comment

A friend who’s studying in the Netherlands and just starting out as an investor emailed me a question about what a portfolio checkup/cleanup is supposed to do.  I thought I’d reply in this post and in tomorrow’s.

two objectives

Basically, you analyze your portfolio carefully and at regular intervals to do two things:

–so you know for sure how your portfolio plan is working and what quantify which stocks or ideas are adding to or subtracting from your performance, and

–so you gradually learn about your investing personality.  By this I mean what things you typically do well and which ones you aren’t so good at.  You want this information, as painful as it may sometimes be to find out, so that you can emphasize the former and minimize the latter.  After all, the main goal is to earn/save money–not to massage your ego.

#1  figuring out performance

There’s a purely mechanical aspect to this.  You have a benchmark like the S&P 500, by which you judge your performance (you could achieve this return by buying an index fund.  You should only spend time and effort to select individual stocks or focused ETFs/mutual funds if you expect a return higher than the index fund will give you).

Over the past three months, the S&P 500 is down about 7.5% (ouch!).  Over the past month, it’s up about 9%.

Your first task is to calculate how your portfolio has performed vs the S&P over the interval you’re studying–both as a whole and each individual issue.  (For what it’s worth, after a long period of doing well, my stocks have been clobbered over the past month.)

what to do with this data, once it’s collected

a.  look for outliers, especially big losers.  Everyone has losers.  Everyone, even the most seasoned professional, also has an almost infinite capacity for denial.  My first mentor as a portfolio manager used to say that it took three winners to offset the damage that one big loser can do if it’s left to run amok and not caught early. So finding losers and eliminating them is important.

b.  ask if your plan is working.  This presupposes you have a plan.  A checkup may well bring out that you’re not bringing your intelligence, knowledge and experience to the party but are, so to speak, mailing it in and hoping that’s good enough.  (We all find out quickly that it isn’t.  Although individual market participants may not be the sharpest pencils, the collective entity is extremely acute.)

For example, in general my plan is:

–world economies are still expanding, although slowly.  So I’m still positioned for an up market.  The EU has me worried.  I’m thinking about shading toward larger, stodgy sort-of-growth stocks as a defensive measure but haven’t done anything much yet.

–there will continue to be a sharp separation between haves (mostly meaning having a job) and the have-nots (the 10% or so long-term unemployed in the US).  I want to own stocks that cater to the former and want to avoid stocks whose market is the latter.

–Asian, especially Greater China, exposure is a good thing, because that’s where most of the world’s economic energy is centered

–I think the continuing proliferation of smartphones, tablets and e-readers plus the rapid development of cloud computing mean there’s money to be made in at least some tech stocks.

For me, the relevant question is how this is working out for me overall.  The answer is:  great, until about a month ago.

A second aspect of figuring out performance is to look, stock by stock, at plan vs. performance.  Reading any of my posts about TIF will get you my stock-specific plan since I bought the security about a year ago.  Again, until about a month ago, things were working well  …since then, not so much.

c.  acting on this information

Even in the best of times, the stock market is always a process of two steps forward, one step back.  Also, all stocks, even the long-term winners, have periods of underperformance.  There’s a real experience-and temperament-based art to deciding how to react to the data that show your stocks are underperforming.

In my case, I’m thinking so far that this is a temporary adjustment phase.  But I’ve also got to at least begin to consider how I’d rearrange my holdings if the underperformance persisted.  This thought process–and the possible move to action–is partly a question of risk tolerance, partly of conviction in the correctness of my analysis of individual stocks, and partly a judgment, based on experience, of what is a normal trading pattern vs. a fundamental change in market direction.

More tomorrow.

five reasons we may be in a trading-oriented market for a while yet

September 19, 2011 By in Constructing a Portfolio, Current Market Thoughts, day trading, market timing, Portfolio management, Recent Market Action, Strategy, Trading Tags: , , , , , , , , , Leave a comment

By a trading-oriented market, I mean one where:

–the indices generally move sideways within a narrowly defined range, and

–individual stock price movements are strongly influenced by traders who have short-term holding periods–a day, a week, even a few hours–and who buy and sell very rapidly.  As a result, both individual stocks and the markets can exhibit sharp up-one-day, down-the-next patterns.

Why should a market like this persist? 

Five reasons:

1.  The economies of the developed world have slowed a lot and are no longer providing clear up or down signals.  And, at the moment, the EU’s continuing bungling of the situation in Greece is producing alternately hopeful and despairing news headlines that short-term traders are using to help them ply their trade.

2.  Pension plan sponsors continue to shift money from traditional investors to “alternatives” like hedge funds, many of which are run by traders and employ a short-term trading style.  This shift continues despite the fact that alternative managers are more expensive and in the aggregate have produced inferior returns pretty continuously for almost a decade.  Don’t ask me why.

3.  Fundamental information about individual companies has become harder to get.  Over my thirty years in the business, brokerage houses have become progressively more dominated by traders.  During the 2007-2009 market downturn, they gutted their research departments as a way to cut overheads.

Also, the shift by individual investors from mutual funds to ETFs and by institutions to alternatives means the research budgets of traditional long-only institutions are not what they once were, either.

4.  Discount brokers offer mostly trading tools and technical analysis to their clients.  Why?  They make most of their money from customer transactions, not from clients outperforming the market.  Also, setting up a research department is complicated and expensive, and it potentially exposes the firm to lawsuits if investment recommendations go awry.

5.  Many mutual funds still have big accumulated losses–both recognized and unrecognized.  In large part, these losses come from individuals buying mutual fund shares at high prices in 2006-07 and then redeemed them at much lower levels in 2009.

As counterintuitive as it sounds, these losses are a big asset to current shareholders.  They allow a manager to change the structure of his portfolio without generating net taxable gains.  This fact also permits–and, in my opinion, should encourage–mutual fund managers to take a more aggressive trading stance to use the losses more quickly.  This maximizes their value to shareholders.  And some newer funds may have years and years worth of losses to avail themselves of.

The result of this is that even the most buy-and-hold-oriented taxable investors may be trading much more than usual.

investment implications

One of the first pieces of Asian investing lore I encountered years ago (and one of the few I’ve found useful) is that the daily market action is like a rapidly turning wheel.  You can stay away from the wheel and not be hurt.  You can jump on the wheel and not be hurt.  They only way you can be severely injured is to try to jump on and off.  In other words, if you dabble in trading and don’t devote your life to it  you’ll get your fingers badly burned.

For the vast majority of us, as individual investors, the best approach is to take a longer investment horizon than the market does–to endure short-term volatility rather than try to profit from it.