The SEC's recent proposal to apply circuit breakers to certain ETFs highlights the strengths and weaknesses of ETFs. Conceived as instruments you can trade all day long while the markets are open, they actually don't serve this purpose all that well. Because the price of an ETF is derived from the prices of the underlying securities, it will always lag behind underlying price changes. When underlying prices are moving rapidly, as they were during the flash crash, the pricing lag of an ETF may create an arbitrage opportunity for the high speed trading firms whose massive computing power lets them spot and exploit price anomalies faster than the typical retail investor can blink. As the big boys pile in, jarring price movements may scare away market makers, who ordinarily provide liquidity, faster than disaffected voters are abandoning incumbents. Ordinary individual investors trying to make a buck or two can (and sometimes did) lose their shirts.
Experience shows that even though ETFs were conceived and marketed as trading instruments, they're really better for long term investment. They often have low management fees and many are quite tax efficient. Used as a long term instruments, ETFs can be competitive with the cheapest traditional index funds. (See http://blogger.uncleleosden.com/2007/06/exchange-traded-funds-for-beginners.html.) Granted, faith in long term investment has fallen as the Dow has fallen. But it's probably still a better idea than short term, in and out trading where you pay commission costs, bid-ask spreads, and sometimes unpredictable prices, only to have your head handed to you.
Showing posts with label ETFs. Show all posts
Showing posts with label ETFs. Show all posts
Sunday, July 11, 2010
Wednesday, October 7, 2009
ETFs: The Bloom is Off
Two years ago, exchange traded funds were like the hot, new car model for which buyers would pay a $3,000 premium over list price, all for the privilege of being waited listed for months before the gotta-have-it vehicle was delivered. Asset management firms charged into the fray, registering hundreds of new ETFs based on all varieties of indexes, including some never before seen in the wild, and threw them at investors to see what would stick.
That was 2007. We know what's happened to the financial markets since then. A turbulent market reveals a multitude of sins, defects and other undesirable features, and no exception was made for ETFs. Here are some of the problems that have emerged.
High Trading Costs. Although ETFs often have comparatively low management fees, the costs of investing also include the "bid-ask spread," which is the difference between the higher ask price at which you buy ETF shares and the lower bid price at which you sell them. Management fees, on average, have been rising as ETFs have become more complex, now often exceeding 0.5% of assets per year. But, for the smaller, less liquid ETFs, trading costs can add an additional 1% to the costs of ownership. This trading cost isn't an annual charge. But it is effectively imposed each time you make a round trip in trades (i.e., buy and sell). Since many investors trade ETFs on a short term basis (a bad idea more often than not), these trading costs can become a major expense.
ETF Value Strays from Underlying Values. Sometimes, the value of the shares of an ETF can deviate from the value of the underlying holdings. The reasons for this vary. Sometimes, the index on which the ETF is based contains illiquid investments (like some bonds) that the ETF has trouble actually buying. In such cases, you're not getting what you probably thought you were getting. Other times, the ETF trades at a premium because investor demand elevates the ETF share price. For example, a relatively easy way to participate in the recent rally in corporate bonds is to buy shares of a bond ETF based on a corporate bond index. But that advantage can be reduced if everyone else has the same idea and bids the price of the ETF above underlying asset values. It's usually not a great idea to pay $1.02 for $1.00.
Leveraged ETFs give an unpleasant surprise. Leveraged ETFs promise to give you a multiple of the price movement of the underlying index. In other words, if the underlying index increases by x, the leveraged ETF is supposed to deliver a return of 2x. If the the underlying index drops by x, the leveraged ETF would show a loss of 2x. Short or inverse ETFs deliver the leveraged opposite of the movement of the underlying index. Some leveraged indexes have sustained significant losses even though the underlying indexes have, over time, gone in a direction that would appear profitable. For example, an underlying index might rise, but the leverage ETF sustains losses. Perhaps the most common reason for this deviation is that leveraged ETFs calculate gains and losses on a daily basis. Even if the underlying index rises over the course of several months, the daily ups and downs can create a compounding effect that generates net losses where a casual observer or investor would have expected gains. Moral of the story: stay away from leveraged ETFs. These things are for full-time investment professionals who are used to walking on hot coals with their bare feet.
The early version ETFs, based on well-known broadly based indexes, continue to be useful and valuable investments in many circumstances. See http://blogger.uncleleosden.com/2007/06/exchange-traded-funds-for-beginners.html. But the fancier and faster-talking the ETF, the more you should put your hand on your wallet.
That was 2007. We know what's happened to the financial markets since then. A turbulent market reveals a multitude of sins, defects and other undesirable features, and no exception was made for ETFs. Here are some of the problems that have emerged.
High Trading Costs. Although ETFs often have comparatively low management fees, the costs of investing also include the "bid-ask spread," which is the difference between the higher ask price at which you buy ETF shares and the lower bid price at which you sell them. Management fees, on average, have been rising as ETFs have become more complex, now often exceeding 0.5% of assets per year. But, for the smaller, less liquid ETFs, trading costs can add an additional 1% to the costs of ownership. This trading cost isn't an annual charge. But it is effectively imposed each time you make a round trip in trades (i.e., buy and sell). Since many investors trade ETFs on a short term basis (a bad idea more often than not), these trading costs can become a major expense.
ETF Value Strays from Underlying Values. Sometimes, the value of the shares of an ETF can deviate from the value of the underlying holdings. The reasons for this vary. Sometimes, the index on which the ETF is based contains illiquid investments (like some bonds) that the ETF has trouble actually buying. In such cases, you're not getting what you probably thought you were getting. Other times, the ETF trades at a premium because investor demand elevates the ETF share price. For example, a relatively easy way to participate in the recent rally in corporate bonds is to buy shares of a bond ETF based on a corporate bond index. But that advantage can be reduced if everyone else has the same idea and bids the price of the ETF above underlying asset values. It's usually not a great idea to pay $1.02 for $1.00.
Leveraged ETFs give an unpleasant surprise. Leveraged ETFs promise to give you a multiple of the price movement of the underlying index. In other words, if the underlying index increases by x, the leveraged ETF is supposed to deliver a return of 2x. If the the underlying index drops by x, the leveraged ETF would show a loss of 2x. Short or inverse ETFs deliver the leveraged opposite of the movement of the underlying index. Some leveraged indexes have sustained significant losses even though the underlying indexes have, over time, gone in a direction that would appear profitable. For example, an underlying index might rise, but the leverage ETF sustains losses. Perhaps the most common reason for this deviation is that leveraged ETFs calculate gains and losses on a daily basis. Even if the underlying index rises over the course of several months, the daily ups and downs can create a compounding effect that generates net losses where a casual observer or investor would have expected gains. Moral of the story: stay away from leveraged ETFs. These things are for full-time investment professionals who are used to walking on hot coals with their bare feet.
The early version ETFs, based on well-known broadly based indexes, continue to be useful and valuable investments in many circumstances. See http://blogger.uncleleosden.com/2007/06/exchange-traded-funds-for-beginners.html. But the fancier and faster-talking the ETF, the more you should put your hand on your wallet.
Tuesday, June 12, 2007
Exchange Traded Funds for Beginners
A relatively new product of the financial services industry has been getting a lot of publicity lately. That's the exchange traded fund, or ETF. The ETF is type of mutual fund that you can buy or sell while the stock market is open. By contrast, traditional mutual funds are bought or sold only after the stock market closes. (You can send in an order for shares of a traditional mutual fund any time, but the order will be filled only after the market closes, at a price based on the closing prices of the stocks and/or bonds that the mutual fund holds.) Although ETFs have been around for about 15 years, they have attained widespread popularity only recently. If you're unfamiliar with them, here are a few basic points.
1. ETFs generally have low costs and expenses, but you have to buy them through a stockbroker. That means you pay a commission. In addition, ETFs have two prices in the market: the "ask" price at which you buy them, and the "bid" price at which you sell them. The "ask" price will be higher than the "bid" price, and the difference between the two--called the "spread"--is a cost of investing. That's because if you buy at the ask price and immediately sell, you'll lose some money from selling at the lower bid price.
Consequently, ETFs are not always the lowest cost product. A low-cost traditional mutual fund may actually be cheaper, because you can buy it without paying a commission or incurring the "bid-ask spread" as a cost of investing. If you're saving small amounts at a time (e.g., $100 or $200 a month), a traditional mutual fund is a cheaper way to invest than an ETF.
2. ETFs are based on market indexes--in other words, the stocks or bonds they hold are the same ones that comprise a market index. For example, an ETF that mimics the S&P 500 will hold the 500 stocks in that index. ETFs started off with broadly based market indexes, like the S&P 500, and were often good choices for long term investment. However, more recently, ETFs have been created to represent increasingly narrow sectors of the stock markets--like just telecommunications stocks or stocks of one particular country. The narrower the index, the more risky the ETF, because it is less diversified. It may provide excellent returns, or terrible losses. The more you invest in narrowly-based ETFs, the more attention you'll have to pay to the overall diversification of your portfolio. In other words, the more work you'll have to do managing your money.
3. ETFs are often tax efficient, in that they are not required to distribute capital gains each year to investors. Investors report gains on their tax returns only when they sell their ETF shares at a profit. But a carefully managed mutual fund can also achieve a high degree of tax efficiency.
4. ETFs theoretically should trade at the same price as the aggregate prices of their underlying assets. This, however, doesn't always occur. Variations in supply and demand at any particular moment can cause an ETF to trade at a discount or premium to the value of its underlying assets. In addition, technical market problems can cause pricing problems. Trades that occur in the underlying stocks and bonds necessarily are reported after they occur. There is always a time lag between trade prices of the underlying assets and the trade price of the ETF. While the time lag may be minor in normal market conditions, when things become hot and heavy, trade reporting in the underlying assets may become delayed, and discrepancies between the value of the underlying assets and the price of the ETF can occur. If this happens, you could pay too much (or get a bargain) on ETF shares. Conversely, you might sell at a price that either is too high (good for you) or too low (bad for you). But, because you won't know about the trade reporting problems, you won't have any idea until after-the-fact whether you got a good or bad price.
5. You can trade an ETF like a stock. In other words, you can own it for minutes, or even seconds, and then sell it. You can sell it short, buy it on margin, use a limit order and the like. Some people may be tempted to trade ETFs short term because they have so many trading options. Stock brokers may encourage such short term trading because it generates commission income for them. However, the history of the stock markets teaches that short term trading generally is less profitable than long term buying and holding. Indeed, many people lose money, rather than make it, when engaged in short term trading. Be cautious using ETFs for short term trading. With their commission expenses, the bid-ask spread, interest charges on margin debt and the risks of trading short term, ETFs probably offer the typical individual investor few advantages, if any, for short term trading.
The ETF is a good long term investment option. If you buy and hold it, you get the most out of it. If you trade ETFs short term, you might money. But you might lose it. You wouldn't use a spoon to eat a steak. Don't use an ETF in ways that aren't likely to help you.
Crime News: whatever financial shape you're in, be glad you don't have to steal toilet paper. http://www.wtop.com/?nid=456&sid=1164394.
1. ETFs generally have low costs and expenses, but you have to buy them through a stockbroker. That means you pay a commission. In addition, ETFs have two prices in the market: the "ask" price at which you buy them, and the "bid" price at which you sell them. The "ask" price will be higher than the "bid" price, and the difference between the two--called the "spread"--is a cost of investing. That's because if you buy at the ask price and immediately sell, you'll lose some money from selling at the lower bid price.
Consequently, ETFs are not always the lowest cost product. A low-cost traditional mutual fund may actually be cheaper, because you can buy it without paying a commission or incurring the "bid-ask spread" as a cost of investing. If you're saving small amounts at a time (e.g., $100 or $200 a month), a traditional mutual fund is a cheaper way to invest than an ETF.
2. ETFs are based on market indexes--in other words, the stocks or bonds they hold are the same ones that comprise a market index. For example, an ETF that mimics the S&P 500 will hold the 500 stocks in that index. ETFs started off with broadly based market indexes, like the S&P 500, and were often good choices for long term investment. However, more recently, ETFs have been created to represent increasingly narrow sectors of the stock markets--like just telecommunications stocks or stocks of one particular country. The narrower the index, the more risky the ETF, because it is less diversified. It may provide excellent returns, or terrible losses. The more you invest in narrowly-based ETFs, the more attention you'll have to pay to the overall diversification of your portfolio. In other words, the more work you'll have to do managing your money.
3. ETFs are often tax efficient, in that they are not required to distribute capital gains each year to investors. Investors report gains on their tax returns only when they sell their ETF shares at a profit. But a carefully managed mutual fund can also achieve a high degree of tax efficiency.
4. ETFs theoretically should trade at the same price as the aggregate prices of their underlying assets. This, however, doesn't always occur. Variations in supply and demand at any particular moment can cause an ETF to trade at a discount or premium to the value of its underlying assets. In addition, technical market problems can cause pricing problems. Trades that occur in the underlying stocks and bonds necessarily are reported after they occur. There is always a time lag between trade prices of the underlying assets and the trade price of the ETF. While the time lag may be minor in normal market conditions, when things become hot and heavy, trade reporting in the underlying assets may become delayed, and discrepancies between the value of the underlying assets and the price of the ETF can occur. If this happens, you could pay too much (or get a bargain) on ETF shares. Conversely, you might sell at a price that either is too high (good for you) or too low (bad for you). But, because you won't know about the trade reporting problems, you won't have any idea until after-the-fact whether you got a good or bad price.
5. You can trade an ETF like a stock. In other words, you can own it for minutes, or even seconds, and then sell it. You can sell it short, buy it on margin, use a limit order and the like. Some people may be tempted to trade ETFs short term because they have so many trading options. Stock brokers may encourage such short term trading because it generates commission income for them. However, the history of the stock markets teaches that short term trading generally is less profitable than long term buying and holding. Indeed, many people lose money, rather than make it, when engaged in short term trading. Be cautious using ETFs for short term trading. With their commission expenses, the bid-ask spread, interest charges on margin debt and the risks of trading short term, ETFs probably offer the typical individual investor few advantages, if any, for short term trading.
The ETF is a good long term investment option. If you buy and hold it, you get the most out of it. If you trade ETFs short term, you might money. But you might lose it. You wouldn't use a spoon to eat a steak. Don't use an ETF in ways that aren't likely to help you.
Crime News: whatever financial shape you're in, be glad you don't have to steal toilet paper. http://www.wtop.com/?nid=456&sid=1164394.
Sunday, June 3, 2007
Stock Market Basics
For readers who are just starting out in the world of saving and investing, here are the basics of the U.S. stock and bond markets. (The financial markets of other nations can be quite different, so research them separately.) There’s much more to learn if you want to become an active investor. But you can get an idea of the concepts here.
1. The corporation is an organization. It sells pieces of itself, called “stock,” in order to raise money to conduct business. (In other words, it takes money to make money, for corporations as well as people.) People who buy stock become owners (collectively with all the other stockholders) of the corporation.
2. Stock. When you buy a share of stock, you own a tiny portion of the corporation. The stock will increase in value if the corporation does well, and it will decrease in value if the corporation does poorly. Many people refer to stock as “shares” (as in shares of stock). If you want to invest in a particular stock, research it carefully.
3. Bonds. A bond is a way that corporations and governments borrow money. An investor lends them a fixed amount of money (e.g., $10,000), which is called the “principal.” They pay interest on the bond for a stated amount of time (e.g., 10 years), and then, if all goes well, they repay the principal (i.e., the money originally invested in the bond). Corporate bonds have “credit risk,” meaning the risk that the corporation might be unable to pay them. Government bonds are less likely to have this problem if they are issued by the governments of wealthy nations. But government bonds of less well-off nations can have significant credit risk. The riskier a bond, the higher the interest rate it will have. Be careful investing in bonds that offer a high return—the return reflects a higher risk that you won’t be repaid.
4. Mutual Funds. Mutual funds are a type of corporation used for investment purposes. Their business consists of investing in stocks and/or bonds. When you invest in a mutual fund, you are buying shares of the mutual fund. That gives you an interest in the fund’s holdings of stocks and/or bonds. The value of your mutual fund shares is based on the values of the fund’s holdings of stocks and/or bonds, and will increase or decrease as they increase or decrease in value. Most mutual fund shares are bought or sold at prices based on the values of their holdings of stocks and/or bonds at the close of the financial markets for the day. You usually buy or sell mutual fund shares by directly contacting the company that manages the fund.
Mutual funds can be index funds or actively managed funds. Index funds invest in a way that copies, or mimics, a financial market index, like the Standard & Poor’s 500 or the Nasdaq 100. Index funds have low costs and fees because they don’t have to pay professional money managers to strategize for them. Actively managed funds hire professional money managers to select stocks and/or bonds for them to invest in. These funds have higher costs and fees, because the professionals have to be paid to do the investment strategizing. Some actively managed funds are quite successful. But most do no better, or even worse, than index funds. An investor who is just starting out has relatively little, or nothing, to gain by investing in an actively managed mutual fund,
An exchange traded fund (ETF) is a special kind of mutual fund that can be bought or sold during the hours the stock market is open, at a price that normally reflects the most recent prices for its holdings of stocks and/or bonds. ETFs are bought or sold through stockbrokers.
5. The stock market and bond market are the principal financial markets for investors. They are open for normal trading from 9:30 a.m. to 4:00 p.m., East Coast Time. You can buy or sell stocks, bonds or exchange traded funds during these times. It is possible to buy or sell some U.S. stocks and bonds in other markets at other times. But the prices you get may be less favorable.
6. Stockbrokers are people and firms that serve as intermediaries in the process of buying and selling stocks. You can’t personally call or e-mail a stock market to buy or sell. You have to go through a stockbroker. (However, you can directly invest in or sell mutual funds--except ETFs--by contacting the company that manages the fund.) Stockbrokers charge commissions and/or other fees for their services.
7. Risks. You’ll probably have very little trouble getting information about the potential rewards offered by investments. You’ll probably have a harder time getting information about the risks (because people selling you investments tend not to emphasize their bad points). However, risk and reward walk hand-in-hand down Wall Street. The greater the potential reward, the greater the risk of loss. If you’re getting a glowing story about how great an investment is, but very little detail about the risk of loss, you will be at an informational disadvantage. You might be tempted to invest because you don’t know how bad the investment could be. Go back to cigarette ads from the early 1960’s. They’ll tell you that it’s enjoyable and sophisticated to smoke. But they’re rather short on information about heart disease, cancer and emphysema. Makes it tempting to light up—and that’s the idea. Make sure you know how an investment can go wrong before investing.
8. Investment Strategies. There are about eight and one-half zillion investment strategies. The large majority of them are (a) inconsequential (i.e., they won’t give you much of an advantage, or any, in the long term), (b) expensive (i.e., they require you to buy and sell investments often, which means large transaction costs that can significantly reduce your returns), (c) bunk (i.e., stupid, also referred to as dumb), or (d) fraudulent (i.e., a way to steal your money). Are there investment strategies that will prove superior in the future? Possibly, but you’ll have a hard time separating them from (a) through (d) above. Most professional money managers do not get returns higher than the stock markets as a whole and some do worse. That’s why investing for a return around stock market averages is a rational strategy. In general, most investors should stick to a simple strategy of investing on a diversified basis for the long term. See our recent blog on why the investor who does average is likely to do well. http://blogger.uncleleosden.com/2007/06/why-average-investor-does-well.html.
New World Hot Dog Eating Record: You've been waiting for this. www.wtop.com/?nid=456&sid=1156698.
1. The corporation is an organization. It sells pieces of itself, called “stock,” in order to raise money to conduct business. (In other words, it takes money to make money, for corporations as well as people.) People who buy stock become owners (collectively with all the other stockholders) of the corporation.
2. Stock. When you buy a share of stock, you own a tiny portion of the corporation. The stock will increase in value if the corporation does well, and it will decrease in value if the corporation does poorly. Many people refer to stock as “shares” (as in shares of stock). If you want to invest in a particular stock, research it carefully.
3. Bonds. A bond is a way that corporations and governments borrow money. An investor lends them a fixed amount of money (e.g., $10,000), which is called the “principal.” They pay interest on the bond for a stated amount of time (e.g., 10 years), and then, if all goes well, they repay the principal (i.e., the money originally invested in the bond). Corporate bonds have “credit risk,” meaning the risk that the corporation might be unable to pay them. Government bonds are less likely to have this problem if they are issued by the governments of wealthy nations. But government bonds of less well-off nations can have significant credit risk. The riskier a bond, the higher the interest rate it will have. Be careful investing in bonds that offer a high return—the return reflects a higher risk that you won’t be repaid.
4. Mutual Funds. Mutual funds are a type of corporation used for investment purposes. Their business consists of investing in stocks and/or bonds. When you invest in a mutual fund, you are buying shares of the mutual fund. That gives you an interest in the fund’s holdings of stocks and/or bonds. The value of your mutual fund shares is based on the values of the fund’s holdings of stocks and/or bonds, and will increase or decrease as they increase or decrease in value. Most mutual fund shares are bought or sold at prices based on the values of their holdings of stocks and/or bonds at the close of the financial markets for the day. You usually buy or sell mutual fund shares by directly contacting the company that manages the fund.
Mutual funds can be index funds or actively managed funds. Index funds invest in a way that copies, or mimics, a financial market index, like the Standard & Poor’s 500 or the Nasdaq 100. Index funds have low costs and fees because they don’t have to pay professional money managers to strategize for them. Actively managed funds hire professional money managers to select stocks and/or bonds for them to invest in. These funds have higher costs and fees, because the professionals have to be paid to do the investment strategizing. Some actively managed funds are quite successful. But most do no better, or even worse, than index funds. An investor who is just starting out has relatively little, or nothing, to gain by investing in an actively managed mutual fund,
An exchange traded fund (ETF) is a special kind of mutual fund that can be bought or sold during the hours the stock market is open, at a price that normally reflects the most recent prices for its holdings of stocks and/or bonds. ETFs are bought or sold through stockbrokers.
5. The stock market and bond market are the principal financial markets for investors. They are open for normal trading from 9:30 a.m. to 4:00 p.m., East Coast Time. You can buy or sell stocks, bonds or exchange traded funds during these times. It is possible to buy or sell some U.S. stocks and bonds in other markets at other times. But the prices you get may be less favorable.
6. Stockbrokers are people and firms that serve as intermediaries in the process of buying and selling stocks. You can’t personally call or e-mail a stock market to buy or sell. You have to go through a stockbroker. (However, you can directly invest in or sell mutual funds--except ETFs--by contacting the company that manages the fund.) Stockbrokers charge commissions and/or other fees for their services.
7. Risks. You’ll probably have very little trouble getting information about the potential rewards offered by investments. You’ll probably have a harder time getting information about the risks (because people selling you investments tend not to emphasize their bad points). However, risk and reward walk hand-in-hand down Wall Street. The greater the potential reward, the greater the risk of loss. If you’re getting a glowing story about how great an investment is, but very little detail about the risk of loss, you will be at an informational disadvantage. You might be tempted to invest because you don’t know how bad the investment could be. Go back to cigarette ads from the early 1960’s. They’ll tell you that it’s enjoyable and sophisticated to smoke. But they’re rather short on information about heart disease, cancer and emphysema. Makes it tempting to light up—and that’s the idea. Make sure you know how an investment can go wrong before investing.
8. Investment Strategies. There are about eight and one-half zillion investment strategies. The large majority of them are (a) inconsequential (i.e., they won’t give you much of an advantage, or any, in the long term), (b) expensive (i.e., they require you to buy and sell investments often, which means large transaction costs that can significantly reduce your returns), (c) bunk (i.e., stupid, also referred to as dumb), or (d) fraudulent (i.e., a way to steal your money). Are there investment strategies that will prove superior in the future? Possibly, but you’ll have a hard time separating them from (a) through (d) above. Most professional money managers do not get returns higher than the stock markets as a whole and some do worse. That’s why investing for a return around stock market averages is a rational strategy. In general, most investors should stick to a simple strategy of investing on a diversified basis for the long term. See our recent blog on why the investor who does average is likely to do well. http://blogger.uncleleosden.com/2007/06/why-average-investor-does-well.html.
New World Hot Dog Eating Record: You've been waiting for this. www.wtop.com/?nid=456&sid=1156698.
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