Part 3b) ETF Strategies

Following up on the passive/passive discussion in the previous blog, the focus of this blog will be on the DIY investor and the passive approach.  Keeping with proper investment protocols we first look at the Investment Policy Statement or , as it is commonly known, the IPS.

Investment Policy Statement: As a general rule, if you do not have a written investment policy statement, you do not have an investment strategy. If you do not have an investment strategy you are not an investor. So what are you? If you are managing your own investments, likely you are either 1- a gambler who unknowingly takes risk in the markets; or 2- you are frustrated and often find yourself frozen and not knowing what to do next.   The vast majority of investors without an IPS are “customers”! They trusted an advisor/planner and thought that they had a strategy. They are caught in the overlapping active/active or active/no strategy categories and are seeing modest market returns eaten up by excessive active management fees (well, not actually seeing that happen as most fees are hidden, but you know what I mean).

Developing an IPS is a blog for the future so for now suffice to say, you need to know your asset allocation targets and ranges. Specifically, what percentage of cash, fixed income, equities and any other asset classes you wish to use in constructing your portfolio. In our basic passive/passive strategy  we will fill the asset requirements with broad based ETF Index funds.

Example only.

ASSET	STRATEGIC TARGET	RANGE	SECURITY
Cash	5%	2.5-15%	Money market account, high interest savings acct
Fixed Income	25%	15-35%	1-5 year bond ladder or GIC ladder, Dex Universal Bond Index, Corporate bond index, government bond index
Canadian Equity	35%	25-45%	TSX 60, TSX Composite Index
U.S. Equity	17.5%	7.5%-27.5%	Dow Jones Industrial Average, S&P 500, Russell 2000
International Equity	17.5%	7.5%-27.5%	EAFE, World Index (ex North America)
	100%

The above is an example of a "basic broad based passive strategy" that would be fairly easy to build with common broad based and low cost ETF Index funds.  The characteristics of this strategy are very positive: low management expense costs, very low trading cost, low tax impact (due mainly to the low trade characteristics of Index funds), broad diversification, and high liquidity. In fact this basic approach will meet the needs of the vast majority of investors and very likely out- performs an existing mutual fund portfolio over time.

While the broad based strategy is highly recommended, it does also have its weak points.

1-      The risk level in a broad based strategy has a beta of one. That level of risk is too high for some investors. As a general rule, if the risk is too high you can lower the equity components (which reduces return and risk), or you can reduce diversification by adding lower beta securities such as replacing part of a broad based index with a lower risk sector fund having a beta of less than one. ( a utilities sector fund might have a beta of approximately 0.5%)

2-      Broad based strategies generally will have less income potential than a dividend focused equity fund. Again, the solutions seem obvious (add a dividend fund) but the consequence is reduced diversification and overweight holdings as the dividend fund replicates a portion of the broader index fund.

3-      While the strategy is low tax, it is not the lowest possible tax strategy. For those willing to sacrifice some of the benefits of the broad based portfolio, you can pay for securities that offer greater tax relief, such as "corporate class funds".

A Word On Tax Strategies:

ETPs have a very useful tax profile for higher income earners. In fact, after fees and performance benefits, the tax benefits are the next  best feature of exchange traded products (ETPs). Most investors in active Mutual Funds do not understand how tax inefficient mutual funds often are. Funds are legally established as trusts and as such are required to flow through income to the unit holders (you). Each active trade has the spin off outcome of generating a) trade costs charged to the fund, b) a capital gain or loss recorded on the fund tax slips. As well, stocks held in the funds spin off dividends that are also recorded on your annual tax slip. With active funds often trading 50-100% of the securities they hold each year, these tax events are very common regardless of whether the fund is making any market gains or not. When funds face high redemption levels securities are sold and again generate capital gains and losses to all fund holders. As you can see, structurally active mutual funds are not able to remain very tax efficient.

ETNs are even more tax efficient as they entail use of contracts that reflect dividend payouts but do not actually receive nor distribute dividends to unit holders. The dividend value is reflected in the "contract" maturity value of the fund. The value of dividends are treated as a distributed capital gain only upon the sale of the units or contract maturity date. For high income investors looking to defer taxes and earn income as tax favoured capital gains, the ETN is a great security. Obviously if you are seeking income via dividend distributions, these notes are not for you. ETNs also carry default risk not generally associated with typical ETFs.

Cautions: Tax strategies are often a means of disguising poor investments as a “strategy”. Who has not been burned by “labour sponsored funds” sold strictly as a tax strategy!

ETPs As Portfolio Insurance

When discussing ETPs it is good to remember that many of the strategies are used by professional traders and portfolio managers. As “exchange traded” securities, you can trade ETPs on the stock exchange. That means you can “short” the securities or you can buy inverse versions of many ETFs. For professionals that may result in long/short strategies where, as an example, a trader buys a stock long (say RBC) and then shorts the financial sector. This attempts to select the winners (RBC)  and discount the less attractive sector players (the other major banks), thus removing market risk from the final trade outcome.

Portfolio Insurance: If an investor has a large net gain in a Canadian stock portfolio, they want to protect the gains but may not want to sell the securities and face a capital gain tax. In this scenario the investor might short the Canadian market ETF to insure their capital gains against a market drop. If the market, including the investor's securities, drops 10% then they make up for the stock losses with the gains on the short position. Rather than buying a short position against every stock held, the investor could simply short the broad based stock index using an ETF Index fund.

Interest Rate Anticipation Strategies: A number of investors are concerned about interest rates rising and hurting returns on fixed income portfolios. Within the ETP product scope, investors can customize interest rate sensitivity (measured by duration) by mixing fixed income ETFs with a variety of durations. Purchasing a Dex Universal ETF Index is the broadest based Canadian bond index fund. By mixing in a ladder strategy (Claymore has popular laddered ETFs) or using the BMO Index funds, an investor can mix long, short and medium term Fixed Income ETFs. By doing so you can shorten the duration and thus lower the interest rate sensitivity of the fixed income holdings.

ETF Passive/Passive: The "broad based strategy" outlined in the chart provided, is the preferred approach for most DIY investors. It is a simple approach with few securities and few moving parts for an investor to monitor. While variations exist, an ETF Index portfolio utilizing 5 funds remains the most basic strategy with the greatest diversification and the most bang for your buck.

Some investors use this as a core strategy within a "Core & Explore" portfolio. With the bulk of the portfolio in the well diversified broad ETF strategy, the "explore" portion of the portfolio (10-20% as an example) can pursue other strategies without tilting risk too far off the intended levels. This approach works well for those that want to mix a little personal stock picking or additional diversification (say gold bullion) into the portfolio, without letting the riskier components distort the overall strategy.

That wraps up the basic ETF review discussed in the last four blogs. Hope it helps you better understand the ETP world!

Mike

Passive vs Active Portfolio Strategies: Which do you use?

How do you know if a "passive" strategy is what you want or need?.....and what exactly is a passive strategy?.....and how do Exchange Traded Products (ETP), such as ETF Index funds fit into a strategy?

Exchange traded products, for our purposes, will include exchange traded funds (ETF) and exchange traded notes (ETN). Both of these products are an effort to reflect the performance of a chosen index as a general rule. Notes will typically use debt instruments (forward contracts) to obtain the index returns while funds generally hold the underlying securities (stocks or bonds) from the index to accomplish the same results. The blog will talk about ETFs, however in most instances you can use ETNs to accomplish the same goals.

ETF’s have changed the game when it comes to investing regardless of whether you are a professional or an individual investor. The goal of serious investors is to: diversify risk, make a positive return, and to keep as much of the return as possible. Professionals generally try to “beat” an index while most individuals aim for a reasonable after tax “total return” relative to the market indexes.

One of the challenges of being an individual investor is the difficulty in understanding which strategies are for “professional investors” and which ones are for “retail or DIY” investors. I want to start with a couple of broad statements to set the stage for how this blog will approach the strategies:

1-      Individuals who “think” they are experts will often take on high risk strategies and often confuse luck with skill. If you “play” the markets, use your “instinct” to tell you when to buy or sell, or feel you have the ability to determine the “sector rotation” timing or market momentum at any given time, then please feel free to skip this section (and perhaps this whole blog) as you won’t accept what I have to say. If you believe a well balanced broadly diversified portfolio can help you share in market gains then please read on.

2-      The terms “passive” and “active” are often utilized when discussing ETF Index Funds and Mutual Funds. The term “passive” can be used to reflect both a type of “security” and an investment “strategy”. Thus an index fund that has a strategy of mirroring a chosen index will be called a “passive” security. An investor who, in turn, tries to hold a diversified strategic allocation of passive funds will be said to have a “passive” strategy. Conversely, an investor who attempts to buy and sell securities in an effort to outperform markets will be considered to have an “active” strategy. If the investor holds funds that also attempt to beat the benchmark indices, the funds will be  deemed an “active” security. As you will have rightly assumed, "passive" means a hands-off approach while "active" means on-going trading of investments.

So, what does that mean? Well, it suggests we can have 4 different scenarios:

1-      Passive Security and Passive Strategy

2-      Passive Security and Active Strategy

3-      Active Security and No Strategy

4-      Active Security and Active Strategy

Passive/Passive:This is what I will call the “true” indexing strategy and is the only strategy this blog site recommends for Do-it-Yourself investors. This approach requires an investor to determine the strategic asset allocation model they wish to maintain, and then to fill that allocation with passive index funds. As an example, a 3 asset class model with 3 equity sub-classes can be utilized to create a great allocation model using 5 passive index funds.

The 3 asset classes are:

 A-Cash – short term low risk debt securities maturing in less than one year, bank account

B- Fixed Income- Interest bearing debt securities maturing in one year or more (1-30 years typically)

C- Equities – individual funds or securities in “stocks” whether common or preferred

Equities sub-classes: Within the equity class we might further break down the holdings into three geographic sectors: Domestic, U.S., and International

In this scenario a simple “passive/passive” portfolio might include 5 securities:

1-       a money market fund

2-      An ETF reflecting the Dex Canadian Bond Universe

3-      Three equity ETF Indexes reflecting – the TSX 500, the S&P 500, and the EAFE index

The joy of this type of investing is that it is easy to understand, easy to implement, and easy to monitor. Investors have some research to do as they need to decide which broad based index they wish to follow i.e. the S&P 500 versus the Russell 3000 or the Dow Jones Industrial Average, but the basic concept is the same.

Passive/Active:

A number of professional investment managers are utilizing passive securities to implement an active strategy. The primary reason is that index funds allow an investment manager, using a single trade, to enter or exit from an asset class or sub-class. As an example, if the previously shown model was utilized by an active manager, trading the ETF Index fund representing the TSX 500 allows the manager to completely enter  (buy) or exit (sell) the primary Canadian stock market. This easy approach to making significant portfolio changes appeals to managers who follow a “macro” approach to their investment strategies. This would not appeal to an investment manager who has a “bottom-up” approach which entails looking at each and every company that you invest in, however for “top-down” strategies” it is quick, effective, and cheap. Similarly, a strategy of “sector rotation” can be implemented by buying or selling a variety of “sector ETFs”. The proliferation of ETF funds has created a large base of index funds representing a wide variety of slices or sub-sets of each broad based index.

Caution: A number of DIY investors have been caught in the trap of holding ectors such as a Canadian Dividend fund or a Canadian Financial sector fund alongside the TSX 500 Index ETF . This causes a loss in diversification as a result of both the sector funds and the broad based index ETFs holding large positions in the same stock. Most true passive/passive investors do not require subsets of the large broad based ETF funds they hold.

Active/Active:

One of the challenges of “active” investing is doing it in a way that prevents one strategy from counteracting a second active strategy. As an example we often see investors with equities split between a “value” fund and a “growth” fund. The net result is similar to holding the full index as whichever style does well is being off-set by the opposite style which is likely underperforming the market. It is rare for the two styles combined to both enjoy a strong year simultaneously unless the whole index also did well. A true active strategy works best when the strategy has a singular favoured approach (pick value or pick growth as an example) at any given time. Some claim they can rotate from one to another effectively and that would seem to be a valid active/active strategy; however if you own a bit of everything in your funds then you are going to reflect a passive strategy at a substantially higher cost.

Active/No Strategy: A large number of folks that sell mutual funds have an approach that utilizes active managed mutual funds alongside a non-existant strategy. That is, they buy and hold active funds with no strategy to make tactical changes to reflect market conditions. While I believe this approach likely does less damage than a poorly implemented active/active approach; this strategy is not really a strategy but rather an abdication of the advisor/planner role as an investment strategist. Investors are sold funds, often with seven year DSC penalties, and the advisor/planner never look at the portfolio again until there is more deposit money to invest (think your annual RRSP phone call). This non-strategy was very evident in 2008 when markets crashed and advisor/planners told clients to “do nothing”. Doing nothing generally reflects a lack of tactical decision making in a strategy. While the active security managers (fund managers) maintain their strategy throughout the market cycle, the advisor driven portfolio strategy is frozen in place and no course corrections are made.

Summary: Within each category there will be room for more than one approach. A proper Passive investment strategy will include tactical rebalancing, strategic rebalancing, and of course adjustments made to the index components by the index committees of the various exchanges. The passive/passive investor may also favour a market capitalization approach, average price, equal weighting or a fundamental analysis approach. Passive does not mean abandoned or ignored and does not imply zero decision making by the investor.

 As a rule you can typically classify yourself in one of the four categories above. If you are passive/passive or passive/active then ETPs are worth considering. The next installment of the blog will deal with strictly passive/passive investing strategies.

ETF Education Part 3 Construction of an ETF

ETF Education  Part 3 CONSTRUCTION OF AN ETF

Review: It is hopefully obvious to those following the recent series of blogs, that ETFs are not quite as simple as we might have believed when they first arrived on the scene. They are like a house in that we look at the furnishings and carpeting to see if we like it, but we rarely check the foundation or the attic to see if it is solid.
We have reviewed how indices were created, how that in turn lead to index mutual funds, and then eventually to ETF Index funds. We noted that the names were often misleading (DJIA for example),that there are differences in how various indices were weighted, and we also looked at who the "players" were in the ETF world. We also looked at several of the common characteristics of ETFs and noted they could be positive (low cost) or negative (tracking error) for investors.

 Now we will dissect some ETF structures to see what we actually own when we buy an ETF. We will look at four common structures that can be used to replicate an index.

1- “Basket of Securities” Structure: Let’s start with a plain vanilla ETF Index Fund. This simplest “open ended structure” is what most people believe they are purchasing when they buy an ETF. In this structure the ETF creators duplicate the performance of an index by actually holding a basket of all the underlying securities through a “designated broker”. As an investor you buy a “unit” from another investor or sell a unit to another investor. The underlying stock is transferred in kind which means no capital gains or trading costs need be incurred with respect to the underlying index components. If you attempted the same trade on your own using, for example, a Dow Jones index of stocks, you would make 30 buys on acquisition of the stocks and 30 sells when you sold out; with each transaction generating a tax event (gain or loss)and brokerage fees. A typical simple ETF structure should be able to closely track an index because it directly owns the index components and thus the index performance, minus fees to maintain the ETF.

2- Representative Bundle Structure: If I want to create a Canadian Fixed Income ETF to track the Dex Bond Universe ( 1,100 bonds at last check), I would need to make an extremely large number of bond purchases to capture the whole index. A significant number of the bonds would be difficult to acquire since they may have been a small issue to begin with. Rather than attempt such a ridiculous approach, a creator can do a statistical measure of the characteristics of the DEX Index. The analysis might look at traits such as average term, duration, yield to maturity, and credit rating of the full universe of bonds. They can then select a smaller number of bonds that, on aggregate, match the characteristics of the full Dex Index. Thus with a basket of 30 or so bonds I can reasonably expect to track the Dex Index performance, at a much lower cost for the unit holders. Of course the risk of the ETF not performing exactly as predicted does exist. When you purchase an ETF Index that uses the “representative bundle” approach you should monitor tracking error closely. It is reasonable to assume that this structure can and should reasonably track the index with minimal risk of performance variance and generally lower costs.

3- Future Contracts: Another way to play the market is to buy a futures contract which promises to deliver the value of the underlying securities at a given time. For example, let’s say a one month future contract on the TSX60 can be purchased on a futures exchange. The contract pledges to pay me the value (or actual shares) of the TSX60 at the end of trading on a specified date. If the index goes up I get the higher value and if the index goes down I receive a lower value. An ETF using the future contract structure, is thus not holding the underlying stocks, but is actually exposed to the “contract” which will fluctuate in value. The future value of a share should not be expected to reflect the “current” value of a share. Markets have expectations for price moves that are reflected in the contract values but not necessarily in the stock’s current price. As well the ETF will need to roll over the contracts as they mature and again will pay for “an expected future price”, not the current price. This roll over process is inefficient and as such this type of structure has a greater risk of tracking error. In fact, the ETF is actually exposed to the futures market, not the index itself. With the increased risk comes a few significant benefits as well.

One benefit of this type of structure is that it allows for increased exposure to commodity markets which are not available as a straight stock strategy. Recently oil has been a commodity that many investors are tracking via an ETF, but corn futures or hog futures are also possible to track when you utilize contracts. At the end of a contract the ETF trades out of the contract so that it does not actually take delivery of the underlying asset. The process has some complexity and contract roll over’s can bring significant tracking errors into the picture. This is especially evident in commodity ETFs. For those wanting more information you can look up the impacts of either contango or backwardation on contract rollovers.

4- Exchange Traded Notes: ETN’s are very similar to future contracts in that the “note” is a promise to deliver a value on a given day. Typically a note is an agreement with a large financial firm such as a bank. The agreement requires the note issuer to pay the note holder a given value on a given day. An Investor could for example sign a note with BNS to deliver the value of the TSX60 on Jan1st of 2012. They would agree to a price and the bank would likely hedge the underlying stocks and make money on a price spread built into the cost of the note. Of course, in the event BNS becomes insolvent before 2012, the investor may face a large loss due to the inherent credit risk of the note holder. Default risk may seem obscure but it is a large part of the reason for the current market crash we are working out way through.On the positive side, ETNs offer a great deal of customization since any agreement can be structured as a note as long as two parties agree to the terms and fees.

The above structures are all in common use today. If you buy an ETF Index Fund you will need to know the structure to know what you are holding (stocks or contracts) and whether or not you are taking on counter party credit risk (notes ). Each structure has its benefits and its drawbacks and you need to understand when you should favour one structure over another.

Proliferation: One of the reasons for the wide variety of structures in the ETF market is because institutional investors are often looking to build securities that offer either exposure or protection from price fluctuations in a specific asset class or commodity. As these products get built they are also offered to retail investors as an ETF they can use for similar exposure or protection. While institutional investors have a very specific requirement to fill a strategic goal, investment sales people often just want to offer something new and flashy for retail investors. A classic example is leveraged ETFs which were sold to unwitting investors by supposed advisors who often had no understanding of how they worked or what risks they exposed investors to. Eventually the industry had to back off leveraged ETFs under a barrage of negative media coverage.

ETF Securities: Below is a list of some of the more common types of ETF Index funds that are common in the market place.

1- Broad Market ETF’s: An ETF that encompasses a significant portion of a large market index is considered to be a broad based ETF. These are the indexes that started the whole indexing phenomenon. In fact, many ETF gurus will tell you that these are the only ETFs a retail investor should purchase. Examples are ETFs tracking the TSX 60 or TSX Composite index, the S&P500 or the Russell 3000. The concept is that with one ETF you gain full market exposure.

2- Sector Indexes: A number of indexes are provided to allow investors to focus on stocks within a specific sector of a market. An example would be Energy ETFs, Technology ETFs, or Financial ETFs. Typically these ETFs follow international guidelines for determining which securities fit in which category of the standard “sectors” . All the sectors added together will form the whole of a broad based index. As such these are often called sub-indexes. In effect this becomes a bet on a single sector outperforming the general market and is useful for traders who use a sector rotation strategy.

3- Style Based ETFs: You can purchase an ETF to allow you to take a bet on one style of investing being more profitable than the whole index. The most common examples are Growth and Value style ETFs. During a bull market where stock prices are rising rapidly you would expect growth stocks to outperform the market. In periods of recovery or market fluctuations you might expect stock selection to favour those who can find under- valued stocks reflected in the Value Index. Similarly you can focus on small cap stocks or dividend paying stocks to outperform the general market or to better match your investment needs.

4- Fixed Income ETFs can also track sub-indexes. Typical sub-indexes would include short term, mid term or long term bond sectors. These can be subdivided again by high, medium, or low credit quality. The fixed income options listed can also focus on government bonds or corporate bonds. As well an ETF can track “real bonds” for inflation protection.

In fact, an ETF Index can be created to track anything from world markets, to African Banks, to Companies that sell mouthwash! The positive is that we get access to cheap fees and strong diversification; the negative is that we have to sort between hundreds of different ETF Index funds.  The key point is that JUST BECAUSE THEY CAN TRACK IT DOES NOT MEAN IT IS WORTH BUYING! As such you can expect to see many new indexes come and go on a regular basis to meet the investment whim of the moment.

So, it has been a longer than normal dialogue for this blog, but there is a lot more to ETFs than meets the eye. If you have gotten this far you can have some confidence that you know more about ETFs than many sales people who sell them and certainly far more than your neighbour who is telling you to buy an ETF to track Outer Mongolian Natural Gas Pipeline Companies! Next blog we will look at some ETF investment strategies! See you in the New Year!

Soismike.........with a special thank you to Ken Hawkins at Ohow.ca for his suggestions on how to work my way through this topic.

ETF Education: Part 2 Lifting the Hood on ETFs

ETF Characteristics

In part one, we reviewed the history of Index tracking, index weighting, and the transformation from Index Mutual Fund to an ETF Index Fund. We also remind investors of a comment concerning the increasing complexity of ETF’s.
In today's blog we will explore ETF’s to see why they exist. The key learning point we are focusing on here is the need to understand that ETFs are built to deliver specific characteristics. It can be more challenging to compare one ETF structure to another if you do not know why it was built a certain way! When we know what characteristics are important to ETF investors we can see how different structures best capture different characteristics that investors seek. We will also get an introduction to the players who make index investing possible.

We will start by looking at ETF characteristics. Contrary to the beliefs of many retail investors, ETF investing is dominated by the big institutional players in the industry. As such an ETF is most often constructed to meet the needs of the institutional investors first. In general, the plain vanilla low cost ETFs based on popular indices were designed for cost conscious institutional investors – the more expensive ETFs were targeted to smaller investors without sufficient dollars to build comparable investment pools at low cost. As an example the XBB although based on a popular index is too expensive for many institutions. They can buy or create cheaper investment pools on their own. This is an example of a characteristic (low fee) being the motivator to build a fund and the absolute cost determining the target market (retail clients). We need to understand why specific ETFs are created and what characteristics are driving their new found popularity. When we know "why" they are being created, we can better understand the different approaches that can be used to structure an ETF.

It is important for retail investors to understand the logic behind ETF construction, because while the large investment managers are extremely qualified to analyse the various security characteristics of an ETF structure, that knowledge is not always obvious to investors nor to the poorly trained front line sales staff (typically your so called advisor). These complex structures then bleed down to retail products which are sold as “ETF Index Funds” with no explanation with respect to the ETF structure. The ETF disclosure/sales material is vague at best and often the product is sold without investors being informed of the different risks and characteristics associated with different structures.

More ETF Basics

While it is always dangerous to issue blanket statements about securities, it is fairly safe to say that most ETF Index funds do have some similar characteristics.

A. The Players:

1- The “creator” of the fund is the company that establishes the fund concept and acquires rights to use the target index from the index owner. S&P for example owns the rights to the S&P500 Index and will issue a license to allow a fund company to create an ETF based on the S&P500 Index.). The creator will issue any required prospectus and get approvals to issue the new securities. As an example Blackrock who own the iShares brand are the “creators” of iShares ETFs. Creators are motivated by gathering large pools of investment dollars and skimming a small peice of revenue from every dollar every year.

2- Market Maker: A market maker, according to an Investopedia definition, is a broker-dealer firm that assumes the risk of holding a certain number of shares of a security in order to ease the process of trading the security.
Market makers are looking for the fastest way to hedge trades, create units, and maximize ETF trading capabilities. When an ETF launches, the lead market maker will typically create the first units, delivering the  shares of an ETF product’s underlying index in exchange for units of the ETF. i.e. the market maker gets 100 units of a new TSX60 ETF in exchange for delivering 100 shares of each stock in the TSX60 to the creator.

Lead "market makers" must stand ready to both buy and sell their products on a continuous basis. They typically hedge all bets and make money on bid and ask spreads. It is desirable to keep the spreads as narrow as possible to prevent hedge funds from exploiting differences between the unit value of the ETF and the value of the underlying shares. This works, in live market conditions, to improve both the liquidity of the ETF and to minimize tracking error.Market makers make their profit on trade volumes.

3-  Advisor/Salespeople: ETFs are marketed to both institutional investors (pension funds, insurance companies, hedge funds etc) and retail investors. The products sold are often identical, but the resources necessary to understand the product varies greatly between the two investor types. The role of sales people is to ensure the playing field is level by doing two things; learning how the product works before selling it, and clearly disclosing how the ETF works, what it costs, and the risks of owning the ETF to investors. Their track record at doing these basic things is dismal to say the least.

B- Dual Liquidity Characteristics of ETFs:

The liquidity of a normal widely held mutual fund or an individual stock security is based strictly upon trade volumes of the fund or security. With an ETF, because it is easy to create or release units on demand, the liquidity restrictions are not solely based on the “ETF unit” liquidity, but also on the liquidity of the underlying securities. This means a new ETF offering on the TSX60 can have high liquidity regardless of trade volumes in the actual ETF units. This is because the TSX60 has high liquidity in the underlying stocks. If I request 50,000 units of a new ETF, the market leader just puts in a request for the shares through computerized trading and issues the 50,000 newly created units within minutes (actually seconds).
CAUTION: While liquidity may appear better in the ETF structure, in actual practice an ETF with low trading volume will tend to have greater tracking error than an ETF with high trading volume even though the liquidity of the underlying securities might be the same. As an example the new and smaller BMO ETF will likely have greater tracking error than the XIU until volumes help the designated market maker to keep the bid and ask spreads narrower.
The one wild card in the liquidity situation , is if the market maker for the ETF abandons the market. The risk is similar for most securities but may be more relevant for ETFs given what happened in the “May 2010 flash crash”. (a story for another blog)

C- Cost Advantage:

 Although some active managed expensive mutual funds are starting to use the term “ETF” in their name to confuse investors; a general advantage of the ETF structure is low cost. This low cost is a significant advantage and thus ETF index funds with higher MERs (expenses) generally are not desirable. ETF Index funds for major Canadian market indices can cost as little as 0.08% annual MER. Typically you will not see any deferred sales fees or trailing commission expenses with an ETF, unlike many high cost mutual funds.

D- Tax Advantage:

Typical ETFs have a more passive approach to investing and thus generate low trade volumes , which then translates to low tax costs. A broad based index ETF would rarely need to add or subtract securities from the underlying basket of securities comprising a unit, since most indices are quite stable. Exceptions would be where mergers eliminate a security or where a security was added or dropped from an index.

E- Tracking Error:

Index funds, whether ETF or mutual funds, attempt to duplicate an index’s performance. In all cases there is likely to be some level of tracking error since the index fund charges an annual expense ratio to cover the cost of maintaining the fund. Also, various structures may be prone to tracking error due to the fact the index fund lags the index when changes are made. An index fund is not generally allowed to make changes prior to the actual index making a change. This allows large investors to "front run" changes to the index which increases tracking error and reduces performance. Another significant cause of tracking error is the ETF structure, so without further ado let’s look at what makes an ETF tick!

So, in summary, in part two we learn:

- ETFs often start life as a specialized product to meet the needs of institutional investors, and then are sold later to retail investors through generally poorly trained advisors(tip; some advisors are ETF specialists and better trained than a typical salesperson on the intricacies of ETFs)

- we now can recognize who the ETF industry players are and how they make their profit from ETFs

- we understand the common characteristics of ETF Index Funds that investors either seek to aquire (low cost, high liquidity, low taxes) or to avoid (tracking error, high bid/ask spreads)

I confess this blog was an added step to my initial ETF education series plan. In preparing the next section on ETF structure, I realized it is easier to understand the "what" of creating an ETF if we better understood the "why" and "who" of  ETFs. Hopefully with this better understanding of the above ETF common characteristics, it will make the next section a little less confusing.

Our next blog, I promise we will get down to the serious business of how ETFs actually work! Part 3 coming very shortly!

Soismike

ETF Education : Part 1 ETF Basics and History

The Good, Bad, and Ugly of Understanding an ETF Portfolio

Like many folks, I “get” the underlying premise of ETF Index investments. The basic premise is to replicate the performance of a given “index” of securities, without the need (or expense) to actively research individual securities. For example, if I want to replicate the performance of the TSX 60 index, I only need to buy one common share of each stock that comprises the TSX 60. Seems to be simple enough, right?

Unfortunately, nothing is ever quite as simple as we would like it to be in the financial world. While ETF Index investing is not nearly as frightening as trying to evaluate hundreds of securities accurately in a timely fashion, you still need to do your homework. In the next few blogs we will look inside the world of ETF Indexes, and try to lift the hood on how they work, rather than just kicking the tires. The areas we will look at will include index construction, index history, index proliferation, ETF structures, and the increasing number of ETF strategies available to investors.

Today we will tackle "Indices"; what they are and how they impact your ETF Index Funds.


Let’s start by going back a in time a bit and discussing “indices” and how they came to be. One of the oldest and most commonly followed indices is the Dow Jones Industrial Average. This index was developed by Charles Dow in 1896 to provide investors with a timely overall measure of the performance of the U.S. markets. It was created by measuring the “average stock price” of the 12 biggest industrial firms and has expanded to include the stock of 30 of the largest companies trading on the U.S. exchanges today. The name remains unchanged but the index is not nearly as focused on “industrial stocks” as the name might imply. The lesson we learn here is that you cannot trust the name of an index to be a totally accurate reflection of what is being measured.

Much later the merger of financial service companies created the Standard & Poors Index. This index changed the weighting process to  “market capitalization” of the component companies instead of the average stock price weighting utilized by Dow.
 The lesson learned here is that not all indices use the same methodology to measure an index. You need to know both what underlying securities comprise the index AND what methodology is being used to weight the index.
Since the simple start a wide range of indices have become available to track markets big and small. In every case you need to know what is being tracked and how components are being weighted.
While in theory you can use any methodology to weight the value of an index, the common ones tend to be:

1-market capitalization ( pure or capped): market capitalization weights the components of the index by multiplying each stock price by the shares outstanding to get the market value of a firm. It then calculates the firms weighting by dividing that number by the total value of all the firms in the index. A “capped” index will generally restrict any single firm from having a weighting greater than a set value ex. 10% of the total index. This capping is valuable in situations where the index has a small number of companies in it or when a single company such as Nortel gets too big and impacts the index’s ability to provide diversification.

2-stock price average: as stated above, the Dow Jones uses the “price” of the stock to calculate the index weighting relative to the total prices of all the stocks in the index. In reality the math does get a little more complex to account for mergers and other events which disrupt pricing, but the basics hold true.

3- fundamental indexing: the London Stock Exchange and Financial Times created a company known as FTSE, which in turn developed a different weighting system commonly called “RAFI”. (research affiliates fundamental index). This weights each stock on a collection of pre-set fundamentals such as sales, book value, cash flow etc. A number of index fund providers now use their own set of fundamental analysis calculations to weight indices.

4- equal weighting: as it implies, each component of the index is treated equally, regardless of share price or market capitalization. This approach puts more emphasis on smaller companies than you would find in a market capitalized index. In general an equal weighted index would be more volatile than one that was cap weighted.

Indices have been created and tracked for over a century so how is it that ETF Index Funds are such a new phenomenon?

Well, creating, tracking. and valuation of indices has benefited from computing power. To trade effectively on an exchange the index needs to be able to provide valuations every second of every trading day: So computerized programs make index trading possible by providing efficient valuations of the underlying assets in the index.
The second thing that needed to happen was to find an innovator who was willing to break with the status quo in the securities industry. It is obviously more profitable to sell an investor 60 stocks through 60 separate trades than it is to buy one ETF unit and accomplish the same result. Similarly, it is more profitable to sell a mutual fund which pays both upfront fees and trailer fees to a broker. In 1976 Vanguard in the USA created the first index fund to track the S&P 500 Index and that opened the flood gates to the index world for fund investors.
 In 1990 Toronto was the origin of the first Exchange Traded Index Fund when TiPS was traded on the TSX to track the TSX 35 Index. That first ETF Index Fund has transformed several times to become the iShares S&P/TSX 60 of today. Vanguard in turn has become the worlds largest provider of ETF Index Funds for investors. To understand why ETF Index Funds are not more popular than mutual funds re-read the second paragraph above about profitability for advisors/salespeople!

So, we have an evolution that includes creating the concept of indices, expanding the methodology for weighting index components, turning an index into a mutual fund, and then turning the mutual fund concept into an Exchange Traded Index Unit.

Some key learning's for Investors are:
1- You cannot trust the name of the index fund to provide sufficient information to understand the fund components
2- Two ETF Index Funds tracking the same index with identical components can behave very different if the components are weighted with different methodologies.
3- It is rarely beneficial to an advisor/salesperson to recommend an ETF Index Fund over alternatives such as stocks or mutual funds.
4- Canada was home to the world's first ETF Index Fund......TiPS!

Next blog we will look at how ETF Index funds have grown in number and complexity, leading to a variety of structures that are often difficult to understand.



Sois mike

Bubble Trouble: Will We Ever Learn!

BUBBLE TROUBLE!

One of the most recognized signs of a bubble is when every person you meet feels they are an expert on investing. We are all good at looking backward and finding “inflection points” where it is obvious in hind sight what was happening. Where we seem to be myopic is in identifying the manure BEFORE we step in it. History is a good teacher; but alas investors are poor students.

I arrived in Toronto in the late 80’s and was involved in mortgaging real estate as the prices skyrocketed. Today it is no big shock to look back and see how the late 80’s real estate collapse was inevitable. Buying real estate in 89 was dumb....in retrospect. Similarly we can look at the stock bubble of 1999 known as the tech wreck. To those that bought a house in 1989 and then put their RRSP savings into Nortel....well our heart goes out to you!

The incident of back to back bubbles is obviously not unheard of. As money fled real estate it crowded into high tech stocks to create the perfect conditions for the double whammy. So how does this relate to today’s market? Well, money fled the stock markets in 2008 and as stocks crashed large amounts of capital began to flow into fixed income investments. The net result appears to be the creation of a perfect scenario for the second half of the double whammy.... a fixed income crash.

In the case of fixed income, there is even more reason for concern than usual due to both behavioural and macro economic factors. The behavioural concern is the belief by many investors that bonds are inherently low risk. This means investors often choose not to pay close attention to the fixed income markets and price fluctuations. As well, many investors unfortunately have an inflated sense of their knowledge of how securities work (as validated by Zweig ). Fixed income instruments such as bonds are interest rate sensitive (duration) and move inversely to the movement of interest rates. If rates rise then fixed income markets drop in value. Also, if the economy weakens then debt instruments like fixed income face credit defaults which cause values to drop as well.

When you combine those facts with the current macro scenario of historic low interest rates and very low economic growth, you create the conditions for a fixed income disaster! Investor capital will flow to wherever they can find better yield. When that happens, the product vultures kick into gear and create “high yield” products to sell to the retail markets. For those who are kicking the tires on fixed income it may not be apparent that “high yield bonds” are known in the business as “junk bonds”. Once again we see retail investors pouring money into opaque fixed income and yield products, ignoring risk and paying higher fees that often exceed the yield they might gain.

It very much looks like the double bubble process has begun! Every investor seems to be “seeking yield” and new product offering are focused on lowering the bar on bond quality. Junk bonds are now buried in “hybrid fixed income” funds and every fund firm is keying the marketing department to hype higher yield going into the 2011 RRSP season. ETF’s are not excluded as iShares launches its new HYbrid fund, joining the BMO High Yield Corporate (U.S) fund launched in late 2009, the iShares U.S. High Yield Bond index launched in early 2010, and a slew of others. According to IFIC the global and high yield bond funds market sales are up 62% year over year to August 2010.

Hang on tight folks. The bond world can be cruel to those who see it as a sleepy back water investment. With cash flow and capital far exceeding the equity markets, bond markets are dominated by the big players and are far from being a transparent playing field. Just when you think you are finally safe investing your hard earned savings again.....WHAM!

Anecdote: I just spoke with a DIY investor who told me he has purchased a fund of emerging market high yield bonds...... what could go wrong!

Sois mike

National Post article Jonathan Chevreau re: DIY Follies

We thank Jonathan for his coverage. "A Little Advice A Dangerous Thing" adds to the discussion started with our DIY Follies blog. Follow Jonathan at the National Post.

http://www.financialpost.com/news/Wealthy+Boomer+little+advice+dangerous+thing/3507590/story.html

Crawling Out From Under An IIROC

IIROC REPORT: New Product Due Diligence Regulatory Review– Common Deficiencies and Requirements for Written Policies, Procedures and Controls

The good folks at IIROC have just released a fresh report designed to hold the investment dealer industry’s feet to the fire! They had their rapid response SWAT team swarming over the latest dealer fiasco's to give investors the heads up on current and relevant deficiencies in the sales of both Principal Protected Notes (PPN) and.... well, basically every new product that comes along!

The fact that these issues were extremely relevant in 2007 and are far less useful or timely now would seem to mean little to our conscientious industry sheepdogs, oops watchdogs, at IIROC. The inspectors at IIROC seem to believe the best time to inspect the barn is after the livestock has gone missing. The good news is that in only 2 short years from 2008-2010, the inspectors were able to confirm the barn door was and still is, wide open!

In effect, IIROC is really disclosing how useless their services are to investors. The reason you inspect is to head off problems not define what went wrong. The regulatory environment in Canada acts as a great coroner..... however what investors need is a good diagnostician! This problem is not new and does not appear to be getting any better!

Barn Door Warnings:

1- Mutual Fund Disclosure Practices are a mess in Canada. This is despite of regulatory reviews that have proposed, reviewed and analyzed the issue since as far back as 2002. According to an article in Advisor.ca in 2009, “POS disclosure has been a major issue of contention in the industry for more than a decade. It was a major plank of the work done by former Ontario Securities Commissioner Glorianne Stromberg in the late 1990s.” So, if you cannot work out a simple two page disclosure in a decade, what actual value do you add?

2- LEVERAGED ETF’s were a significant addition to the product line-up for advisors heading into the current mess. These are high risk leveraged products which can drain an account faster than you can imagine. So what training and skills did advisors require before pushing them on investors in the stock crash of 2008.... apparently only the skill to calculate a large up front commission fee. And who was there to protect investors? Well, not IIROC since the issue was driven primarily by FAIR Canada, an investor advocacy group that issued a warning report on leveraged ETF’s in May of 2009 after IIROC had watched over $2 billion in these funds get traded over a period of over two years! Hello.....watch dogs are supposed to sound the alarm before I get robbed not after!

3- Money Market Funds were actually being sold at a time when the return was less than the fee to own them. One would think this would jump off the page as an opportunity for a regulator to regulate the actions of dealers managing and selling the products. But, again the outcry was from others but not from our watchdogs!

Without getting too sidetracked, I think you get the issue! Investors in Canada are not being proactively protected when a self regulatory body such as the IIROC only appears willing to pull its thinking appendage out of its output channel well after the damage is done. It appears equally obvious that reviews such as this one are only being organized after others have blown the whistle on abusive practices. It cannot be coincidence that these reports are general and never seem to provide concrete examples of who benefited from the problem at hand and what were the consequences to those who benefited.

Report Highlights: I think the report truly does speak for the industry practices, or lack their of, so let’s look at the conclusions from the report itself:

COMMON DEFICIENCIES:

1- Absence of a clear definition of “new product” : This conclusion is simply that dealers do not even know what a new product is. They can sell it no problem and they understand the commissions with no problems.... but knowing if a product was available before last week is a little tougher!

2- Absence of an adequate analytical framework for the consideration of whether the “new product” should be offered :I guess we should not be surprised if the dealers do not check on suitability of the new product given the point above that they do not even recognize a new product when they start selling it. I guess the dealers are not as professional and diligent as new car sales people who can tell you the features on a new car model within 30 seconds of the car arriving on the lot! I would bet however, every advisor knew within 30 seconds what commissions and trailer fees were available.

3- Absence of consideration of proficiency, training and marketing issues: Again, it is a wonder that new complex financial products can get on the shelf at major brokerage firms with no consideration whatsoever to the ability of the advisor to understand and properly explain the product. A great example was the variable annuities which were so popular that Manulife is choking on the sale of the product. An advisor told me straight up that they called in the product rep from Manulife and after the presentation the advisor had no clue how the product worked but was fine to begin selling it!

4- Absence of Product Due Diligence Committees: This last point helps explain the term “reasonable deniability”. The dealers do not create committees to review new products because then they would be aware of the risks and training needed before the product could be sold. It would also increase the risk of a lawsuit since written minutes acknowledging the concerns raised above would create liability for the firm. No, the decisions are made with open eyes and with malicious intent; never create a committee that exposes risk which must then be disclosed and dealt with.

“So, what now our hardy and tardy regulators? Another few years of study, another memo on best practices?”

“You have published findings that by your own report are atrocious! Investors have lost and are continuing to lose millions due to these deceptive and incompetent practices.”

“ What is the call to arms? How do we use this information to better improve our industry? How do we ensure investor rights and interests come first?”

“ What..... do I have a quarter......and I should call somebody who what?”

Oh, I get it. Thanks for your report on what we should have done in 2006 but still are not doing in 2010; and will not be required to do now that you have filed your report! "We couldn't have not done it without you!"


sois mike

DIY Follies

DIY Follies and The Danger Of Web Experts!

First let me start by saying I am a big supporter of DIY investing, both professionally and personally. I believe investing is too important for people to completely trust their money to a third party advisor, regardless of how qualified the advisor might appear to be. I also think that fees in Canada are so egregious that many investors can make a better return on any DIY portfolio than they will on a “fat fee” fund strategy.

So what frustrates me about DIY? It is the smug self assured certainty of many DIY investors I hear from or read comments from. The web has been a great source of information on DIY investing, and much of it is good stuff. Unfortunately a lot of it is also total crap. It seems that reading a single book and wasting a few hours an evening on web blogs is actually deemed sufficient training to become an unlicensed expert advisor to the masses. To make matters even worse, the advice is most often anonymously shared by somebody hiding behind an ego driven pseudonym. Who would not want to follow the advice of “dividendman” or “investpert”! (my made-up examples in case these pretentious pseudonyms are really being used by somebody out there)

So let’s take a look at some of the idiotic recommendations that appear regularly on investment blogs from DIY advisor wannabee’s:

1- Only Idiots invest in Fixed Income: This one is an idiotic comment that even some mediocre professional advisors spout! With the professional advisor it is understandable because they make more money selling stocks than bonds. With the DIY guys it is because they are navel gazers! They often have no concept of risk or downside protection, little understanding of investment horizons, and believe anybody who disagrees with them is a moron. Not surprising many also claim to be young and thus have little money and plenty of time! By the same theory you should invest in lottery tickets since you have years to invest which greatly increase your odds of success.....right?

• 1a- Contra the DIY: Equity investing is high risk. The returns on equities are typically higher over the long term but with no certainty that the returns will be superior on any given day, month or year. The larger market corrections can take over three years to recover and equity markets can move sideways for decades at a time. In fact some money managers believe we are in a seventeen year sideways market as I write. In looking at a top investment firm’s numbers for the past 5 years, I see a fixed income fund with average 5 year returns of 6% and with no negative returns in the 5 year period. The same firm’s equity portfolio was a top performer over the past 5 years and has a return of 6.3%. Net of fees (2% on equity and 0.9% on fixed income) and the fixed income portfolio has higher returns, lower volatility and lower fees. So what if the person was indexing their DIY portfolio? The benchmark returns were 3.7% for the equity fund and 4.9% for the fixed income fund.

2- Dividend Funds are the perfect strategy for everybody: The blog world is filled with folks who push the concept of 100% dividend stocks. They suggest that only the bright geniuses like themselves are aware that “dividends pay you to hold the stock in good markets or bad” and that historically, the “consistent dividend growth is the secret to better investment returns”. In fact dividends can pay more than GICs so sell your low interest GICs and buy dividend stocks and you will grow rich!

2a – Contra the DIY: Dividends are indeed a good thing! They are not however the primary investment goal of all clients. Most dividend companies are in older mature and thus lower growth industries. If you are in equities for growth then you may find non-dividend paying energy or tech stocks more appropriate than the dividend approach. The blue chip dividend stocks are often very highly priced with similarly high price earnings ratios. When dividends outstrip GICs it should come as no surprise that the additional return is compensation for increased risk. The other nasty part of a dividend strategy is when a firm suddenly decreases the dividend and the stock drops like a rock. It can take a lot of years of 3.2% dividends to make up for a 35% price drop! (think Manulife for a recent real life lesson)

3- Don’t Invest in Foreign Markets Because of a- currency risk, b- currency conversion fees, c- Canadian markets will outperform! : The Canadian market is a top performing market. European markets are weak sisters that never make a good return and Japan is a wasteland! The smart money invests in Canada because we have natural resources that can only become more valuable over time. We also have gold that will save us when the world ends as we know it. The stock markets all move together so it does not pay to diversify by geography. The loonie is king and foreign holdings increase currency risk too much.

3a –Contra the DIY: In fact diversification has very little to do with long term currency risk and long term investors do not suffer a lot of losses on currency fees (which are still annoying and to be minimized). The diversification into foreign countries is done for two reasons. Foreign countries often have less than perfect market correlation which means if we drop 30% and Europe drops 25% in a bad market, we would benefit by holding some Europe equities on average. Historically the major markets do not hold the top spot for more than a few years before a nation drops back and is replaced by a new market that is heating up. You cannot reasonably predict the world wide shifts so benefit from holding a little of many markets. You do not expect peak performance from every market every year.
The second reason to diversify geographically is to diversify across sectors. Canada is a small market with little health or high tech companies to be had. Foreign firms often provide better exposure to business sectors the Canadian market cannot offer.



4- Follow My Lead Because I Made 30% Returns For Every Year in The Last 7 Years!

I buy only a- dividend, b- small cap, c-gold and diamonds, d- options, e- outer Mongolia futures, and I have beaten the pros for years. Everybody else is stupid and I am a genius and am willing to share my brilliant approach with you! Honest! Check my blog! Honest! Ask my brother-in-law! Honest!

4a Contra the DIY: Unfortunately, I am only exaggerating a little bit! There are several thousand very bright and well educated investment experts with almost unlimited support from top analysts. They did not miss your magic formula for success! You are not a genius unless you do it, have it audited by professionals, and can repeat it over and over. You may be lucky, you may have incorrectly measured results or you may be full of crap! It’s hard to tell from this side of the screen, but I am very confident you are not a genius! Honest! Really! Seriously!

The DIY world is a great place with a lot of bright folks who are interested in investing! But be aware, not every comment is created equal and a little assumed knowledge can indeed be very dangerous. The key to success in the DIY world is very simple: Do Your Own Research! Blogs can be fun and informative but they are not tested or validated. The top forums or blogs will most often make it very clear they are expressing “opinions”, not expert opinions, and just somebody’s opinions. They also make it clear they are not licensed security advisors and you should not buy or sell on their opinions, but rather may want to research what they are commenting on.

Your sceptical of advice friend.....SOIS Mike!