Choosing an ETF

August 16, 2016

Investing in an exchange-traded fund (ETF) begins with screening many funds to identify a few candidates, then rating the candidates. My preferred open-source screeners are XTF.com and ETF.com, both of which have inclusion criteria for selecting desirable ETFs and exclusion criteria for rejecting undesirable ETFs.  Aim to find a reputable low-cost ETF that best matches the performance of its category.

Asset class

Assets are potential sources of income to investors.  Consequently, an asset class is a group of assets that earn income the same way.  The ETF portfolio holds assets consistent with the fund’s investment strategy, which is either to copy a market index by process of passive management or compete with a market index by process of active management. The index measures the performance of an asset market.

Competing ETFs are typically grouped in one of the following asset classes:

  1. EQUITY is a share of ownership claimed through the purchase of a company’s stock. Equity ETFs earn capital gains and dividends from stocks.
  2. REIT.  The real estate investment trust (REIT) is a company that owns and manages income-producing real estate. The REIT earns money from rent, mortgage interest, or other real estate investments. At least 90% of the REIT’s taxable income must be given to shareholders in the form of dividends. REIT ETFs earn capital gains and dividends from REITs.
  3. FIXED INCOME securities pay an expected amount of interest (e.g., bonds) or dividends (e.g., preferred stock).
  4. COMMODITIES are raw materials sold in markets for use in making finished products. Commodities are sold for cash or traded in futures contracts.
  5. CURRENCY is a system of money in the form of cash or notes. The currency market trades different currencies to profit from trading fees and differences in interest rates.

Inclusions

The following inclusion criteria direct the search for reputable candidate funds desired by most individual investors:

  1. Passively managed ETFs typically charge lower fees than actively managed ETFs and likely outperform actively managed funds over long time-periods.
  2. U.S. listed ETFs comply with SEC regulations, U.S. stock exchange rules, and the U.S. tax code.
  3. One of these Asset classes: Equity (stocks), REIT (real estate), or Fixed Income (bonds).

Refine your inclusion criteria by selecting reputable indices and desired market categories.

Exclusions

The following criteria should be excluded by all but the most adventurous investors!

  1. Exchange-traded notes (ETNs) are not ETFs.
  2. Closed-end funds (CEFs) are not ETFs.
  3. Leverage and inverse ETFs are very tricky investments.
  4. Actively managed ETFs charge higher fees in order to create porfolios that outperform or underperform a market index.
  5. These asset classes:
    Alternatives (imitation hedge funds)
    Asset Allocation (actively managed mix of assets)
    Multi-Asset/Hybrid (diversified asset classes)
    Volatility (exposure to volatile market)
    Commodities (potential tax burdens)
    Currency (potential tax burdens)

Reputable index

All ETFs compete on the basis of an Index they use to design an investment portfolio. Some Indices make better measurements of market performance than others. Beware that some Indices measure untested markets. Generally speaking, the best-in-class ETFs use reputable market indices. One way of choosing a reputable index is by selecting a long-standing, oft-quoted Index provider or Index name.

Index providers are companies that specialize in measuring market performance and selling the information to financial institutions. Table 1 provides a sample of reputable Index providers.

Table1

Category and Index names

Asset Classes have unique categories. Each category may be measured in a variety of indices listed in Tables 2-4.

table2

 

table3

 

table4

Rating the candidates

By now you should have several ETFs that could satisfy your investment goal. Verify that they belong to the same category, then assess their suitability based on the following critera:

  1. Net assets, Total assets, Assets Under Management (AUM), or Market cap AT LEAST $1 BILLION.
  2. Inception date AT LEAST 5 YEARS AGO
  3. Expense ratio BELOW 1%, LOWER IS BETTER AMONG COMPETITORS
  4. Legal structure PREFERABLY “OEIC” OR “UIT” (table 5)
  5. Number of holdings CONSISTENT WITH THE MARKET INDEX.
  6. Tracking error, LOWER IS BETTER AMONG COMPETITORS
  7. Premium (Discount), LOWER IS BETTER AMONG COMPETITORS

The finishing touch

It’s a good idea to review the Annual Report of your selected ETF.  Your potential tax burden is determined by the ETF’s legal structure, its portfolio turnover, and your tax accountant’s hourly fees.

table5

Copyright © 2016 Douglas R. Knight


#SmallTradesPortfolioDESIGNER

April 21, 2013

(updated 7/31/2013)

The Small Trades Portfolio Designer is used to test model portfolios that hold 1-9 sectors of financial market returns plus a cash supply of U.S. dollars.  The program is pre-loaded with monthly returns computed from broad market indices during the 15 year period of 1997 to 2011.  You create the model portfolio by entering an allocation plan, investment amount, and rebalancing strategy.  The results are displayed in tables and charts on the same worksheet. You have the option of assessing the impact of trading costs and investment fund fees on portfolio returns.  The program can be downloaded for free by clicking here: SmallTradesPortfolioDESIGNER.

Allocation plan

At the top of the worksheet, each class of securities is labeled according to a unique combination of market region, market sector, and asset class.

designer1

Consider, for example, funding a portfolio that is 54% invested in large-cap U.S. stocks, 36% invested in U.S. bonds and 10% stored in cash.   For every $100 invested, $54 are allocated to U.S. large-cap stocks, $36 to U.S. bonds, and $10 to a cash reserve.  The allocation plan consists of weighting factors 0.54/0.36/0.10 [the article designing a buy-and-hold portfolio offers advice on creating allocation plans relevant to your investment goal].  The following entries are made next to the appropriate labels:

designer2

Rebalancing strategy

designer3Suppose the portfolio is funded with $10,000 [comment: lower payments might be less efficient investments when factoring in the costs of trading fees and expense ratios].  Two methods of rebalancing the portfolio are scheduled (e.g., every year) and signaled.  Suppose you wish to test the signaled method by choosing “no schedule” from the pull down list of the “Rebalance schedule” cell and “signal 3” from the pull down list of the “Rebalance signal” cell.   “Signal 3” is a command to rebalance the portfolio when market forces unbalance the portfolio to an unacceptable degree of error.  The result is an intermittent series of rebalancing episodes that modify the historical returns.  “Signal 1” and “signal 2” evoke a different number of rebalancing episodes by modifying the boundary for unacceptable allocation error.  It’s an empirical process for finding the best result.

Investment costs

designer4

The “risk-free bond rate” is used to calculate the Sharpe ratio.  I recommend a rate that estimates the risk free return for the holding period of the test portfolio (e.g., a 10 year Treasury Note at inception of the portfolio).  The default bond rate is 2.98% for the 15 year period of this program.  Trading fees and annual expense ratios always reduce investment returns, sometimes by a considerable amount.  Assess these by entering the typical trading fee charged by your broker and an estimated annual expense ratio derived from investment funds and advisor’s fees.  Or consider testing the default costs of $10 for trading and 1% for an annual expense ratio.  These entries are left blank for this tutorial.

Results

The historical returns are summarized by statistics and charts for the  “Unbalanced” (“buy-and-hold”) and “Rebalanced” portfolio. The outcomes of the “Unbalanced” and “Rebalanced” portfolio would be identical without a rebalancing strategy [furthermore, a portfolio of one asset cannot be rebalanced].  In the following table, “CAGR” is the annualized growth rate of the portfolio’s accumulated returns.  “Sharpe ratio” is the average annual investment return adjusted for market fluctuations.   A negative Sharpe ratio implies that risk-free U.S. government bonds are better investments.  Higher values of CAGR and Sharpe are preferred.  The “final value” is the portfolio’s market value at the end of the investment period.

designer5

Chart 1 shows the returns based on test conditions.  The market fluctuations ultimately reach the final values shown in the table.  An effective rebalancing strategy creates a gap between both curves.

designer6

Rebalanced portfolio

Rebalancing may not improve the investment performance of a portfolio.  However in this example, the signaled rebalancing strategy outperformed the unbalanced portfolio (CAGR 6.59% is better than CAGR 5.65%).  Not shown is that scheduled rebalancing “every 3 years” also outperformed the unbalanced portfolio (CAGR 6.38% vs CAGR 5.65%).  In this tutorial, the result of selecting “signal 3” for the signaled strategy generated a 37.7% boundary error labeled as the “rebalance signal” in the program.

designer7

“Signal 3” also triggered 4 rebalance episodes over 15 years (chart 2) when there were no trading costs at inception or rebalance.

designer8

Warning messages

The next chart uses red arrows to show the location of warning messages.  These disappear when satisfactory entries are made in the program.  Be aware that the “asset allocations” must total 100% or else the blue-lettered message “Allocations are incomplete” reminds you to check the entries.

designer9

Applications

The investable securities of the program’s market sectors are index funds, stocks, bonds, real estate investment trusts (REITs), and commodities futures. Index funds are particularly good substitutions for market sectors of the model portfolio.

Test other model portfolios.  The 60/40 Stock-Bond Portfolio, exclusive of a 10% cash holding, is a favorite of many investors.  The 60/40 unbalanced portfolio’s 6.07% “CAGR” and 0.29 “Sharpe ratio” provides a standard for comparison with other allocation plans.  Try creating higher returns by experimenting with different allocations.  Consult the article designing a buy-and-hold portfolio for advice on creating allocation plans relevant to your investment goal.

Apply the rebalancing strategy.  Either the scheduled or signaled strategy can be used to rebalance a portfolio of index ETFs that match the allocation plan of a model portfolio.  The scheduled strategy is straight forward.  Simply rebalance the ETFs according the best schedule determined by this program.  The signaled strategy is not straight forward.  It requires transcribing  data from this program to the Small Trades Portfolio REBALANCER program in the following way:

1. Enter the “Rebalance signal” from the Results of this Designer program into step 1 of the Rebalancer program.  In this example, the correct entry would be 37.7%.

2. Result 1 of the Rebalancer program will display a “Rebalance” message when any of the portfolio’s ETFs satisfies criteria for correction.

Conclusions

A leap of faith is needed to apply the model portfolio to your investment goals.  This program is based on recent 15-year returns and your best bet is to assume that the next 15 years will provide a different investment performance due to market uncertainty.  Even so, I don’t know any investor who completely ignores history.

This program tests strategies for rebalancing a model portfolio.  I know of no other program that provides such information!

The potential impact of trading fees and fund expense ratios is considerable when many portfolio holdings are rebalanced frequently and the expense ratios are high [that’s why respected authors recommend minimizing costs by seeking high-quality, no-fee, no-load investments].  A good rebalancing strategy should augment the expected return of the unbalanced portfolio.

You can download this program free of charge by clicking on SmallTradesPortfolioDESIGNER.  If the program inspires your investing for the betterment of self and society, consider giving a tax-deductible contribution to your favorite charity or my favorite charity.

Copyright © 2013 Douglas R. Knight  


Asset classes

November 30, 2012

For purposes of investment, an asset is any item of economic value owned by an individual or corporation.  The fundamental assets of our economy –natural resources, skilled labor, and infrastructure– are used to produce a wide variety of goods and services 1.  Included among all goods and services are the financial assets that can be converted to cash in marketplaces where trading generates profits and losses.  An asset class is a group of financial assets that have the same legal structure and share the same market exposure 2.  Table 3 lists the asset classes of greatest interest to individual investors.

Table 3.  Asset classes for individual investors.

Asset class Global capital Risk Return Liquidity
Bonds 45 Low Low High
Equities (Stocks) 28 High High High
Real estate 6 Low High Low
Cash equivalents 4 Low Low High
Derivatives 650 High High High
Commodities High Volatile High
Gold Medium Low High
Infrastructure Medium Medium Low
Art & Collectibles Medium Medium Low

 Legend:  Asset class is an investment category that can be characterized by market region, business sector, and other useful criteria.  Global capital  is the estimated year-end total amounts of capital invested in asset classes during 2004-2008, except that derivatives were valued as the total theoretical principal value during 2010 3,4,5.  Each number represents trillions of U.S. dollars.  The Risk of an investment loss and likelihood of an investment Return are use to facilitate decisions about allocating assets to an investment portfolio.  Liquidity refers to the ease of trading financial assets.  Assets that are easily convertible to cash have high liquidity 2.

Bonds

Bonds are debts that require the borrower (issuer) to pay a lender (investor) the amount borrowed (principal) plus interest over a specified time (maturity).  Interest is the relevant source of future cash flow to investors.  Bonds offer businesses and agencies an alternate source of borrowed capital in addition to bank loans in the currency market.  Central government bonds typically have the highest credit ratings in their countries.

  • Credit ratings are used to evaluate the risk of borrower default on timely payments of interest and principal.  Bond default is any missed or delayed payment, or the exchange into a new package of securities.  Riskier bonds (i.e., junk bonds) generally have higher yields that the safer investment-grade bonds.
  • Bond yield (ratio of interest/price) serves as an index of investment return.
  • Bond liquidity is variable and decreases with the length of maturity.

Classes of bonds that qualify for inclusion in a bond market index are government, securitized, corporate, high-yield, and emerging-market debt.  Interest rates on bonds tend to increase with inflation because fixed income investors require a real return 5.

Equities

Equities are shares of ownership in a company that provide rights to corporate income and capital after the settlement of all obligations to creditors.  Shareholders typically have voting rights in matters of corporate governance.  The relevant source of future cash flow is characteristically linked to corporate earnings and dividends.  The long-term return of equities –~7% in mature markets– is considered to be high and tends to provide protection against inflation.  In contrast, the short-term return on equity tends to decline during periods of high inflation 5, 6.

Private equity is a group of unlisted equities that are traded in private markets, rendering them illiquid (and opaque) by comparison to the ease of trading in public markets 5.

The global capital markets can be divided into developed markets and emerging markets 4.  In 2010, emerging markets comprised 16% of the global equity market capitalization.  Emerging market equities have characteristically higher risk and higher returns than developed markets 5.

Real estate

Real estate investments provide ownership of physical assets (i.e., commercial and residential properties) and rights to future income stream from the property & land.  The best way to view real estate is as a physical asset in which the relevant source of future cash flow is cash yield (e.g., rent).  Physical assets deteriorate unless maintained by costly capital expenditures.  The appraisal value of a property is its current and future income stream.  Various real estate assets provide a spectrum of risks and returns to investors.  Investors can enter the real estate market through private or public markets.  Private markets promote unlisted investments in property and funds.  Private real-estate investments are valued at net asset value of the underlying property.  They tend to be high cost, high return, and illiquid enterprises.  The opposite tendencies apply to real estate investments in public markets.  Public markets list shares of real estate companies and real estate investment trusts (REITs).   The investments are valued at public auction prices.  Assuming that most of the return from real estate investment is derived from stable long-term income, real estate investments are considered low-risk, high-return.  Real estate is an illiquid investment due to pricing discrepancies and transaction time 5, 6.

Derivatives

Derivatives are contracts between a buyer and seller that are based on the price movements of underlying assets.  In 2010, the underlying assets were distributed among interest rates (79%), currencies (8%), credit default swaps (4.6%), equities (2%), commodities (0.4%), and otherwise unallocated (6%).  The biggest demand for derivatives arose from the risk management of portfolios by financial institutions.  For example, Banks use interest rate derivatives to manage potential mismatches between assets and liabilities.

“Futures” are contracts to buy (‘long position’) or sell (‘short position’) an asset for a fixed price at a future date.  Price movements of futures mimic those of the underlying assets 5.  “Swaps” are contracts to exchange payments based on different assets.  For example, the interest rate swap requires an exchange between the cash amount for a fixed interest rate and the cash amount for a floating interest rate.  The contract is written to begin with equal fixed and floating interest rates.  The sides of the swap are called legs; the fixed leg and the floating leg.  “Options” are rights, not obligations, to buy or sell an underlying asset at a fixed price (‘strike’) up to the time of maturity.  The buyer of an option pays a premium for the right to buy or sell.  The right to buy is known as a “call” and the “long position”.  The right to sell is known as a “put” and the “short position”.   The right, not the obligation, to trade distinguishes the option contract from the future and swap contracts 5.

Commodities/Gold

Commodities are materials (e.g., precious metals, base metals, foods, energy) that produce no direct income.  They have no obvious claim to an underlying cash flow but are viewed as liquid assets which provide diversification and a hedge against inflation.  The volatiles prices are driven by perceived differences between supply and demand 5.

Gold is a precious metal held by central banks and used interchangeably with money.  Gold historically provides a long-term hedge against inflation, but this may not continue.  Gold is highly liquid and used as an “insurance policy” 5.

Infrastructure

Infrastructure is a class of physical assets (e.g., toll roads, healthcare facilities) that require the management of contracts and capital reinvestment.  They are permanent assets needed for the orderly operation of an economy.  The underlying cash flow from infrastructure is expected to be stable and sufficient to hedge against inflation.  New assets are expected to generate capital growth and established utilities are expected to generate dividend yield 5.

Art and collectibles

Physical assets such as art and wine don’t have an underlying cash flow, but may increase in value over time.  They may be expensive to store and maintain.  Investments in art are considered to be high risk (due to low returns in a down market), costly, and illiquid 5.

Investments excluded from asset classes

Hedge funds and related funds are able to use leverage to gain investment exposure to currencies and asset classes.  Currency is not considered an asset class since it is a basic property of all financial assets.  However, the forward currency market enables the capture of excess currency returns 5.

The allocation of asset classes to an investment portfolio is an important determinant of investment returns that deserves further discussion.

Copyright © 2012 Douglas R. Knight

References

1.           “Free exchange.  The real wealth of nations”.  The Economist, June 30, 2012.

2.           Asset class.  Dictionary of Financial Terms. Copyright © 2008, Lightbulb Press, Inc.  http://financial-dictionary.thefreedictionary.com/Asset+Class

3.           Global Investable Capital 2004 ppt.  Frontier Asset Allocation Slides.  SunGard Online Investment Systems, Copyright 1997-2005 SunGard Expert Solutions.

4.           Asset Allocation Part 1: What It Is and Why You Need It, by JIM FINK on MAY 6, 2010 in STOCKS TO WATCH , Copyright © 2012 Investing Daily, A Division of Capitol Information Group, Inc. http://www.investingdaily.com/10929/asset-allocation-part-1-what-it-is-and-why-you-need-it .

5.           John Nestor, Sion Cole, David Buckle, et al.  Charity Compendium 2011. A long-term perspective on charity fund investment.  UBS Wealth Management.  © UBS 2011. All rights reserved. October 2011.

6.           Buttonwood: The great divide. Why American house prices have corrected more than those in Europe.  The Economist. Apr 28th 2012, Copyright © The Economist Newspaper Limited 2012.  www.economist.com/node/21553459/print


Financial Markets

August 5, 2012

Choices

Our opportunities for accumulating personal wealth include banking, investing, and gambling of disposable income.  Millions of people seek these opportunities and generally receive one of the following rewards:

  1. Savers receive about one cent per year for every dollar deposited in their bank account, and their account is insured against loss 1,2,3.  Unfortunately, the purchasing power of a dollar declines by about two cents per year due to inflation 4.
  2. Investors receive an average four cents per year for every dollar spent on an investment-grade bond 5 and nine cents per year for every dollar spent on a stock 6.  U.S. Government Bonds are considered to be risk-free investments.
  3. Gamblers’ returns are less certain.  One online casino reports a loss of one cent, or more, for every dollar wagered in any of dozens of different games 7.

You can quibble about the accuracy of these numbers but their relationship suggests that investing is the best opportunity for accumulating wealth. Investing takes place in financial markets where the trading of assets generates investment returns.  This article describes the investor’s choices for trading assets.

Markets

Markets are places where buyers and sellers make transactions.  Financial markets facilitate transactions involving securities, commodities, derivatives, money, and other financial assets.  Capital markets specialize in trading securities of debt (e.g., bonds) and equity (e.g., stocks).  Capital is the cash or goods used by businesses to generate income 8.

There’s considerable academic interest in factors that determine the flow of capital in and out of markets.  Aside from that, market size depends on the net flow of capital at any point time.  The year-end closing value of transactions in 2010 illustrates the huge SIZE of the global financial market at one point time 9.

The bank deposits signify non-invested capital and the other categories are investment opportunities.  The year-end closing value of all transactions in 2010 also illustrates the great DEPTH of the global financial market 9,10.

Financial markets compete on the basis of participants’ needs, regulatory barriers, and asset classes. Regulators control the spigot of capital flow between participants.  Access to fair and liquid markets is crucial to the investor’s success.  The advantages of global capital markets over domestic markets include the following 11:

  • For businesses,
    • a larger supply of funds from investors
    • a lower cost of capital due to the larger supply of funds
  • For investors,
    • a bigger selection of investment opportunities
    • global portfolio diversification lowers the total risk of the investment portfolio

Celebrities

The famous investor, Benjamin Graham 11, introduced two market participants who possess quite different temperaments.  The one named “intelligent investor” is discriminant and deliberately makes trades that run contrary to the advice of “Mr. Market”.  The other named “Mr. Market” is moody and finds comfort in duplicating the trading behavior of other participants.  Mr. Market is quick to sell securities when feeling pessimistic and quick to buy securities when filled with optimism.  Mr Market’s potential profits and losses are illustrated in the following chart of annual returns from the global stock market 10.

The value investor seeks to do better by buying Mr. Market’s securities at bargain prices and reselling them at premium prices.

Copyright © 2012 Douglas R. Knight

References

1.           Personal savings.  © 2012 American Express Company. All rights reserved  http://personalsavings.americanexpress.com/savings-product.html?extlink=ps-us-PersonalSavings-PS000SA.

2.           FDIC National Survey of Unbanked and Underbanked Households.  Executive Summary.  Federal Deposit Insurance Corporation.  December, 2009, http://www.fdic.gov/householdsurvey/executive_summary.pdf

3.           MoneyRates.com.  Copyright © 1999-2012 by MoneyRates.com. All Rights Reserved. http://www.money-rates.com/savings.htm

4.           CPI Inflation calculator.  United States Department of Labor.  Bureau of Labor Statistics.   http://www.bls.gov/data/inflation_calculator.htm/

5.           Kellie Geressy-Nilsen.  Investment-Grade Bond Yields Near Record Lows.  Credit Markets.  The Wall Street Journal.  August 3, 2011.  Copyright ©2012 Dow Jones & Company, Inc. All Rights Reserved http://online.wsj.com/article/SB10001424053111903454504576486153913336380.html.

6.           Matt Krantz.  Which investment asset class returns 20% on average a year? USA TODAY Updated 6/14/2011 1:54 PM.   © 2012 USA TODAY, a division of Gannett Co. Inc.  http://www.usatoday.com/money/perfi/columnist/krantz/2011-06-13-big-investment-returns_n.htm.

7.           Return To Player (RTP) information.  Dublinbet.com.  http://www.dublinbet.com/getting-started/guides/?guide=return-to-player-information.

8.           Investorwords.com.  ©2011 by WebFinance Inc.  www.investorwords.com

9.           Charles Roxburgh, Susan Lund, and John Piotrowski.  Mapping global capital markets 2011.  The McKinsey Global Institute.  Updated Research, August, 2011.  Copyright © McKinsey & Company 2011.

10.         John Nestor, Sion Cole, David Buckle, et al.  Charity Compendium 2011. A long-term perspective on charity fund investment.  UBS Wealth Management.  © UBS 2011. All rights reserved. October 2011.

11.         Benjamin Graham.  The Intelligent Investor, revised edition.  HarperCollins, New York, 1973


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