2017

January 1, 2018

My SmallTrades Portfolio holds stocks and broad-market index ETFs (chart 1).

chart 1. SmallTrades Portfolio in 2017.

Chart 2 shows the diversification of ETFs as measured by percentages of year-end market values among ETF classes.

chart 2. Diversification of ETFs in 2017.

Chart 3 shows the diversification of stocks among 8 market sectors as measured by percentages of year-end market value for each stock sector and the ETFs.

Chart 3. Distribution of stocks and ETFs by market sectors.

Chart 4 shows the distribution of stocks according to market capitalization.

Chart 4. Combined market capitalizations.

Performance

My investment goal is to outperform the “Benchmark” Standard & Poors 500 Total Return Index, yet my portfolio has never outperformed the Benchmark (chart 5).

Chart 5. Portfolio performance.

Chart 5 shows growth trends for the benchmark (blue dashed line) and portfolio (solid blue line) since 2007 [the benchmark represents a passively managed, buy-and-hold investment; my portfolio is an actively managed investment].  On the Y axis, a unit value of $1.00 was assigned to both the total market value of the Portfolio and the Benchmark on December 31, 2007. Ratios of subsequent market- and benchmark values to the 2007 baseline are displayed line plots on the chart.

In 2014, my investment policy was modified to buy stocks of good companies and hold them for the long term. Chart 6 shows the result of my stock investments (red line) compared to the Benchmark Index (blue line) and ETF investments (red dashed line). The unit value of $1.00 was calculated on December 31, 2013. Since then, the stock group clearly outperformed the Benchmark and ETFs.

Chart 6. Stock and ETF performances.

Risk Management of ETFs

Broad-market index ETFs are primarily protected against stock losses by the passive management of investment portfolios which mimic the composition and performace of reputable market indices.

ETFs are secondarily protected by rebalancing significant allocation errors as described in the SmallTrades Portfolio’s strategies for risk management. In theory, a significant drift of asset classes occurs when one asset class surpasses a 24-28% allocation error. My preferred allocation of ETF market values is 30% stocks, 30% REITs, 20% bonds, and 20% gold bullion.

A perfect allocation of ETFs would result in 0% allocation error.  Furthermore, allocation errors would reflect disproportional gains or losses of market value.  Chart 7 shows the year-end allocation errors (blue bars) and error limits (red dashed lines) of my ETFs. There was growth of the Global Stocks ETF and decline of the remaining ETFs. Any allocation error that exceeds an error limit (red dashed line) should trigger trades that rebalance the ETFs to the preferred allocation.  My ETFs were not rebalanced in 2017.

Chart 7. ETF allocation errors in 2017.

Risk management of Stocks

My stocks are primarily protected against risks of steep loss by diversification of the market sectors, as illustrated in the preceding chart 3. The second line of defense is stop-loss orders.  In keeping with the investment goal of holding good stocks for the long run, I set ‘stops’ at a wide margin to prevent recent market fluctuations from triggering an unwanted sale.

Plan

The SmallTades Portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. In 2017, I failed to sell large cap stocks in order to buy good small cap and mid cap stocks. Consequently, 60% of the total market capitalization of my stock portfolio was in the Large Cap category.  In 2018, I would like to reduce the Large Cap category to 40% total market capitalization and boost the market capitalization of small- and mid cap stocks issued by good companies with potential growth of earnings.

Portfolio history

  1. On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in a Roth account.
  2. During 2007-2010 the actively managed mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’.  Four mistakes led to a big loss:
  3. mistake #1: after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of the company’s large debt and lost $45,000 during Lehman’s decline to bankruptcy.
  4. mistake #2: substantial long term profits from good companies were lost by selling holdings for short term profits. My strategy was to earn a quick 30% in the first year and re-invest in the next winners. It was too difficult to identify the next winners.
  5. mistake #3: day-trading was a game of chance that I played and managed to break even; meanwhile, good stocks grew in value.
  6. mistake #4: a trial of investing in leveraged ETFs resulted in losses due to negative compounding.
  7. I abandoned the goal of a 30% annual return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad-market index ETFs and 20% stocks for the long term. ‘Good’ companies attract and retain investors for many years. I will search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, partiicipating in an investment club, using stock screeners, and attending investor conferences. Then I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
  8. Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since my retirement income didn’t depend on making withdrawals from the SmallTrades Portfolio, I increased my ETF exposures to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.

ETF risk, Restricted Redemption

September 26, 2011

Restricted redemption.  Unlike ownership in mutual funds, retail investors cannot redeem ETF shares at net asset value.  Retail investors can only sell shares in the stock market at prices that might be quoted at a premium or discount relative to net asset value.


ETF Structure

September 24, 2011

[11/4/2014 update: the topic of systemic risk was added to the end of the post. 5/13/2016 update: the risk of Index selection was added to Figure 1 and described as one of the investment risks.]

Exchange-traded funds (ETFs) are popularly known as ‘cheap’ mutual funds.  Both types of fund own a pool of investments for the benefit of shareholders, but ETFs offer the advantages of listing their shares in the stock market and charging low trading fees1-4.

Figure 1 illustrates the functional structure of ETFs as interpreted from previously published diagrams1,2 and articles3,4,5.

Fig1v8, ETFstructure

The core message is that a specialist creates ETF shares in the primary market and sells them to any investor in the stock market.  The investor earns profits by collecting dividends from the ETF and reselling the shares for capital gains.

Here’s how it works:  The left hand side of figure 1 illustrates the primary market where a large ‘block’ of ETF Shares is created from a Basket of assets (shown by the green arrows) or redeemed for a basket of assets (shown by the red arrows).  The ‘block’ –also known as a creation/redemption unit— contains a fixed number of shares.  The ETF portfolio holds many baskets of assets, which are collectively called underlying assets.   The underlying assets are stocks, bonds, commodities, commodity pools, or currencies depending on the investment strategy of the fund.  The specialist –also known as an authorized participant— is a professional broker-dealer who is granted the privilege of trading ETF shares in the primary and secondary markets.  Only the specialist can create and redeem the ‘block’ of shares in the primary market.

The right hand side of figure 1 illustrates the secondary market for ETF shares.  The secondary market is the stock exchange where ETF shares are listed for trading activity () between the specialist and any number of investors.  The ETF shares are only traded for cash in the stock market.  Most ETF investments create taxable earnings that are distributed to the shareholders.

On both sides of figure 1, the primary and secondary markets are regulated by the U.S. Securities and Exchange Commission.  In the primary market, every share is valued at a constant fraction of the portfolio’s net asset value (NAV).  The portfolio’s net asset value is the difference in cash value between its total assets and total liabilities.  In the secondary market, every share is valued at a negotiated cash price ($).  Both values are typically kept in close proximity by the process of arbitrage (see below).

The Index is published by a financial services company as a separate enterprise and is continually updated to account for fluctuations in market prices of the portfolio’s underlying assets during trading hours.  The index provides a benchmark for measuring the portfolio’s net asset value.  Most ETFs are index ETFs whose investment goal is to match the fluctuating performance of a selected Index.

The red dots in figure 1 identify four principal sites of investment risk: 1) Index selection, 2) ETF portfolio mismanagement , 3) ETF portfolio low wealth, and 4) Investor tax burden.

Investment risks 

The legal structure of the ETF determines its management style,  investment strategy and tax consequences4.  These functions incur the following investment risks:  Index selection-  Market indices for U.S. stocks and U.S. bonds are generally less risky than those for commodities, currencies, and derivatives.  The established, broad-market indices for stocks (e.g. Dow Jones Industrial Index, S&P 500 Index, Russell 1000) are less risky than the stock market sector indices.  Management error- the ETF’s legal structure determines whether its portfolio is managed or unmanaged.  Assets in a managed portfolio can be borrowed, lent, or rebalanced and errors in these activities may diminish the value of ETF shares.  Low wealth- any ETF with an exceptionally low wealth may be at risk for an early termination and the shareholder is likely to lose profit at liquidation of the fund.  Tax burden-  shareholders are liable for payment of taxes on ETF earnings.  Some ETFs have more complicated tax codes than others based on their legal structure.

Primary benefits  

A major benefit of investing in an ETF is the frugal diversification achieved by owning shares of the fund.  The household investor may choose to purchase any number of shares at one low brokerage fee for each trade.  Diversification is achieved by investing in a broad-market ETF or specialty ETF depending on the needs of the investor.

Another big benefit to the household  investor is the ability to trade ETF shares at auction price in the stock market during trading hours.  By contrast, shares of mutual funds are purchased and redeemed at a net asset value that can only be determined after the closing of stock market trading hours.  Thus, the mutual fund’s market value is less transparent than that of the ETF.

Other investment funds

Mutual funds, closed-end funds, and exchange-traded notes operate differently from ETFs:

  • Mutual fund shares are not listed in the stock exchange6,7
  • Closed-end fund shares are not redeemable8
  • ETNs don’t participate in the creation/redemption process5

Arbitrage  

Arbitrage is the profit-seeking operation used by specialists to capitalize on transient differences between share NAV in the primary market and share price in the secondary market5.  Suppose that shares are selling at a considerable premium in the stock market, which means that the market price exceeds NAV by a potentially profitable amount.  The specialist uses high-speed trading to form a creation unit at lower NAV and immediately sells the unit at higher price in the stock market.  Market forces eventually realign the price and NAV.

Suppose instead that shares are selling at a considerable discount in the stock market, which means that the market price is below NAV by a potentially profitable amount.  The high-speed specialist redeems a unit of lower priced shares for a basket of higher valued assets.  Market forces eventually realign the share price and NAV.

Arbitrage is beneficial to the ordinary investor by 1) providing a trading opportunity in the stock market, and 2) aligning the share price to share NAV.

Systemic risk

At least 80% percent of ETF trading occurs in the secondary market where price corrections are made by an auction process.  Less than 20% of the trading occurs in the primary market where malfunctions might disrupt the pricing of ETFs and other securities in the financial system.  Potential disruptions of the financial system are called a systemic risk.  Three malfunctions of the ETF primary market pose a systemic risk9.

  1. Illiquidity. The liquidity of underlying assets might not match the liquidity of ETF shares.  For example, in the summer of 2013 an announcement by the Federal Reserve caused a massive sale of bonds that lowered the liquidity of bonds and the NAV of bond ETFs.  There was a transient drop in prices of the bond ETFs until the auction process corrected the secondary market.
  2. Specialist failure. The specialist might distort the price of an ETF by failing to create or redeem shares.  Or, the specialist might go out of business during the settlement period of trading and leave the ETF short of shares.  The industry protects against specialist failure by employing many specialists, insuring trades by dealing through a clearing house, and/or requiring the specialist to post collateral.
  3. Leverage. Index ETFs don’t use borrowed money to manage a portfolio.

The systemic risk of ETFs is judged to be low and reasonably regulated9.

Conclusion  

Although the functional structure of ETFs is more complicated than that of mutual funds, ETFs have the reputation of being more tax efficient than mutual funds.  ETF investment risks can be evaluated with the use of a scorecard.

Copyright © 2011 Douglas R Knight, updated in 2013 and 2014

VIDEO: What is an ETF

References

1.  BIS Working Papers No 343: Market structures and systemic sisks of Exchange-traded funds. Srichander Ramaswamy, Monetary and Economic Department of the Bank for International Settlements, April, 2011.  http://www.bis.org/publ/work343.pdf

1B. “Exchange-traded funds. From vanilla to rocky road. The Darwinian evolution of exchange-traded funds”.  The Economist, February 25, 2012.

2.  Exchange Traded Products- Education.  ETF & ETV Activity Flow.  ®2011 NYSE Euronext.  http://www.nyse.com/about/listed/1266318204137.html

3.  SEC Concept Release: Actively Managed Exchange-Traded Funds, SECURITIES AND EXCHANGE COMMISSION, 5/18/2004.  http://www.sec.gov/rules/concept/ic-25258.htm

4.  Exchange Traded Products- Education.  ETFs.  ®2011 NYSE Euronext.  http://www.nyse.com/about/listed/1266318204096.html

5.  Exchange Traded Products- Education. Creation/Redemption process. ®2011 NYSE Euronext.  http://www.nyse.com/about/listed/1266405887198.html

6.  Mutual Funds. U.S. Securities and Exchange Commission. Modified 12/14/2010.  http://www.sec.gov/answers/mutfund.htm

7.  ETF Education Center, ETFs vs. Mutual Funds. ©2011 ETFguide.com.  http://www.etfguide.com/mutualversusetf.htm

8.  Investment company registration and regulation package. U.S. Securities and Exchange Commission. Modified 4/2/2009.  http://www.sec.gov/divisions/investment/invcoreg121504.htm

9.  Exchange traded funds. Emerging trouble in the future?  The Economist, October 25, 2014.  http://www.economist.com/news/finance-and-economics/21627717-regulators-are-worried-trendy-new-product-will-sow-instability-emerging


ETF Valuation

September 24, 2011

Figure 2 (below) was obtained from the interactive chart provided by Bloomberg.com.  The chart shows price trends for 3 different valuations of SPY (SPY is the stock market’s ticker symbol for the SPDR S&P 500 ETF Trust).

  • SPYNV:IND (red) represents the S&P 500 Depository Receipts Index Net Asset Value, which measures the NAV per share of SPY
  • SPTR:IND (green) epresents the S&P United States 500 Total Return 1988, which measures the total return of 500 stocks in the S&P 500 Index in reference to 1988.
  • SPY:US (orange) represents the share price of SPY.

Fig. 2 SPY’s Index, NAV, and Price movements

In the legend above the chart, the numbers are the closing prices on 9/30/2011.  In the chart, the price movements are expressed as ‘percentage changes’ on the vertical axis in relation to ‘time’ on the horizontal axis.  The parallel behavior of the graphs provide evidence to support (1) the investment goal of the Fund, which is to match the NAV to the performance of the Index, and (2) the effectiveness of arbitrage in matching the share price to the NAV.

Fund documents report the following discrepencies between ETF valuations:

  • Discrepencies between NAV and Index performance are reported as “tracking error“.
  • Discrepencies between share price and NAV are reported as “premium(discount)“.

Copyright © 2011 Douglas R Knight


ETF risk, Assets

September 24, 2011

Downside risk of asset classes

Equities

  • Decline of market price from multiple causes
  • Principal and dividends are not guaranteed

REITs

  • Loss of rental income, interest income, or property value

Bonds

  • Loss of income from early repayment of debt
  • Delayed or missed payment of principal or interest
  • Decline in market price

Bonds nontaxable

  • Delayed, terminated, or diminished payments from multiple causes

Precious metals

  • Decline of market price
  • Theft from safe keeping

Commodities

  • Decline of market price
  • Commodity pool futures contracts may not correlate with commodity price (e.g., the price of a futures contract may unexpectedly fall toward the spot price of the commodity upon approaching the expiration date, tending to lower the net asset value of the portfolio).

Derivatives

  • Loss from derivatives may exceed loss from the underlying assets.
  • Collateral assets may be illiquid

Currencies

  • Currency exchange rates fluctuate
  • Currency futures contracts may diverge from the underlying currency
  • Risks related to holding bonds or derivatives

Cash equivalents

  • Loss of income from declining interest rate
  • Decline of short-term bond price from rising interest rate
  • Borrower default

ETF risk, Trading

September 24, 2011

Trading risk. The risks of trading ETFs in the stock market include high-frequency trading, large-volume trading, “circuit breaker rules”, and “shorting”.  Some ETFs may be an institution’s preferred vehicle for trading, in which case the fast trading of large volumes can increase market volatility.  A large sell-off of ETF shares possibly contributed to the May 6, 2010, “flash crash” of stock prices13,14,15.  The “circuit breaker rules” require stock exchanges to pause trading when there is a rapid, severe decline in market price.  The pause duration depends on the severity of decline and the time of the trading day16.  “Shorting” of either the underlying assets or ETF shares outstanding involves borrowing the assets, or shares, at market price, selling them at a different market price, and returning the borrowed assets, or shares, to the lender.  The lender charges a fee and the borrower (“short seller”) incurs a profit or loss.  A hidden risk of these activities is “failed trades” as evidenced by delayed or cancelled settlements.  ETFs may lend no more than a third of their underlying assets.  Mutual fund shares cannot be lent to short sellers17,18.

copyright © 2011, Douglas R. Knight

References

13.  SEC Looks Into Effect of ETFs on Market, Scott Patterson, Wall Street Journal, September 7, 2011.

14.  Choking the Recovery: And Unrecognized Risks Of Future Market Disruptions. Harold Bradley and Robert E. Litan. Published Nov. 8, 2010, revised Nov. 12, 2010.  © 2010 by the Ewing Marion Kauffman Foundation. All rights reserved.

15.  Exchange-Traded Funds: Too much of a good thing. The risks created by complicating a simple idea, June 23rd 2011, The Economist.

16.  Circuit Breakers and Other Market Volatility Procedures.   U.S. Securities and Exchange Commission, Modified: 08/09/2011.

17.  Ari L. Weinberg.  Exchange Traded Funds: When ETFs are LendersWall Street Journal, July 6, 2011.

18.  Canaries in the Coal Mine. Systemic Risk for Financial Firms and Investors. March 2011. © 2011 by the Ewing Marion Kauffman Foundation.


ETF risk, Management

September 24, 2011

The legal structures of unit investment trusts (UITs) and grantor trusts (GTs) don’t permit portfolio management, so there is only a small risk of management error.  By contrast, open-end investment companies (OEICs) and limited partnerships (LPs) have a managed portfolio with the associated risks of lending, borrowing, and rebalancing assets.

  1. Managers can earn extra fees by lending portfolio assets, but at risk of delaying the redemption of ETF shares during times of high demand and acquiring undesired collateral assets.  Delayed redemption can result in the portfolio’s loss of net asset value and the systemic risk of failed trades.  UITs and GTs aren’t permitted to lend assets1,2.
  2. The supplemental use of derivatives (e.g., swaps) is a form of borrowing that can acquire undesired collateral assets with low liquidity.
  3. The rebalancing of assets incurs operational costs that increase fund expenses and may inflate the tax burden of investors.  The annual “portfolio turnover” is a measure of rebalancing activity.  A 100% turnover means that the entire portfolio is replaced in one year, in which case any capital gains are classified as short-term and taxed at higher rate than long-term gains3.

copyright © 2012 Douglas R. Knight

References

1.   BIS Working Papers No 343: Market structures and systemic sisks of Exchange-traded funds. Srichander Ramaswamy, Monetary and Economic Department of the Bank for International Settlements, April, 2011.

2.  Exchange-Traded Funds: Too much of a good thing. The risks created by complicating a simple idea, June 23rd 2011, The Economist.

3.  Portfolio Turnover.  Richard Loth, Investopedia.com.


ETF risk, Tax burden

September 24, 2011

ETFs are taxed on earnings from the underlying assets of the investment portfolio. But it’s the shareholders, not the ETF, that pay all U.S. Federal and State taxes on the portfolio income.  The shareholder’s tax burden is the total cost of a tax accountant’s fees combined with tax payments.  The warning signs of increased tax preparer’s fees are Schedule K-1s and trust letters.  The cost of tax preparation may increase by an obligation to prepare tax reports for state governments where a grantor trust or partnership earns income.  I exclude regulated investment companies (RICs) from incurring extra costs of tax preparation (most index ETFs are registered by the U.S. Securities and Exchange Commission as RICs).   The tax rates are higher for precious metals than for long term capital gains.  Portfolio turnover rates above 100% tend to increase the tax burden by generating higher capital gains and ordinary income1,2,3,4,5,6.

U.S. Tax forms4,7,8  The federal tax structures of Grantor Trusts and Partnerships are complex and may require many reporting forms.

  • RICs. Most open-end investment companies and unit investment trusts qualify as RICs.  Brokers provide tax form 1099 to RICs shareholders.
  • Grantor trusts.  Shareholders must report distributions in a trust letter.
  • Limited partnerships.  Returns must be reported on Schedule K-1, which is more complex than tax form 1099.  Shareholders must report their share of the partnership’s income, gains, losses, and deductions on federal income tax returns even if cash distributions are not made.
  • Limited partnerships OR tax-deferred accounts (e.g., IRAs). Shareholders must pay tax at the corporate rate if they incur an “unrelated business taxable income (UBTI)” above $1,000, in which case they must file form 990-T 9.

Tax rates.  Tax rates for income and capital gains are published annually by the Internal Revenue Service.

  • RICs.  The “portfolio turnover rate” reveals a hidden expense of investment operations10,11Turnover rate is the annual replacement rate of portfolio assets.  A 100% turnover rate means that all assets were replaced during the year with two consequences: 1) trading fees decreased the portfolio’s net assets, and 2) the portfolio’s capital gains are taxed at a higher rate when holding periods are below one year.  RICs with higher turnover rates typically invest in high-yield bonds, taxable bonds, REITs, and short-term stocks as sources of frequent taxable distributions in contrast to RICs with lower turnover rates that hold stocks for the long-term and distribute fewer taxable capital gains to shareholders.  Unit investment trusts offer a shelter from the federal unrealized capital gains tax by operating at a low turnover rate.12
  • Grantor trusts.  Long-term capital gains from precious metals are taxed as short-term capital gains (currently 28%) because precious metals are considered ‘collectibles’.
  • Limited partnerships.  Capital gains from futures are subject to taxation by the 60/40 allocation rule (60% at long-term tax rate of 15% and 40% at the short-term tax rate of 28%).

Tax preparation time7

  • Routine.  The tax preparation of RIC-returns involves collection of form 1099, confirmation of the broker-supplied cost basis, computation of income & capital gains taxes, and filing the tax return.
  • Additional.   Additional time is needed for collection of trust letters or K-1 schedules, unusual tax calculations, and complex tax laws.  Brokers are not required to provide the cost basis of investments in open-end investment companies until 2012; nor are they required to provide the cost basis of UITs, grantor trusts, and partnerships until 2013.  Limited-partnership shareholders are liable to file income tax returns in other states when sufficient income is generated from those states.  Out-of-state taxes raise the total income tax and extend the routine tax-preparation time.

Tax efficiency10,11,12.  Passively managed funds are more tax efficient than actively managed funds due to the lower portfolio turnover of passive management.

A tax advantage of ETFsover mutual funds is the ‘erasure’ of unrealized capital gains during share redemption.

  • Mutual funds distribute unrealized capital gains to the retail investor, who is left paying a tax on imaginary gains.
  • ETFs distribute unrealized gains to the authorized participant, not the retail investor.

The ‘erasure’ of unrealized gains by authorized participants is augmented by preferential redemption of security lots with lowest cost basis.  The latter strategy works better for ETFs with lower turnover rates (e.g., passively managed versus actively managed ETFs).

copyright © 2011 Douglas R. Knight, updated June, 2012

References

1.  Partnerships. http://www.irs.gov/businesses/small/article/0,,id=98214,00.html

2.  Abusive Trust Tax Evasion Schemes – Facts (Section II). http://www.irs.gov/businesses/small/article/0,,id=106538,00.html .

3.  Sales and Trades of Investment Property. http://www.irs.gov/publications/p550/ch04.html

4.  U.S. Income Tax Return for Regulated Investment Companies. http://www.irs.gov/pub/irs-pdf/i1120ric.pdf

5.  Internal Revenue Bulletin No. 2003-32, August 11, 2003. Section 851. Definition of Regulated Investment Company.

6.  Little, Pat.  Is that an ETF? Research Note, Hammond Associates, September, 2010.

7.  Laura Saunders, Jason Zweig. Extreme Tax Frustration. Wall Street Journal, June 25-26, 2011.

8.  ETF Education Center, The history of exchange-traded funds.  ©2011 ETFguide.com.

9.  Publication 598 (03/2010), Tax on Unrelated Business Income of Exempt Organizations, revised: March 2010.

10.  Ferri, Richard A., CFA.  All About Index Funds, second edition.  McGraw Hill, 2007.

11.  The “tax efficiency of fund is tied to turnover ratio”, Motley Fool, The Columbus Dispatch, page D4, 3/20/2011.

12.  Investment Company Factbook, 50th Edition, A Review of Trends and Activity in the Investment Company Industry. Investment Company Institute, 2010.


Appraising ETFs with a Scorecard

September 24, 2011

The enormity of the Exchange-Traded Fund (ETF) industry – currently valued in excess of $1 trillion — reflects a growing popularity among investors.  Two big advantages of owning ETFs are the low-cost diversification of investments and the ease of trading ETF shares in the stock market.  The main concerns are investment risk and structural risk.  Since ETFs vary according to their advantages and disadvantages, the purpose of this article is to describe the appraisal of ETFs by use of the following example (click → ETF scorecard for program):

Scorecard preparation:

ETF selection.  Online screeners — such as Morningstar.com’s — are used to select one or more ETFs from a large database of available funds. The screening criteria vary among websites but typically include several attributes of performance, investment strategy, and market exposure. Online screeners also provide access to market quotes and fund documents.

ETF data.  Table 1 illustrates a scorecard for two ETFs that are labeled by their stock market trading symbols.  The data in Table 1 were obtained from fund documents (prospectus, annual report, fact sheet) that are available online in the fund’s website, financial services websites (e.g., www.morningstar.com), and/or the SEC website (http://www.sec.gov/edgar.shtml).

Scorecard interpretation:

Longevity is the time interval between commencement of ETF operations (“inception”) and the publication date of the ETF document.  Longer is better.  ETFs with at least 10 years of longevity offer the advantage of durable operations.

Net assets describe the wealth of the ETF.  More net assets are better.  In today’s market, funds with net assets exceeding $2 billion typically offer the advantages of name recognition and operational success.  “Net assets” is the monetary value of the portfolio when calculated as the difference between total assets and total liabilities.

Underlying assets are the portfolio’s primary class of investments used to determine the shareholder’s returns.  Commodities, currencies, and futures are generally more risky than stocks and bonds.

Portfolio composition identifies the portions of asset classes held by the ETF.  Portfoliosare governed by diversification rules published in the Investment Company Act of 1940 and the U.S. Tax Code9,10,11.  The diversification rules are designed to protect portfolios and shareholders from losses incurred by holding concentrated portfolios of securities.  Diversified portfolios are generally less risky than non-diversified portfolios.

Market region is the country or geographic region of markets for the fund’s investments (domestic, foreign, or global).  ‘Market’ refers to a homogeneous group of financial assets (e.g., stocks).  The risk and liquidity of investments can vary according to market (e.g., stocks) and region (e.g. Mongolia).

Market sector is a subgroup of the market with a common characteristic such as a type of business, industry, product, etc. (e.g., automobile manufacturing).  Some sectors are riskier than others by virtue of their market (e.g., futures) or sector (e.g., commodities).

Index is a measurement of the market value of the fund’s underlying assets.  The index is prepared and published by an independent financial firm.  Most ETFs use an index to execute and evaluate their investment strategy while the remaining few restrict their use of the index to evaluation of performance.  Beware of unfamiliar indices based on inconsistent or unclear methodology25.

Legal structure determines the scope of ETF operations4,8,12.  In the U.S. stock market, funds labeled as ETFs must hold at least 80% of the underlying assets in securities relevant to the fund’s name.  ETFs are structured either as an open-end investment company (OEIC) or unit investment trust (UIT) for the common goal of investing in a diverse collection of securities.  Fewer funds – often called exchange-traded vehicles (ETVs) — are structured as a limited partnership (LP)or grantor trust (GT) for exposing the investor to a concentrated portfolio of commodities, currencies, or securities.  The risk of a concentrated portfolio is that fund performance is exaggerated by the returns or losses of the largest holdings.

  • Unmanaged portfolio– The UIT and GT operate a fixed portfolio of securities — derivatives excluded — that replicate the composition of a market index.  The underlying assets are never rebalanced, never reinvested – (only distributed to shareholders after correction for expenses) –, and never loaned.  UITs have a renewable expiration date.
  • Managed portfolio– The OEIC and LP operate a professionally managed portfolio in which managers may rebalance assets according to investment strategy, invest in derivatives, reinvest portfolio earnings, distribute earnings to shareholders after correction for expenses, and lend portfolio assets.  The OEIC and LP may incur the risk of leverage by investing in derivatives and the risk of ‘failed trades’ by lending securities1.

Investment goal is the desired performance of the portfolio in relationship to the investment performance of the index.  Most ETFs seek to match the price and yield performances of the index before deducting the fund’s operating expenses.  Some ETFs seek to outperform (e.g., leveraged ETF) or underperform (e.g., inverse ETF) an index.  The investment goal determines the shareholder’s returns.  TIP: Use an interactive chart to informally compare the past performances of the portfolio, ETF shares, and index.

Investment strategy is the fund’s stated plan for achieving its investment goal.  The main strategies are passive, active, and leveragePassive management is the process of maintaining a portfolio that mirrors the index.  The prime methods of passive management are replication and sampling.

  • Replication- “(The) replicate index-based ETF holds every security in the target index and invests its assets proportionately in all the securities in the target index.” 27
  • Sampling- “(The) sample index-based ETF does not hold every security in the target index; instead the sponsor chooses a representative sample of securities in the target index in which to invest. Representative sampling is a practical solution for an ETF that has a target index with thousands of securities.” 27

Active management is an investment strategy designed to outperform the index.  Leverage is typically the riskiest strategy.  Leverage is the use of debt in the form of derivatives to achieve a desired rate of investment performance.

Risk & uncertainty are external factors that may cause a loss on investment.  Risk is predictable and uncertainty is not.  A comprehensive list of risk factors is discussed thoroughly in the ETF’s prospectus and annual report.  Only the most relevant factors need to be mentioned in the scorecard.

Structural risk is the possibility that one or more factors related to ETF structure could interfere with trading or generate losses.  I classify these factors as restricted redemption, trading risks, asset risks, and managerial risk.

Tax burden.  Taxation is a unique risk that threatens to diminish investment returns.  U.S. citizens must pay income tax on the investment earnings of an ETF’s portfolio and on their personal capital gains from trading ETF shares in the stock market.  The total tax burden consists of the income tax plus the tax accountant’s fee.  If the accountant charges an hourly fee, the tax burden will increase in proportion to total time spent on tax preparation.  Grantor trusts and Limited Partnerships may inflate the routine tax preparation fee according to extra time needed to prepare trust letters, K-1 forms, 990-T forms, unusual tax calculations, and out-of-state tax returns. The fund prospectus gives important tax information that is time-sensitive and should be confirmed by a professional tax advisor such as your accountant.

Two ways of reducing the tax burden are to invest in tax-free ETFs and hold ETFs in tax-deferred accounts (TDAs).  The underlying assets of tax-free ETFs are tax-free agency bonds.  The taxation of a RIC, grantor trust, and limited partnership can be deferred when held in a tax-deferred brokerage account.  However, TDAs don’t protect from the taxation of “unrelated business taxable income” earned by a limited partnership12,22.

Scorecard summary

The following statements illustrate a summary of the scorecard (Table 1) for purposes of comparison and decision:

  • SPY is a durable, wealthy fund that strives to match the performance of the broad U.S. stock market at the main risk of incurring losses from market volatility.
  • USO is a small commodity pool that tracks sweet-crude oil prices at high risk of increased tax burden coupled with the risk of investing in futures.

Conclusions

The internet provides ETF screeners that allow investors to select an ETF based on desired market exposure and investment performance.  Selected ETFs deserve further appraisal by use of a scorecard to examine the fund’s investment strategy, structural risk, and potential tax burden.   The screening criteria and scorecard summary can reveal expected outcomes and the need for risk management.

copyright © 2011 Douglas R. Knight, updated 2012

References

1.   BIS Working Papers No 343: Market structures and systemic sisks of Exchange-traded funds. Srichander Ramaswamy, Monetary and  EconomicDepartment of the Bank for International Settlements, April, 2011.  http://www.bis.org/publ/work343.pdf

2.   Exchange Traded Products- Education.  ETF & ETV Activity Flow.  ®2011 NYSE Euronext.  http://www.nyse.com/about/listed/1266318204137.html

3.   SEC Concept Release: Actively Managed Exchange-Traded Funds, SECURITIES AND EXCHANGE COMMISSION, 5/18/2004. http://www.sec.gov/rules/concept/ic-25258.htm

4.   Exchange Traded Products- Education.  ETFs.  ®2011 NYSE Euronext.  http://www.nyse.com/about/listed/1266318204096.html

5.   Exchange Traded Products- Education. Creation/Redemption process. ®2011 NYSE Euronext.  http://www.nyse.com/about/listed/1266405887198.html

6.   Mutual Funds. U.S. Securities and Exchange Commission. Modified 12/14/2010.  http://www.sec.gov/answers/mutfund.htm

6a.  Maxey, Daisey. “ETFs and Products hit $1 Trillion in U.S.”, page B17, Wall Street Journal, B17, 12/18/2010.

7.   ETF Education Center, ETFs vs. Mutual Funds. ©2011 ETFguide.com.  http://www.etfguide.com/mutualversusetf.htm

8.   Investment company registration and regulation package. U.S. Securities and Exchange Commission. Modified 4/2/2009.   http://www.sec.gov/divisions/investment/invcoreg121504.htm

9.   The Investment Company Act of 1940. Section 3. Definition of Investment Company.  Security Lawyer’s Deskbook,  The University of Cincinnati College of Law, © Copyright 1998-2011, University of Cincinnati,  ronald.jones@uc.edu.   http://taft.law.uc.edu/CCL/InvCoAct/sec3.html

10.  Internal Revenue Bulletin No. 2003-32, August 11, 2003. Section 851.-Definition of Regulated Investment Company.

11.  The Investment Company Act of 1940. Section 5. Subclassication of Management Companies. Security Lawyer’s Deskbook, The University of Cincinnati College of Law, © Copyright 1998-2011, University of Cincinnati,  ronald.jones@uc.edu.   http://taft.law.uc.edu/CCL/InvCoAct/sec5.html

12.  Little, Pat.  Is that an ETF? Research Note, Hammond Associates, September, 2010.

13.  SEC Looks Into Effect of ETFs on Market, Scott Patterson, Wall Street Journal, September 7, 2011.  http://online.wsj.com/article/SB10001424053111903648204576554770203689108.html?mod=ITP_moneyandinvesting_0

14.  Choking the Recovery: And Unrecognized Risks Of Future Market Disruptions. Harold Bradley and Robert E. Litan. Published Nov. 8, 2010, revised Nov. 12, 2010.  © 2010 by the Ewing Marion Kauffman Foundation. All rights reserved.

15.  Exchange-Traded Funds: Too much of a good thing. The  risks created by complicating a simple idea, June 23rd 2011, The Economist.  http://www.economist.com/node/18864254

16.  Circuit Breakers and Other Market Volatility Procedures.   U.S. Securities and Exchange Commission, Modified: 08/09/2011.  http://www.sec.gov/answers/circuit.htm

17.  Ari L. Weinberg.  Exchange Traded Funds: When ETFs are Lenders. Wall Street Journal, July 6, 2011.  http://online.wsj.com/article/SB10001424052702303823104576391573704929238.html?KEYWORDS=when+etfs+are+lenders

18.  Canaries in the Coal Mine. Systemic Risk for Financial Firms and Investors. March 2011. © 2011 by the Ewing Marion Kauffman Foundation.

19.  Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs).  Financial Stability Board, 12 April 2011.  http://www.financialstabilityboard.org/publications/r_110412b.pdf

20.  Exchange-traded funds: A good idea in danger of going bad. The reckless expansion of “synthetic” funds requires a few new rules, June 23rd 2011, The Economist.  http://www.economist.com/node/18867037?story_id=18867037

21.  Portfolio Turnover.  Richard Loth, Investopedia.com.  http://www.investopedia.com/university/quality-mutual-fund/chp7-fund-activity/portfolio-turnover.asp#axzz1XIp6eGp8

22.  Laura Saunders, Jason Zweig. Extreme Tax Frustration. Wall Street Journal, June 25-26, 2011.  http://online.wsj.com/article/SB10001424052702304231204576403674025064848.html?KEYWORDS=extreme+tax+frustration

23.  ETF Education Center, The history of exchange-traded funds.  ©2011 ETFguide.com.  http://www.etfguide.com/exchangetradedfunds.htm

24.  Publication 598 (03/2010), Tax on Unrelated Business Income of Exempt Organizations, revised: March 2010.  http://www.irs.gov/publications/p598/index.html

25.  Ferri, Richard A., CFA.  All About Index Funds, second edition.  McGraw Hill, 2007

26.  The “tax efficiency of fund is tied to turnover ratio”, Motley Fool, The
Columbus Dispatch, page D4, 3/20/2011.

27.  Investment Company Factbook, 50th Edition, A Review of Trends and Activity in the Investment Company Industry. Investment Company Institute, 2010.  www.icifactbook.org.


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