Aug 24th, 2006
With all the changes markets have seen in the past few years, one of the most remarkable has been the rise of exchange-traded funds, or ETFs. In the year 2006 alone, the number of ETFs quadrupled from fewer than a hundred to nearly four hundred... and the new ones keep on coming.
It would be reasonable to assume ETFs are a relatively new invention, given the way their popularity seemed to blossom overnight. But in reality, the blooming process took quite a while; exchange-traded funds were first introduced in the early 1990s. The big daddy of them all, the S&P 500 ETF (SPY:nyse), saw its debut in 1993.
What exactly is an ETF?
An exchange-traded fund, or ETF, is meant to combine the diversification benefits of an open-end mutual fund with the buying and selling ease of an individual stock. Unlike mutual funds, ETFs can be bought and sold during market hours, using the same order types that apply to stocks. The more popular ETFs also have options (puts and calls) available, something you won't ever see with mutual funds.
The original ETFs, like SPY, were designed to track stock indexes (and compete with index-based mutual fund vehicles). As ETFs continue to grow in popularity, however, Wall Street is figuring out how to slice and dice them in ever more creative ways. Now, in addition to the traditional index trackers, there are ETFs oriented to sector themes, industry themes, market caps, dividends, commodities, currencies, fixed income, and so on. There are even double leverage ETFs meant to amplify market movement in both directions, and inverse ETFs meant to go up when a market goes down. (More on those shortly.)
How do ETFs work?
The typical exchange-traded fund is linked to an underlying "basket" of shares. The contents of the basket depend on what the ETF's holdings are. (Nor is it always stocks in the basket; some ETFs are linked to government securities or even futures contracts.)
Because ETFs are "open-ended," there is no restriction on the total number of shares. The more shares that investors and traders wish to buy, the more shares are issued. Perhaps the trickiest aspect of exchange-traded funds is keeping the contents of the basket in line with the number of ETF shares bought or sold on a rapid-fire basis. Whenever investors buy more shares of, say, OIH, the oil service ETF, the market makers behind the scenes have to buy more shares of the companies that make up the basket: Transocean, Schlumberger, Baker Hughes, and so on.
The issuer of the ETF (known as the fund manager) makes money by charging a small expense fee, generally less than 1% of assets and potentially as low as 0.1% of assets. These low rates make ETFs highly competitive in comparison to traditional mutual funds. The ETF market makers, on the other hand, do not charge a fee. Instead, they make their money by capturing small price discrepancies between the market price of the ETF and the collective price of shares in the basket being bought or sold.
These market makers are known as Authorized Participants, or APs, and have a special arrangement with the fund manager to trade the ETF shares against the contents of the basket, in line with real-time market demand. The blocks traded by APs as they make a market in the ETF are known as "creation units." The typical unit is 50,000 ETF shares, but the size can vary from as few as 10,000 to as many as 600,000 shares.
In regard to the reasons it took so long for ETFs to get popular, the huge size and rapid-fire trading techniques employed by ETF market makers offer a clue. It was likely necessary to develop the back-office technology and computing power capable of handling such complex orders before things could really take off. (The rise of actively managed hedge funds, who took to ETFs like a duck to water, also played a significant role.)
Concentration
While ETFs are designed to give buyers quick diversification into a specific sector or portion of the market, many ETFs end up concentrated very heavily in just a few individual stocks.
The Biotech HOLDRs ETF (BBH:amex), for example, has 39.73% of its underlying "basket allocated" to one company, Genentech (DNA:nyse). Another 20.79% of the BBH basket goes to Amgen (AMGN:nasd), and another 14.94% to Gilead Sciences (GILD:nasd). This means that over three quarters of the returns of the fund are based on the performance of just three behemoths of the Biotech industry!
This shows how ETF concentration can be a two-edged sword. In line with the ability to purchase a specific slice of the market quickly and easily, it is important for investors in ETFs to fully understand what they are buying. ETFs can vary in quality by various measures, from diversification to liquidity to market representation.
Tax Benefits
A particularly strong benefit of ETFs for long-term investors is the special tax treatment. While holders of typical mutual funds are subject to paying tax when the mutual fund sells positions, holders of ETFs only have to pay taxes when they sell the ETF shares themselves. So an investor could decide to hold a diversified ETF for 10 years… say, SPY once again for this example… and compound his assets at the same rate as the S&P 500 (less the minimal management fee), only paying taxes at the end of the decade upon sale.
Conversely, investors in an indexed mutual fund may be subject to taxes along the way, if a manager sells positions at a gain within the fund. This is a much bigger problem for actively managed mutual funds, which typically generate more transactions and can have significant taxable gains.
Versatility benefits
ETF investing is evolving at an ever accelerating pace, as competing fund management companies offer more products covering different sectors and portions of the market.
From large, mid, and small cap indices, to value and growth styles, to individual sectors such as energy, financials, technology, health care, staples, telecom, utilities and so forth, the choices are staggering. Investors can even venture into fixed income vehicles such as Lehman's 20+ year treasury bond fund (TLT:amex), or commodity-based vehicles like the streettracks gold ETF (GLD:nyse), or foreign exchange vehicles like the CurrencyShares Euro Trust (FXE:nyse).
All of these can be traded in a regular brokerage account, creating ease of use for investors who would rather not go to the hassle of opening separate accounts for investing and trading in bonds, commodities or foreign exchange.
Offsetting risk
One of the most popular uses of ETFs is to offset risk in an existing portfolio. For example, an investor may have five healthcare names he or she feels confident in over the long haul, while at the same time, the economy and the market could be showing signs of slipping.
Since the vast majority of stocks tend to trade in step with overall market trends, this investor may choose to short an equal dollar amount of XLV, the popular healthcare index ETF, to offset some of the general market risk (known as systematic risk) in the portfolio, while still keeping the long-term individual stock positions intact.
Synthetic shorts
The availability of inverse ETFs allows investors to hedge their portfolios, or take outright bearish positions on the market, in accounts where this type of option was previously impossible. Individual Retirement Accounts, for example, do not allow short positions. But through the purchase of ProShares Leveraged Market ETFs, investors can buy shares of vehicles designed to go up when the market goes down.
Three of the most popular ProShares ETFs are the ultrashort S&P 500, Dow 30, and QQQQ ETFs (symbols SDS, DXD, and QID respectively). These vehicles are designed to inversely represent the daily movement of the index with double leverage—so if the S&P goes down 1%, the ultrashort S&P 500 ETF should go up 2%. (The correlation is not perfect, but fairly good.) These inverse double leverage ETFs trade millions of shares daily, due to their versatility and ease of use in quickly protecting against market downside.
Fast exposure
Other investors might use ETFs as a vehicle to quickly gain exposure to a sector or industry on a short-term basis. There might be a sense of urgency in gaining exposure to gold miners, for example, fulfilled by a position in the Market Vectors Gold Miners ETF (GDX:amex). Then, after further review, a handful of names might emerge to prove the best investments in this area, letting investors ease out of the GDX while putting the same capital to work in specific picks.
Backing out
An interesting strategy for more concentrated ETFs might be to single out one or two stocks held in the basket, and synthetically back those stocks out of the performance of the fund. For instance, hypothetically assume that an investor is bullish on the US consumer (hypothetically!), but does not believe that the consumer will spend much in big box mass market retailers.
Instead, our investor sees a growing trend to department stores, specialty drug stores, and specific consumer electronic type companies. This investor might take a position in the Retail HOLDRs (RTH:amex), but wish to back out the performance of Wal-Mart and Target (which make up 16.5% and 9.72% of the index specifically). Our investor could buy X dollars worth of RTH, and then short proportionally representative amounts of WMT and TGT to cancel out their presence in the basket. Our investor has now essentially created a customized retail ETF, which does not have exposure to the expected underperformers.
Pairing up
There are also opportunities to use ETFs paired against each other to profit from evolving trends. For example, a prudent investor might have taken a look at the market at the end of 2006, and realized that looming economic risk would favor rotation into higher quality large caps and away from riskier growth stocks. However, since timing can be a difficult issue, and market swings can increase risk, this risk averse investor might wish to reduce overall market risk, and just focus on the expected outcome swing for big caps vs small caps.
An impressive strategy would have been to take a $50,000 long position in DIA (the Dow Jones Industrials ETF) and a corresponding $50,000 short position in the IWM (Russell 2,000 ETF). The bet would have paid off both ways, with the investor making 7.23% on the Dow portion from Dec 31st to July 31st, and at the same time making 1.19% on the short Russell piece.
The best part of this strategy is that the investor wouldn't have to endure excruciating swings up and down as the overall markets entered a turbulent period at the end of July 2007. Both the short IWM and the long DIA positions dropped quickly during this timeframe, but since the long and short positions were in place, overall swings in the value of the spread (paired position) would have been small.
Going abroad
With the growth of emerging markets coming to the fore, international exposure is becoming an imperative. So it's fortunate that individual investors can buy ETFs which correspond to the more liquid names for various international stock markets too. These country oriented exchange-traded funds trade on US exchanges like any other ETF, and purchasing them is as easy as entering an order for any other US based stock.
While there are a wide range of international funds available, iShares has the best assortment of country specific ETFs (available at www.ishares.com).
Ever onward
One of the more exciting (and sometimes exasperating) things about ETFs is the rapid pace of new developments. With fresh concepts being approved on a monthly (if not weekly or daily) basis, the opportunities in exchange-traded funds are multiplying faster than anyone can keep up.
As with most explosions of innovation, many of the exotic and overspecialized ETFs being rolled out today will not be around in a few years time. But those exchange-traded funds that do survive and thrive will make it easier for all market participants to enjoy greater investing and trading opportunity at lower cost.
