For those (few) of you who follow my blog, it’s been quite a while since I’ve caught up on articles published elsewhere. So, this first post will just include links to some recent stories from Pensions & Investments and The Wall Street Journal.
Hot market, ETF popularity hurting securities lending (sub) - This article took a look at the somewhat controversial area of securities lending, including pension funds that moved into ETFs for the additional income from lending. As ETFs increased in both assets and liquidity, demand to borrow dropped and had some funds reconsidering. ETFs also lend their underlying securities, a topic I covered in 2011.
Institutions’ resistance to active ETFs may ease (sub) - During the 20th anniversary celebration for SPY, many people began to ask the next question…when will active ETFs take hold? To truly catch on, it will take institutional-level faith in the product and, perhaps, a less transparent vehicle. Money-market mutual fund reform, however, could turn institutions and corporations to ultra-short active ETFs (which I during the 2012 hearings).
Firms Try Varied Designs to Add ETFs - As asset managers look for more cost-efficient ways to offer their strategies across platforms, they have honed in on a few alternatives to launching entirely separate investment companies.
Qwafafew: Quants and Quaffs - On the lighter side, I worked with Rachel Louise Ensign on this amusing story about a group of quantitative analysts and their regular gatherings in New York and around the U.S.
My recent stories in the Wall Street Journal - “What ETF Managers Do” and “ETF Managers Don’t Buy and Sell Securities. Usually.” - helped me put the role of the ETF manager (or index manager) in perspective. They are very driven by process and mandate as security selection, for the most part, has been removed from the position.
Instead, they must consider the margin of every move that they do have to make and how that will positively or negatively affect tracking difference.
In a recent piece for Pensions & Investments, I highlighted a $1.4 billion underlying-for-ETF trade made in 4 iShares ETFs. The trade was discussed by BlackRock CEO Larry Fink at a September conference and again by the head of iShares in October. This not so subtle signal was a call-out to large institutions that bond ETFs are the new dealers.
With dealer inventory down significantly since 2008, corporate debt investors will increasingly find that their path to liquidity is through an ETF (and, of course, its management fee.) In the article, I also point to a recent study by The TABB Group which concludes that price discovery and liquidity of corporate bonds through ETFs could hasten the shift to more transparent and electronic bond exchanges.
While I’m still keeping up ETFolution at Forbes, I’ve been tied up by a few big stories and other projects.
The first was a profile in Forbes magazine on Reggie Browne, the head of ETF trading at Knight Capital. Reggie has spent most of his career trading derivatives and now ETFs. At Knight, along with his business partners, he has built a business that surrounds ETFs and is looking to grow along with the success of the structure. While securities trading shrinks, Reggie’s expectation is that the market for ETFs will continue to grow. Despite recent fund closures, inflows into ETFs are on a record pace in 2012.
Next, I helped put together a feature and data package on ETFs for the Wall Street Journal. Trying to identify five trends that would rule the ETF market for the next five years was a tough assignment, but I think we’ve hit on some consensus. Read the story for details, but one aspect that I didn’t add was a mix of new entrants and consolidation of smaller firms. Financial services, over time, tend to consolidate as technology increases competition and reduces margin.
The ETF market is experiencing these phenomena in earnest right now.
In the media, we love to mark beginnings and endings. We are quick to make predictions and fast with “I told you so.” In between, not so much.
Ever since exchange-traded funds were introduced in 1993, media and finance types have been predicting the rise/fall of ETFs relative to mutual funds and even stocks. Telling the story of ETFs, and the struggles between/among providers, has been chalked up to “inside baseball,” as I’ve been told.
My latest article and infographic in the Wall Street Journal and a few recent stories in Barron’s and The Financial Times serve up a product market in transition. While there may be close to one thousand ETFs in the U.S. market that are not economically viable, such small products make up a tiny segment of all assets in ETFs. (28% of SPY by assets.)
But there’s no reason that any one of these thousand little guys can’t make it in its own right or stay afloat longer than the media would like for a good story.
The financial product market is in constant transition. Yesterday’s top hedge fund is today’s implosion and tomorrow’s genius. That the ETF market is one of whales and minnows is only a footnote to the macro trend.
Over a year ago, the asset management world got a wake-up call from Pacific Investment Management. Pimco, as the company is known, announced it would roll out the Pimco Total Return ETF to complement its flagship fund.
Those of us who follow investment product trends all perked up. See “The Other Side of Active ETFs” for my take at the time.
I recently followed up at The Wall Street Journal with Pimco COO Douglas Hodge, as the company takes a victory lap on the Total Return ETF and re-ups with other notable funds.
Over the past few months, I’ve spent a lot of time gauging the macro effects of Pimco’s move and will write more on ETFolution at Forbes.com. In the meantime, I’m going to start gathering some links here on my coverage (and others) on Pimco and active exchange-traded funds:
- Active ETFs Flaunt Their Differences (video at WSJ)
- ETFs After Pimco Total Return
- Pimco Total Return Sheds a Light on Transaction Cost
- Pimco Total Return: Mutual Fund or ETF?
- BOND and the Future of Active ETFs
- Real Potential of Active ETF Imagination
- The Day the Mutual Fund Died (from TheReformedBroker)
My latest story in the The Wall Street Journal’s “Investing in Funds” was about the intricacies of index fund tracking error. The stat, which can be hard to find and even harder to define, is a signal for how well an index fund tracks its benchmark. Some funds and indexes may have an inherent tracking error, due to the nature of the underlying index and the liquidity of the securities.
Using tracking error to compare funds is most useful in the rare situation of two funds tracking the same index and bearing the same cost. Outside of that, tracking error is useful only when viewed as a trend, if that.
The second level discussion around tracking error, however, can be helpful in understanding how index funds are managed. I touched upon some of this in “ETFs are People Too” and will reiterate here. To understand tracking error and index fund management (and why your fund may be better/worse than the next one), study these aspects of your funds management and processes:
Expense Ratio: Expense ratio is usually, but not always, the management fee charged by the fund’s adviser to run the fund. At times, the total expense ratio includes the management fee as well as fees charged by other funds or ETFs held by the ETF. (This pass through notion of “acquired fund fees” gets a little silly. After all, no mutual funds report through the net operational costs of the individual companies they hold.) Total expense ratios can also be driven down to a net expense ratio when the adviser waives or rebates back to the fund any cost above a cap.
Sampling: Also called optimization, sampling is an upfront admission by indexers that not all indexes are actually entirely investible. Bond indexes, in particular, can be hard to replicate based on the unavailability of certain bonds as well as the notion that some bonds are very hard and expensive to trade, regardless of their inclusion in a benchmark index. For stock funds, the ability to sample or optimize is largely dependent on the size of the fund and whether the manager, or market makers, can create baskets of the underlying securities effectively.
Rebalancing and Reconstitution: When an index is rebalanced, i.e. reweighted among its constituents, or reconstituted, i.e. screened for potential entrants or drop-outs, the index announces the changes in advance and then makes the changes several days (or weeks) later. Index fund and ETF managers, however, have to face the operational challenges of actually making those trades as close to real-time as the index shift. While ETF managers hope to make these changes mostly through market makers, at times they will actually have to buy and sell securities on their own.
Securities Lending: When interest rates were higher and demand (and appetite) to short stocks was greater, ETFs (and mutual funds) would enhance returns by lending out stocks and bonds. Due to the manner in which ETF shares are created or redeemed, whereby a market maker delivers a basket of securities or receives a basket of securities, securities lending by ETFs is generally more conservative than mutual funds. When securities are loaned out, they are over-collateralized, meaning that ETF issuer receives slightly more than the value of the security being lent. Net revenue from the loan, after lending agent fees, is income for the fund and can actually offset part of the expense ratio.
Dividends, Interest and Cash: Whether cash comes in through creation baskets or is paid by underlying holdings through dividends and interest, ETFs must reinvest cash in their holdings as well as set some aside to pay the fund’s expenses. For funds organized as Unit Investment Trusts, primarily SPY, QQQ or DIA, dividends are not reinvested in the fund and, therefore, create what is known as “cash drag” during upmarkets and a “cash buffer” during down markets. Regardless of structure, cash accrues daily to pay the manager and contributes to tracking error.
For more on my view of the market for ETFs and other asset management products, read ETFolution at Forbes.com.
The early results are in. Needs more time.
For those of us watching the proposals to enhance market making in exchange-traded products, time to consider the Nasdaq Stock Market and NYSE Arca plans has been extended.
While the Nasdaq proposal received 17 comment letters of varying degrees of support and refusal, the program proposed by NYSE Arca has thus far garnered just 2 comments. Sure, many of those who already commented on Nasdaq—filed earlier—may have said their piece, but the two commenters who came back for more on the NYSE Arca program are significant.
In one corner is the Investment Company Institute, which generally represents the interests of mutual funds. In the other corner is The Vanguard Group, the largest ICI member by mutual fund assets.
As I’ve mentioned before, NYSE Arca is home to the vast majority of exchange-traded product primary listings, but not necessarily the vast majority of ETP trading. In fact, it’s third after a reporting facility run by FINRA and then Nasdaq, according to XTF.com.
Industry comments surrounding the Nasdaq proposal were encouraging. Even Vanguard effectively abstained from a view.
As for the NYSE Arca proposal, ICI had some questions but still “strongly supports” a pilot to test the NYSE’s proposal.
Vanguard, not so much.
“We do not support the Proposal as currently structured,” reads the letter from Vanguard Chief Investment Officer Gus Sauter. This is quite a rebuke from a company advising 48 exchange-traded funds listed on NYSE Arca
While it’s possible that more comment letters may come in on the Arca proposal, this disagreement alone should mean back to the drawing board.
Over the course of the next few weeks, I’ll be digging into this deeper on ETFolution at Forbes.com.
Talk about burying the lede.
In a press release entitled “Morningstar Announces Fund Analyst Research Team Appointments,” the company announced investment fund nirvana.
And no one blinked.
No longer bound by the arbitrary restrictions of product structure, Morningstar is aligning its fund research team into active, passive, alternative and fund of funds.
Most investors don’t hold exchange-traded funds or active mutual funds exclusively. Instead, they invest across a spectrum of vehicles. Our new alignment of coverage into active, passive, alternative and funds of funds research reflects the evolution of how investors are evaluating and employing investments in their portfolios. — Morningstar President of Fund Research Don Phillips
Phillips has appointed Scott Burns to the position of Director of Fund Analysis, overseeing the coverage. Burns came up through Morningstar’s equity research team, then moved on to exchange-traded funds and recently helped build out closed end funds and alternatives.
Watching the rise of ETF-managed portfolios, I’ve often asked whether too many investors and advisers have put on blinders to certain products because: “I don’t DO ETFs” or “I stay away from closed-ends.” I would prefer to hear that people find the right product at the right cost, regardless of structure.
Of course, each product set has its nuances. Traditional mutual funds are opaque. Exchange-traded funds can fluctuate around net asset value. Closed-end funds can use leverage and trade at discounts.
Unifying fund analysis at Morningstar is a step toward showing the world that investment products are investments first and products second.
For more, ETFolution at Forbes.com.
After reading Henry Blodget’s piece on how he was figuratively at the center of the Facebook IPO scandal, I looked back upon a story I wrote following the Wall Street research settlement. My conclusion:
Where will the evidence come from when water cooler chatter actually returns to the water cooler?
Of course, my editor and I picked a sensational headline - Will E-Mail Kill Wall Street? - to drive home the rhetoric. But the Facebook whisper number controversy proves that we haven’t learned much in 10 years.
And even a Google-style modified Dutch auction wouldn’t have solved this problem.
Working in and around interactive publishing for more than a decade, I’ve watched every content provider face decisions around abandoning/considering/maintaining/resuming charging for content. Most recently, The New York Times put up its porous paywall, even as other publishers search for premium content and services to upsell.
Technology-driven change has forced models to change across industries for decades. But when you take a closer look, you’ll find that technology has just altered how traditional systems of sales, distribution and monetization have adapted.
In my recent post at Forbes, I drill down in the latest machinations in the mutual fund/ETF market. One of the crowning glories of ETFs was that they did not have to pay for distribution or sales. Exchange-trading took care of distribution and market makers were compensated on spreads.
Recent proposals, however, are offering to increase the incentives to market makers to trade smaller ETFs. Currently, exchanges pay “lead” market makers a greater rebate for posting liquidity to certain markets. Now, the exchanges want to bring in fund issuers to make greater/optional payments to lead market makers, hoping that an initial push will help get small, young ETFs off the floor.
In the ETF market, only time will tell whether a product is good or not, and a little extra boost could definitely help. But it’s also worth looking at what has been most successful, simple, easy to use products that practically sell themselves.
And that’s the point. The ETF market has functioned (more or less) effectively for almost 20 years in the U.S.
Products that worked and adpated stuck around. Those that didn’t bid goodnight.
So, I’m not surprised that the mutual fund/ETF market would be willing to try its old distribution tricks on a new platform. It’s the nature of the beast.
While hardly biblical, Vanguard Chief Investment Officer Gus Sauter passed this wisdom on to a conference hall full of financial advisers at InsideETFs in January.
As I was also in attendance, my latest stories in the “Investing in Funds” issue of The Wall Street Journal encapsulate Sauter’s notion.
For the first story, I asked several financial advisers and strategists to create a multi-asset portfolio that they would offer income-seeking investors. Three advisers offered up portfolios using mostly bond ETFs and one firm rang in with a more multi-asset approach, picking off payment streams from closed-end funds, preferred stocks and even master limited partnerships. As to why the other advisers didn’t use those assets, they claimed that valuations had already passed such items through their screens. The article also offers some insight into how money managers take different approaches to the same problem - providing income for investors, while also taking pains to protect the downside.
There is no one right answer.
In the second story, I wanted readers to understand some of the nuances of large ETF trades that don’t come out everyday. While ETFs trade like stocks, they are not. Because they are actually traded units of an investment company, shares can be created or redeemed by market makers known as authorized participants.
These authorized participants, as well as institutional brokers, help facilitate large orders by working with investors and fund distributors to manage flow between secondary markets (the exchanges) and off-market creation/redemption of new shares. I talked to one adviser who was shifting clients into a new ETF in the portfolio and worked with both the broker and the issuer to get the trade done effectively.
For large, liquid ETFs, such concerns are rare, unless you are a whale. For small, thinly-traded or new products, diligent trading is key. For more, Emerging Global Advisors offers a PDF worth a glance on sourcing liquidity.
Also, be sure to check out my blog at Forbes.
“Growth for ETFs will be circumscribed by cutting and splicing the market as finely as possible,” says Morningstar’s Traulsen. “Firms will have to put out new funds and compete on price.”
The quote above is from an article I wrote in 2003 entitled “ETFs Turning Ten.” Nearly a decade (and billions in assets) later, most of the observations in that story still ring true.
I’ve recently started writing again at Forbes.com and am spending even more time analyzing the ETF market, both as an investor and as an interested observer. I’ve even renamed this blog and my blog at Forbes.
ETFolution is a forum to discuss how exchange-traded products are tranforming asset management and financial advisory. While I see the benefits, savings and transparency in the structures, I am not entirely convinced, as my friend Josh Brown ponders, that ETFs will crush traditional mutual funds in ten years. In fact, many critics of ETFs may yet have their day. And, as Tom Lauricella points out at MarketBeat, some already are.
While I don’t expect (or plan) to write everyday, I will be sure to note and analyze critical issues in the ETF market and how they affect the interested parties, including investors.
If there are any issues you believe to be undercovered, let me know.
The March 1 listing of the PIMCO Total Return Exchange Traded Fund will be a pivotal event for the mutual fund industry.
As the exchange-traded version of the $244 billion Total Return Fund starts trading, the industry will get see one of its flagship actively-managed funds price throughout the day. Yet the new ETF’s ability to build assets over time will be the true test of the structure and the future of active funds.
As I noted on The Wall Street Journal’s MarketBeat last year, the acceptance of the exchange-traded model by the largest mutual fund is a signal that the regulated asset management business has fundamentally changed.
At its core, an exchange-traded product should remove any trading and accounting externalities and isolate manager cost and margin. TRXT, the ticker for Total Return Exchange-Traded, comes out at 0.55 basis points, higher than the 0.46 basis point fee charged by the institutional class, but well lower than many of the other share classes of Total Return, including load and annuity classes.
While TRXT will be similar to the core fund, it won’t feature derivatives nor can it be nearly as diversified.
Still, the rest of the actively-managed fund world will be watching to see how fast TRXT gains traction. PIMCO’s Enhanced Short Maturity Strategy Fund (MINT) at $1.8 billion AUM is the category leader in active ETFs (as well as longer-duration money fund alternatives.) Actively-managed equity ETFs haven’t had nearly the success, despite the best efforts of AdvisorShares to advance the model.
But the move by PIMCO to open up the Total Return strategy to ETF investors could mark both the end of the beginning for ETFs and the beginning of the end for traditional funds.
My latest (last?) story at WSJ is a primer on the tax issues affecting ETFs. For the most part, they are straight forward. Equity ETFs are as efficient (or slightly more so) than equity-indexed mutual funds.
Bond ETFs, especially with cash create/redeem during a year of rising bond prices, had some capital gains to distribute.
IndexUniverse put out two compendia on ETFs and taxes late last year. Truly yeoman’s work and incredibly helpful. Check out the complete guide to ETF Taxation as well as their summary of 2011 distributions.
Also, with the help of some folks at WisdomTree and Teucrium, I learned a little more about the nuances of futures-based commodity ETP taxation.
One of the WisdomTree funds I looked at —WisdomTree Brazil Real Fund— paid out a large distribution. According to the company, the fund has an August fiscal year end, at which point it had distributions to pay out (and paid those out in December.) Those distributions amounted to 29% of the NAV by December.
Another hitch for futures funds, realized gains (or losses) are marked to market for the individual investor at the close of the tax year at 60% long-term, 40% short-term and then used to increase/decrease the basis.
There’s no actual distribution from the fund, just a distribution of the tax liability.
In early December, Fidelity Investments went “state of the art” in updating its exchange-traded fund application, according to one of my sources.
While I detailted in my story at The Wall Street Journal that filing is very preliminary (as was pointed out in Index Universe in early December and Barron’s more recently), there is no reason to think that Fidelity can’t take market share in ETFs almost immediately. Schwab’s growth to $5 billion in ETF AUM in less than 2 years is the proof Fidelity needed.
Granted that the simplicity of ETFs is that they are exchange-traded, meaning that anyone with exchange access can trade the products, Fidelity has access to a giant community of individual investors and advisors that many start-up ETF providers do not. While other brokers - including Schwab, Scottrade and TD Ameritrade and now E-Trade - have teased their own ETFs with low-cost or zero commission trades, Fidelity knows from its current relationship pitching 30 iShares ETFs at $0 how well that works.
At Charles Schwab, they will gladly take long term assets under management (even at 0.06 bps) against the friction of a $9.95 trade.
Fidelity closed November with $93 billion in indexed assets under management, less than 10% of its total mutual fund assets. The company also has the solid Fidelity Select mutual fund franchise that could mimic (with a twist) the Select Sector SPDRs from SSgA.
Many have asked me what this may mean for Fidelity, the ETF market or even their Fidelity-administered 401(k) plan. At this point, it’s too early to tell, but there’s no doubt that interested parties should take notice.
My latest story at SmartMoney.com, How to Sift Through All Those ETFs, sheds light on some new and interesting tools for ETF investors, or any investor. While I didn’t approach portfolio theory and risk profiles, these tools can constitute a good second step for adding ETFs to your investments.
The ETF market has grown significantly this year, some might even say to its own detriment, but shouting about ETFs with few assets is noise on top of new and innovative products trying to gain traction.