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.
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:
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.
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.