Archive for the 'ETF' Category

Growing Pains at Bond ETFs

Kurt Brouwer October 13th, 2009

Exchange traded funds (ETFs) have many of the built-in advantages that mutual funds have, but there are also differences.  In my view, the biggest difference is not the fact that ETFs trade throughout the day or even how ETF pricing works, but rather that ETFs have a very short operating history.

We use both mutual funds and ETFs so I am not at all negative about exchange traded funds, but I am aware that there will be growing pains as the ETF industry matures.

In this piece from the Wall Street Journal [registration may be required], we see problems arising in bond ETFs.  Namely, that it is hard to price some of the underlying bonds in the various ETF portfolios accurately.  Or, it may be difficult for a given ETF to replicate a bond index exactly because the index may hold some bonds that are not traded frequently.

Eleanor Laise at the WSJ spells out some of the issues [emphasis added]:

Bond ETFs Are Popular But Pricing Is a Problem (Wall Street Journal, October 6, 2009, Eleanore Laise)

…Share prices of many bond ETFs are drifting far from the value of their underlying holdings, which can create big trading costs for investors. Some of the funds are straying from their benchmarks, meaning investors aren’t getting the returns they expected.

…ETFs, typically cheap, straightforward products designed to act like index funds, generally track the performance of a benchmark for stocks, bonds or commodities. But they differ from traditional mutual funds because they trade throughout the day on an exchange.

Keeping ETF returns in line with the indexes has proven to be tough in the murky bond market…

…State Street Corp.’s SPDR Barclays Capital High Yield Bond ETF fell nearly 1% in the 12 months ending Aug. 31, even while its benchmark gained 6%…

…The iShares iBoxx $ High Yield Corporate Bond ETF, for example, traded at a 7% premium at one point in April, and traded within 0.5% of its NAV on only five days in the third quarter…

Such wide gaps aren’t generally supposed to appear in ETFs. Big investors can typically buy up the fund’s underlying holdings and swap them for ETF shares, arbitraging away any significant gaps between the ETF share price and NAV.

But bonds can be so tough to trade that large investors become reluctant to perform this function for fixed-income ETFs. Even when they do make the trades, they incur big trading costs that get factored into the price of the ETF shares…

In another WSJ piece, Tom Lauricella adds a bit of detail to this problem:

Bond ETFs Are Usually Priced Higher Than What They’re Worth (Wall Street Journal, October 5, 2009, Tom Lauricella)

On Sept. 30, 39% of U.S.-bond ETFs traded at a premium of greater than 0.5% to NAV, according to Morningstar Inc. To a large degree, these pricing issues reflect the challenge faced by all bond investors. Most bonds don’t trade on exchanges. And the gap between the “offer” price at which you can buy a particular bond and the lower “bid” price at which you can sell it is typically much wider than on stocks.

The headline for Tom Lauricella’s piece is a bit exaggerated, as headlines often are.  And, I’m well aware that the reporter does not generally get to write the headline, so I won’t give Tom a hard time for it.  I would have written, Bond ETFs Often Trade at Slight Premiums or Discounts.  It’s not as exciting though.  The WSJ continues:

Bond ETFs set the NAV based on estimates of the prices they would get if they sold their holdings. Meanwhile, most bond ETFs are bringing in new money now, so the dealers responsible for creating ETF shares need to constantly buy new securities. That takes place at the higher “offer” side. To compensate, dealers will price the ETF shares higher than NAV, resulting in the bias toward a premium.

If it’s a matter of buying and selling at inflated prices, it’s a wash. But sometimes, investors who bought at a premium end up selling at a discount. “If everybody is selling, it’s also a time where there may not be much liquidity in the bond market, and…funds will be trading at NAV or at a discount to NAV,” says Kenneth Volpert, a principal at Vanguard Group.

In fact, when investors fled corporate bonds last fall, many bond ETFs traded at meaningful discounts. This year, some $25 billion has gone into bond ETFs, a good portion of which is chasing big returns in high-yield bonds, which are notoriously difficult to trade in tough times. How would ETF prices handle that money being pulled out in a flash?…

So far, the discrepancies between a given ETF’s share price and its net asset value (NAV) seem to be manageable.  As anyone who has ever purchased bonds knows, bond traders do a good job of exacting their pound of flesh, particularly for thinly-traded securities.  So, the cost of putting together a portfolio that matches a given index would be very difficult and costly.

This last point is a good one though.  If all the investors in a given ETF want to get out at the same time, raising cash may be an issue.  And, if a given ETF has to raise a lot of cash quickly, it will probably get dinged a bit on those securities that it sells.

Burgeoning Bond Funds

Kurt Brouwer September 24th, 2009

Money market fund yields approaching zero have grabbed the attention of millions of investors who are now making the move into bonds funds.

Jason Zweig, at the Wall Street Journal, notes the trend and provides a bit of caution for those seeking yields [emphasis added below].

If you have not read him before, Zweig is an excellent and prolific writer for Money and other publications such as the Wall Street Journal.  He also has written or edited several books, his most recent being Your Money and Your Brain (Simon & Schuster, 2007).

Don’t Trip in Search for Bond Yields  (Wall Street Journal, September 18, 2009, Jason Zweig)

The Federal Reserve’s policy of driving interest rates down toward zero may have kept the financial system alive. But it is killing savers, and driving them to do desperate things.

The first sentence of this piece suggests that investors were doing desperate things by going into bond funds.  No doubt that is true in some cases, but it is also true that getting a yield of zero is unrewarding.  In fact, if you are getting a yield approaching zero from a money market fund — while inflation is running about 1-2% — well then you are losing purchasing power every year.

So, making a move into bond funds makes sense provided you do so wisely (see Purchasing Power for more on inflation and purchasing power).

Nearly 78% of taxable money-market funds, the traditional parking place for savings, are offering 0.1% or less in annualized yield, according to Crane Data LLC, a research firm. On a $10,000 balance, that will earn you a maximum of 83 cents — yes, $0.83 — in monthly interest income. All told, these funds hold $1.3 trillion that will generate a return of just about zilch for the people who worked so hard to save it.

Bear in mind this number in bold above, $1.3 trillion, is just the amount held by so-called retail investors.  The amount held by institutions of various sorts is actually higher, well north of $2 trillion.  The Investment Company Institute reports total money market fund assets of $3.48 trillion as of September 24th. Then, if you add in bank deposits, Treasury Bills and so on, the number gets even bigger.  In other words, there’s lots of money out there in very low-yielding investments.

Choose carefully and conservatively

The type of bond fund you choose is very important.  Fortunately, there are plenty of conservative taxable bond funds from which to choose that have yields of 3-5%.   And, there are many solid tax-exempt or municipal bond funds with attractive tax-free yields.

On the other hand, if investors are going from very low-risk money market mutual funds to high risk bond funds, then that is a problem.  Higher risk bond funds would be those with longer average maturities or those that hold high yield or junk bonds.

The Wall Street Journal continues:

Last month, investors put twice as much money into intermediate-term and junk-bond funds as into short-term bond portfolios. As a result, they have exposed themselves to much greater risk from rising rates or falling credit quality. When interest rates go up, as in 1994, investors in longer-term bonds can get slaughtered.

…Bonds are safer than stocks. But, at today’s high prices and low yields, bonds are riskier than they were a few months ago. The easiest way to tell is by looking at duration: the change in a bond’s market value when interest rates go up or down by one percentage point. If, for example, you own a bond with a duration of four, then its value will go up about 4% if interest rates fall by a percentage point; the bond will lose about 4% if rates rise by one point…

So, be careful out there.  And, please don’t shop for the highest yield because that will lead you to long-term bond funds and/or junk bond funds.  There is nothing wrong with putting some of your fixed income money into junk bond funds, for example, but do it only if you are diversified and also if you understand how volatile long-term bond funds and junk bond funds can be.  For example, a long-term bond fund has roughly the same volatility as a diversified stock fund.

And, what exactly is duration, anyway?

Zweig mentioned a bit of financial jargon that is worth a moment of your time.  Duration attempts to marry two separate aspects of a bond or a bond fund: first, the average maturity of all the bonds in the portfolio and, second, the average yield or interest income coming in to the portfolio.

The article is correct that we use duration as a rule of thumb to estimate portfolio volatility in the event of a quick spike in interest rates.  However, it’s just a rule of thumb, not exact.  It’s also not the only the only factor that determines volatility.  Imagine the dismay felt by someone last year who had invested in a fund with low duration, but a high commitment to mortgage bonds or junk bonds?

What to do now?

If you have money in a money market fund that is destined for use in the near future such as paying taxes or next year’s tuition for your daughter or son, then I would keep it in a money market fund or maybe a bank certificate of deposit.  Or, you could consider a very short-term bond fund.

On the other hand, if you were keeping the money in cash just due to uncertainty of where to invest for the long haul, then a solid portfolio of bond funds could be excellent as part of your overall portfolio.  Or, if you are purely an income investor, then a diversified portfolio of bond funds could be fine.

My favorite bond fund (see The Biggest Bond Fund) is Pimco Total Return (pttrx).  It has a current (SEC) yield of about 4.93% and a duration of 4.4 years.  Pimco has a similar fund with a shorter duration, Pimco Limited Maturity (ptldx), which has a current yield of 3.44% and a duration of 2.1 years.

Vanguard also has a number of excellent taxable funds and tax-exempt funds. In the tax-free arena, I like Vanguard Intermediate Term Tax-Exempt (vwiux), which has a Federal tax-free yield of 3.20% and a duration of 5.9 years.  Also, Vanguard Limited Term Tax-Exempt is good.  It has a tax-free yield of 1.67% and a duration of 2.4 years.

My advice is to move slowly and deliberately if you are considering a change from money market funds into bond funds.  The rewards are tangible, but make sure you understand the risks.

Average Holding Period for Stocks — 6 Months

Kurt Brouwer August 8th, 2009

clusterstock-nyse-f.jpeg

Source: Clusterstock

This chart covers stocks on the New York Stock Exchange.  As you can see, the trend has been towards more trading and speculation for many years.  I suspect much of this is driven by institutional investors rather than individuals.

Pimco: actively managed ETFs

Kurt Brouwer July 22nd, 2009

In addition to Pimco’s flagship mutual fund, Pimco Total Return, the firm has many other mutual funds that are actively-managed.  Actively-managed mutual funds seek to outperform a given index or benchmark by either having higher returns or buy obtaining similar returns at lower risk.  Now, Pimco is planning a series of exchange traded funds that are also actively-managed.  This Bloomberg piece has the details [emphasis added]:

Pimco Plans First Active ETFs to Match Barclays, State Street (Bloomberg, July 22, 2009, Sree Vidya Bhaktavatsalam)

Pacific Investment Management Co. plans to open its first actively run exchange-traded funds as the world’s biggest bond manager seeks to catch up with rivals in the fastest-growing segment of the mutual fund business.

Pimco will offer five ETFs in which the investments are selected by portfolio managers, according to a registration statement filed today with the U.S. Securities and Exchange Commission by the Newport Beach, California-based company. Three will invest in debt maturing in less than one year and two will focus on municipal bonds, according to the filing.

…”When you look at a five-star shop like Pimco, it adds value over and above what an index can give you,” Scott Burns, director of ETF analysis at research firm Morningstar Inc. in Chicago, said in an interview yesterday. “Investors can get that benefit and have the advantage of an ETF structure.”

…ETFs, which trade all day like stocks instead of being priced only at the end of the session like the typical mutual fund, originally were conceived to mimic indexes such as the Standard & Poor’s 500. Active ETFs are designed to combine the stock- or bond-picking appeal of an actively run mutual fund with the trading flexibility of an ETF.

…”ETFs are increasingly an important investor tool,” Don Suskind, Pimco’s head of ETF product development, said in an interview. “By offering active ETFs, we believe there will be a broader set of investors that can access Pimco’s investment expertise.”

John Cummings, an executive vice president at Pimco who manages $9 billion in bond assets, will run the two municipal funds, according to Pimco’s filing. They are the Pimco Short Term Municipal Bond Strategy Fund and the Intermediate Municipal Bond Strategy Fund.

Pimco didn’t disclose the managers for its short-term debt funds. Those offerings are the Enhanced Short Maturity Strategy Fund, which will invest in debt with durations of less than one year; the Government Limited Maturity Strategy Fund, focusing on short-term government bonds; and the Prime Limited Maturity Strategy, which will buy debt with average durations of less than 90 days.

I can’t see a big advantage here in terms of an ETF versus a no-load mutual fund.  It will be interesting to see if these do well.

See also: Portfolio Changes at Pimco

 

Full Disclosure: Kurt Brouwer owns Pimco Total Return (pttrx)

Emerging Markets: Are they too pricey?

Kurt Brouwer July 13th, 2009

One of the joys — and sorrows — of our global financial markets is that trends happens much more quickly now and areas that are undervalued often do not stay that way for long.  Case in point:  this year’s very strong stock market performance in emerging countries such as Brazil and China.  This Bloomberg piece suggests that those markets have gone up too far and too fast [emphasis added]:

Emerging Markets Priciest Since 2007, When Shares Fell (Bloomberg, July 10, 2009,

The last time stocks in developing countries got this expensive was in October 2007, just before the MSCI Emerging Markets Index began a 12-month tumble that erased half its value.

The MSCI gauge trades at 15.4 times reported earnings, compared with 14 for the Standard & Poor’s 500 Index, according to weekly data compiled by Bloomberg. When developing nations last commanded a premium, the 22-country benchmark sank 54 percent in the next year.

…All 22 emerging-market currencies tracked by Bloomberg depreciated against the yen in the past month, and 16 weakened against the dollar. The yen usually attracts investors during economic turmoil because Japan’s trade surplus makes the nation less reliant on overseas lenders, while the dollar benefits from its status as the world’s reserve currency.

While developing nations’ economies grew an average 1.7 times faster than developed countries in the past 20 years, their stocks traded at a discount because their economies and returns were more volatile. Brazil’s annual inflation averaged more than 1,000 percent in the 1990s, and South Korea required a $57 billion bailout from the International Monetary Fund during the Asian financial crisis of 1997.

Emerging markets, such as China, Brazil and India, often have much higher growth rates than developed economies such as Germany or France or the U.S.  However, emerging countries are, by definition, periodically plagued by developmental issues ranging from problems with governance and the rule of law, over dependence on commodity exports, undeveloped local consumer markets and other issues. Just as happened in the U.S. in the 1800s, the experience in many emerging countries is a series of huge booms and painful busts.

Bloomberg continues:

…Developing nations’ share of global equity value climbed to an all-time high this month as investors poured in a record $26.5 billion last quarter, according to data compiled by Bloomberg and EPFR.

…Developing nations traded at a discount to American equities from 2001 to 2006 even after their economies expanded at almost three times the pace, according to Bloomberg and IMF data. They moved to a premium in October 2007, the peak of a five-year advance that sent the MSCI gauge up fivefold. The index’s drop in 2008 was almost 16 percentage points steeper than the S&P 500′s 38 percent slide, the worst since 1937.

…While BlackRock Inc.’s Bob Doll projects developing-market equities will be the most attractive stock investments over the next few years, he says they may lead a short-term retreat as investors reduce expectations for an economic recovery.

“A lot of risk assets are ahead of themselves,” said Doll, vice chairman and chief investment officer of global equities at New York-based BlackRock, which had $1.3 trillion under management as of March 31. “Almost always, what goes up the most, pulls back the most.”

The volatility of emerging markets makes it an imperative that when you invest in a given country, you must know that market very, very well.  Failing that, I recommend that you invest in emerging markets using a diversified mutual fund or ETF.

Via: Real Clear Markets

See also:

Are these ETFs Overbought?

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