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THE MAGAZINE FOR ETF INVESTORS //////////////////////////////////////////////////// JANUARY 2018
THE
MAGAZINE
FOR
ETF INVESTORS
//////////////////////////////////////////////////// JANUARY 2018

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There are risks involved with investing in ETFs, including possible loss of money. ETFs are subject to risks similar to those of stocks.

 

Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes.

 

Shares are not individually redeemable, and owners of the Shares may acquire those Shares from the Funds and tender those Shares for redemption to the Funds in Creation Unit aggregations only, typically consisting of 10,000, 50,000, 75,000, 100,000 or 200,000 Shares.

Before investing, investors should carefully read the prospectus/summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the Funds call 800 983 0903 or visit powershares.com for prospectus/summary prospectus.

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T H E M A G A Z I N E F O R E
T H E
M A G A Z I N E
F O R
E T F INVESTORS ////////////////////////////////////////////////////// JANUARY
2018
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JANUARY 2018 1

FACE IT:

EVERY MARKET TREND HAS AN EXPIRATION DATE

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Investors should carefully consider the investment objectives and risks as well as charges and expenses of a fund. The prospectus contains this and other information about the fund and should be read carefully before investing. To obtain a prospectus for Exchange Traded Funds: Call 1-844-4JPM-ETF or visit jpmorgan.com/ETF. International investing has a greater degree of risk and increased volatility due to political and economic instability of some overseas markets. Changes in currency exchange rates and different accounting and

Which is why J.P. Morgan Asset Management is committed to sharing expertise, insights, and solutions to help you build stronger portfolios that weather every market cycle.

3 ETF solutions for the long term:

JPIN

for international exposure

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jpmorgan.com/ETFs | #etfsbyjpmam LET’S SOLVE IT. taxation policies outside the U.S. can affect returns.
jpmorgan.com/ETFs | #etfsbyjpmam LET’S SOLVE IT. taxation policies outside the U.S. can affect returns.

taxation policies outside the U.S. can affect returns. Investing involves risk, including possible loss of principal. J.P. Morgan ETFs are distributed by JPMorgan Distribution Services, Inc., which is an affiliate of JPMorgan Chase & Co. Affiliates of JPMorgan Chase & Co. receive fees for providing various services to the funds. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility.

VOLUME 18 | NO. 01

Contents

FEATURES

10

30

34

PUBLISHER, GLOBAL HEAD OF SALES

Noel d’Ablemont Smith nsmith@etf.com

CHIEF EXECUTIVE OFFICER

Dave Nadig

dnadig@etf.com

REPRINT SALES

sales@etf.com

EDITOR

Drew Voros

dvoros@etf.com

MANAGING EDITOR

Heather Bell

COPY EDITOR

Lisa Barr

HEAD OF DESIGN

Patrick Hamaker

GRAPHIC DESIGNER

Bernarda Vásquez

ETF.com

1460 Broadway, 16th Floor New NY 10036

www.ETF.com

ETF University

A look at the basics of the ETF industry, as well as some

deep dives into the more complex issues

SPY Turns 25

A quarter of a century ago, the first U.S.-listed ETF made its debut

and changed the face of global markets

Smart-Beta Supplement

Larry Swedroe discusses the importance of factor diversification

DEPARTMENTS

6

New ETF Launches

42

Countries In Review

Vanguard debuts broad corporate bond ETF. Plus our list of launches for November

Most country ETFs ended up in positive territory in November

 

44

ETF Data

8

ETF Explainer: ITB

Our monthly databank breaks

We look at the drivers behind the movements of iShares’ homebuilders ETF

down ETF returns for every market segment

 

52

The Last Word

38

Sectors

Some commonly used investment

Across the board, sectors were generally up in November

terms actually annoy investors

40

Commodities In Review

November was a mixed month for commodities, with industrial metals the hardest hit

4 ETF.com/ETF Report

© 2018 ETF.com. All rights reserved. The text, images and other materials contained or displayed are proprietary to ETF.com, except where otherwise noted, and constitute valuable intellectual property. No material from any part of any ETF.com publication, product, service, report, email or website may be downloaded, transmitted, broadcast, transferred, assigned, reproduced or in any other way used or otherwise disseminated in any form to any person or entity, without the explicit written consent of ETF.com. For permission to photocopy and use material electronically, please contact sales@ETF.com or call 646-558-6985.

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© S&P Dow Jones Indices LLC, a division of S&P Global 2017. All rights reserved. S&P ® and Indexology ® are registered trademarks of Standard & Poor’s Financial Services LLC. Dow Jones ® is a registered trademark of Dow Jones Trademark Holdings LLC. It is not possible to invest directly in an index. S&P Dow Jones Indices receives compensation for licensing its indices to third parties. S&P Dow Jones Indices LLC does not make investment recommendations and does not endorse, sponsor, promote or sell any investment product or fund.

NEW FUNDS

By Heather Bell

ETF

Launches

4% 4% COMMODITIES INVERSE 1% 4% ALTERNATIVES INT’L FIXED INCOME 5% ASSET ALLOCATION 245 ETFs
4%
4%
COMMODITIES
INVERSE
1%
4%
ALTERNATIVES
INT’L FIXED INCOME
5%
ASSET ALLOCATION
245
ETFs
YEAR-TO-DATE
6%
LEVERAGED

15%

US FIXED INCOME

35%

US EQUITY

26%

INT’L EQUITY

FEATURED ETF

Vanguard Total Corporate Bond ETF (VTC)

New fund combines three ETFs in one wrapper

In November, Vanguard debuted its first

ETF in nearly two years and its first ETF- of-ETFs. The Vanguard Total Corporate Bond ETF Shares

(VTC) amalgamates three Vanguard ETFs tracking subsets of the Bloomberg Bar- clays U.S. Corporate Bond Index, which is the new fund’s

benchmark. VTC comes with an expense ratio of 0.07% and lists on the Nasdaq exchange. The new ETF holds three other Van- guard ETFs representing different matu- rity buckets: the $22 billion Vanguard Short-Term Corporate Bond ETF (VCSH), the $18 billion Vanguard Intermediate- Term Corporate Bond ETF (VCIT) and the

VTC Quick View

ISSUER

Vanguard

SEGMENT

Fixed Income: U.S. – Corporate Investment Grade

EXPENSE RATIO

0.07%

STRUCTURE

Open-Ended Fund

DATE LAUNCHED

11/9/2017

$2 billion Vanguard Long-Term Corpo- rate Bond ETF (VCLT). Like VTC, its three component ETFs all charge 0.07%. Basically, investors who buy the new ETF will be getting one- stop shopping for the same price if they are seeking broad exposure to the corpo- rate bond market. The fund is comparable to the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), which also covers the broad investment-grade corporate bond market. The two funds have similar secu- rity quality, duration and total cost of ownership. However, LQD has an expense ratio of 0.15%. The new addition brings the total number of Vanguard ETFs to 71. The firm is the second-largest ETF issuer, with $821 billion in assets under management.

ETF issuer, with $821 billion in assets under management. ETF FILING ACTIVITY LAUNCHES U.S. EQUITY AAM

ETF FILING ACTIVITY

LAUNCHES

U.S. EQUITY

AAM S&P 500 High Dividend Value

Aptus Fortified Value

ERShares Entrepreneur 30 Fund

First Trust SMID Cap Rising Div Achievers

iShares U.S. Dividend and Buyback

John Hancock Multifactor Small Cap

JPMorgan U.S. Dividend

JPMorgan U.S. Minimum Volatility

JPMorgan U.S. Momentum Factor

JPMorgan U.S. Quality Factor

JPMorgan U.S. Value Factor

Oppenheimer Russell 1000 Dyn Multifactor

Oppenheimer Russell 1000 Low Vol Factor

Oppenheimer Russell 1000 Momentum Factor

Oppenheimer Russell 1000 Quality Factor

Oppenheimer Russell 1000 Size Factor

Oppenheimer Russell 1000 Value Factor

Oppenheimer Russell 1000 Yield Factor

Oppenheimer Russell 2000 Dyn Multifactor

ProShares Decline of the Retail Store

Reverse Cap Weighted US Large Cap

U.S. FIXED INCOME

First Trust Municipal High Income

Vanguard Total Corporate Bond

INT’L EQUITIES

AAM S&P EM High Dividend Value

FormulaFolios Smart Growth

Franklin FTSE Australia

Franklin FTSE Brazil

Franklin FTSE Canada

Franklin FTSE China

Franklin FTSE Europe Hedged

Franklin FTSE Europe

Franklin FTSE France

Franklin FTSE Germany

Franklin FTSE Hong Kong

Franklin FTSE Italy

Franklin FTSE Japan Hedged

Franklin FTSE Japan

Franklin FTSE Mexico

Franklin FTSE South Korea

Franklin FTSE Taiwan

Franklin FTSE United Kingdom

Principal International Multi-Factor

Virtus Glovista Emerging Markets

BUILT BY INVESTORS, FOR INVESTORS.

Energy, metals, agriculture, timber, water. One ETF.

Energy, metals, agriculture, timber, water. One ETF. FlexShares ® GUNR exchange traded fund delivers what

FlexShares ® GUNR exchange traded fund delivers what emerging markets demand – energy, metals,

agriculture, timber, water – in a single balanced stock portfolio. GUNR focuses on “upstream” companies that extract raw materials, rather than “downstream” processors. Giving investors direct inflation-hedging exposure to natural resources, without added market noise.

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For more information, visit flexshares.com/natural

CAPITAL

APPRECIATION

RISK

MANAGEMENT

GUNR

INCOME

GENERATION

LIQUIDITY

MANAGEMENT

Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest. Foreside Fund Services, LLC, distributor.

Investment in FlexShares Morningstar Global Upstream Natural Resources Index Fund (GUNR) is subject to numerous risks including possible loss of principal. Highlighted risks: concentration (more than 25% of assets in a single industry); global natural resources (risk associated with global natural resources); foreign securities (fund typically invests at least 80% of assets in ADRs and GDRs); emerging markets (countries potentially less liquid and subject to greater volatility). See prospectus for full description of risks.

GUNR is subject to the global natural resource industry. As the demand for or prices of natural resources increase, the Fund’s equity investment generally would be expected to also increase. Conversely, declines in demand for or prices of natural resources generally would be expected to cause declines in value of such equity securities. Such declines may occur quickly and without warning and may negatively impact your investment in the Fund.

The Morningstar ® Global Upstream Natural Resources Index is the intellectual property (including registered trademarks) of Morningstar ® and/or its licensors (“Licensors”), which is used under license. The securities based on the Index are in no way sponsored, endorsed, sold or promoted by Morningstar ® and its Licensors and neither of the Licensors shall have any liability with respect thereto.

MANAGED BY

IN DETAIL

By Heather Bell

ETF Explainer: ITB

iShares U.S. Home Construction ETF

Each month, we consider an ETF selected by ETF.com based on its performance and importance
Each month, we consider an ETF selected by ETF.com based on its performance and importance to investors. This month
we look at the steady rise of the $2.4 billion iShares U.S. Home Construction ETF (ITB), which is up more than 100% over the
past 12 months.
ITB Quick View
ISSUER
BlackRock
RETURN
SEGMENT
Equity: U.S. Homebuilding
57.2 %
60 %
EXPENSE RATIO
0.44%
AUM
$2.4 Billion
NOV
50
2
COMPETING FUND
XHB
OCT
3
40
JUL
10
30
MAR
MAY
16
31
20
JAN
26
10
0
-10
-20
DEC
JAN
FEB
MAR
APR
MAY
JUN
JUL
AUG
SEP
OCT
NOV
2017
JAN
26
New home sales fall to a 10-year low, but Pulte sees an
18% increase in earnings and an increase in revenue of
more than 20%, boosting its shares by more than 5%.
JUL
10
DR Horton hits a multiyear high, its share price driven up by
a strong backlog and inventory as well as a merger agreement
with Texas-based Forestar Group.
MAR
16
Home Depot hits a 52-week high after focusing on
productivity and growth initiatives in its stores and
recording strong sales and earnings growth.
OCT
3
Homebuilder Lennar’s stock rises nearly 3% after it reported
third-quarter profits were up 5.6% on an increase in the
number of homes it sold at higher prices.
MAY
Lowe’s stock slides after missing earnings and sales
growth projections for the first quarter of 2017.
NOV
31
2
Details of the GOP tax plan outlining a cap on mortgage
interest deductibility sent homebuilders tumbling, with
Toll Brothers falling roughly 5%.
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All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. Equity securities are subject to price fluctuation and possible loss of principal. Income and dividends will fluctuate and are not guaranteed.

Before investing, carefully consider a fund’s investment objectives, risks, charges and expenses. You can find this and other information in each prospectus, and summary prospectus, if available, at www.LeggMason.com/ETF. Please read the prospectus carefully.

Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial advisor. © 2017 Legg Mason Investor Services, LLC. Member FINRA, SIPC. Legg Mason Investor Services is a subsidiary of Legg Mason, Inc. 763541 ADVR412430 10/17

INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE
INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE
of Legg Mason, Inc. 763541 ADVR412430 10/17 INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE
ETF UNIVERSITY AN EDUCATIONAL GUIDE FOR ETF INVESTORS Lara Crigger and Debbie Carlson contributed to
ETF UNIVERSITY AN EDUCATIONAL GUIDE FOR ETF INVESTORS Lara Crigger and Debbie Carlson contributed to

ETF UNIVERSITY

AN EDUCATIONAL GUIDE FOR ETF INVESTORS

Lara Crigger and Debbie Carlson contributed to the articles in this ETF Education Section

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BUT WHAT ABOUT ETFs? All that’s great, but you’re not reading this to learn about mutual funds. You want to learn about ETFs. So what is an ETF? Well, it’s a mutual fund too. It’s a pooled investment vehicle that offers diversified exposure to a particular area of the market. It can invest in stocks, bonds, commodities, currencies, options or a blend of assets. Investors buy shares, which represent a proportional interest in the pooled assets.

It’s a mutual fund in every aspect … except one. And that’s a big one, which is hinted at in its very name:

exchange-traded funds.

BEING EXCHANGE-TRADED With an exchange-traded fund, you buy shares in an ETF directly from any brokerage account. Just like you buy shares in a stock, you can enter a buy order in your Schwab or Fidel- ity account and buy any ETF you want. You can also do it whenever you want. Whereas orders to buy or sell a traditional mutual fund can be processed only once per day (after the close of trading), ETF trades can take place any time the market is open. You can buy shares in the morning and sell them in the afternoon. You can buy them at 10 a.m., sell them at 11 a.m. and buy them again after lunch if you want. You can also perform all sorts of stocklike strategies with ETFs that you never could with mutual funds: selling short, placing stop-loss or limit orders, even buying on margin. And that’s just the beginning: The fact that ETFs are “exchange-traded” creates a series of other benefits that, according to many market observers, makes them a better overall choice than traditional mutual funds for many rea- sons: lower costs, better tax efficiency and more. Of course, in other situations, they can be worse: commissions, trading spreads and other risks. What is an ETF? In sum, it’s a tool that allows investors to access different corners of the market—everything from U.K. equities to Chinese tech stocks to high-yield bonds, spot gold bullion and more—at low costs, from the comfort of a traditional brokerage account. It’s like a mutual fund. Or, perhaps, a mutual fund:

Offering low-cost access to virtually every corner of the market, ETFs allow investors big and small to build institutional-caliber portfolios with lower costs and better transparency than ever before. But what exactly is an ETF? And how does it provide these benefits?

WANT TO KNOW HOW ETFs WORK? FIRST UNDERSTAND HOW MUTUAL FUNDS WORK To understand how ETFs work, the best place to start is with something familiar, like a traditional mutual fund. Imagine half a dozen investors, sitting at home, each try- ing to figure out the best way to invest in the stock market. They could each go out and buy a few stocks on their own, but who has the time or resources to manage a portfolio of 50 or 100 stocks? Instead, they decide to band together. They pool all of their money and hire a professional investment manager to invest it for them. To keep track of who invested what, each investor receives “shares,” representing their stake in the total investment. Because it’s your money, you want to know how much your investment is worth … every day. So every day, the mutual fund tallies up the value of everything it owns and divides it by the number of shares that exist. Whammo- presto: You know exactly what each share is worth. If you want to buy more shares, you know the amount of cash to send the mutual fund for each share. If you want to sell shares, you know exactly how much cash to expect in return. It’s an elegant system, and mutual funds have existed for close to 100 years. They currently provide exposure to stocks, bonds, commodities and other assets.

version 2.0.

AN ETF …

… is structured as a mutual fund

… can be listed and traded on an exchange, like a stock

… can be traded intraday, shorted and bought on margin

… generally involves lower costs and better tax efficiency

WHAT IS AN

ETF?

12 12 ETF.com/ETF Report

ACSI American Customer Satisfaction Core Alpha ETF RVRS Reverse Cap Weight US Large Cap ETF

ACSI

American Customer Satisfaction Core Alpha ETF

RVRS

Reverse Cap Weight US Large Cap ETF

BVAL

Brand Value ETF ADVERTISEMENT
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Differentiated approaches; differentiated results.

Differentiated approaches; differentiated results. www.exponentialetfs.com An investor should consider the

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An investor should consider the Fund’s investment objectives, risks, charges and expens- es carefully before investing. The prospectus and summary prospectus contain this and other important information about the Fund and are available by calling 734.882.2401. Please read the prospectus or summary prospectus carefully before investing. Investments involve risks. Principal loss is possible. Exponential ETFs are distributed by Quasar Distributors, LLC

 

HOW DO APs IMPACT LIQUIDITY? An AP’s ability to create and redeem shares helps keep ETFs priced at fair value. For example, if demand for an ETF increases and a premium develops, APs step in to create more shares and push the ETF’s price back in line with its actual value. If there’s a rush to sell and a discount develops, APs buy ETF shares on the open market and redeem them with the ETF issuers to reduce supply. Generally, the greater the number of APs for a particular ETF, the bet- ter: The force of competition is more likely to keep the ETF trading close to its fair value. The task set forth for an AP is not necessarily an easy one: Sometimes the underlying market that they must access to change the supply of ETF shares is illiquid, or just difficult to access. An exchange-traded product tracking the S&P 500 will be easy to access and easily hedge-able for most APs, while one tracking Nigeria equities will be tough. Mostly, APs are invisible to indi-

Authorized participants (APs) are one of the major parties at the center of the ETF creation/redemption mechanism (see p. 15), and as such, they play a critical role in ETF liquidity. In essence, APs are ETF liquidity providers that have the exclusive right to change the supply of ETF shares on the market.

THE ROLE OF AUTHORIZED PARTICIPANTS When an ETF company wants to create new shares of its fund, whether to launch

a

new product or meet increasing market demand, it turns to an AP, which may be

market maker, a specialist or any other large financial institution. Essentially, it’s someone with a lot of buying power. It is the AP’s job to acquire the securities that the ETF wants to hold. For instance,

a

an ETF is designed to track the S&P 500 Index, the AP will buy shares in all the S&P 500 constituents in the exact same weights as the index, then deliver those shares to the ETF provider. In exchange, the provider gives the AP a block of equally valued ETF shares, called a creation unit. These blocks are usually formed in blocks of 50,000 shares. The exchange takes place on a one-for-one, fair-value basis. The AP delivers a certain amount of underlying securities and receives the exact same value in ETF shares, priced based on their net asset value (NAV), not the market value at which the ETF happens to be trading. Both parties benefit from the transaction: The ETF provider gets the stocks it needs to track the index, and the AP gets plenty of ETF shares to resell for profit.

if

vidual investors and advisors. Still, it’s good to know they’re there.

AUTHORIZED PARTICIPANTS …

… are designated by the ETF issuer

… have the exclusive right to change the supply of ETF shares on the market

The process can also work in reverse. APs can remove ETF shares from the mar- ket by purchasing enough of those shares to form a creation unit and then delivering

those shares to the ETF issuer. In exchange, APs receive the same value in the under- lying securities of the fund.

HOW DO APs GAIN THE RIGHT TO CHANGE THE SUPPLY OF ETP SHARES? ETP issuers decide. Prior to launch, the issuer will designate one or more AP to the fund. More can sign up over time. The most popular ETFs will have dozens of APs.

… create shares when a premium develops by providing baskets of holdings to the issuers

… redeem shares when a discount develops by buying them from the issuer to sell the individual holdings on the market

What Are Authorized Participants?

14 14 ETF.com/ETF Report

AN EFFICIENT WAY TO ACCESS THE MARKET The other key benefit of the creation/ redemption mechanism is that it’s an extraordinarily efficient and fair way for funds to acquire new securities. As discussed, when investors pour new money into mutual funds, the fund company must take that money and go into the market to buy securi- ties. Along the way, they pay trading spreads and commissions, which ulti- mately harm returns of the fund. The same thing happens when investors remove money from the fund. With ETFs, APs do most of the buying and selling. The AP pays all the trading costs and fees, and even pays an additional fee to the ETF provider to cover the paperwork involved in processing all the creation/redemp- tion activity. The beauty of the system is that the fund is shielded from these costs. Funds may still pay trading fees if they have portfolio turnover due to index changes or rebalances, but the fee for putting new money to work (or redeeming money from the fund) is typically paid by the AP. (Ultimately, investors enter- ing or exiting the ETF pay these costs through the bid/ask spread.) The system is inherently more fair than the way mutual funds operate. In mutual funds, existing sharehold- ers pay the price when new investors put money to work in a fund, because the fund bears the trading expense. In ETFs, those costs are borne by the AP (and later by the individual investor looking to enter or exit the fund).

What Is The Creation/ Redemption Mechanism?

The key to understanding how ETFs work is the “creation/redemption” mechanism. It’s how ETFs gain exposure to the market, and is the “secret sauce” that allows ETFs to be less expensive, more transparent and more tax efficient than traditional mutual funds.

It’s a bit complicated, but worth understanding.

WHY IT’S IMPORTANT The creation/redemption process is important for ETFs in a number of ways. For one, it’s what keeps ETF share prices trading in line with the fund’s underlying NAV. Because an ETF trades like a stock, its price will fluctuate during the trading day, due to simple supply and demand. If many investors want to buy an ETF, for instance, the ETF’s share price might rise above the value of its underlying securities. When this happens, the autho- rized participant (see p. 14 for an explanation of what they do) can jump in to intervene. Recognizing the “overpriced” ETF, the AP might buy up the underlying shares that com- pose the ETF and then sell ETF shares on the open market. This should help drive the ETF’s share price back toward fair value, while the AP earns a basically risk-free arbitrage profit. Likewise, if the ETF starts trad- ing at a discount to the securities it holds, the AP can snap up 50,000 shares of that ETF on the cheap and

redeem them for the underlying secu- rities, which can be resold. By buying up the undervalued ETF shares, the AP drives the price of the ETF back toward fair value while once again making a nice profit. This arbitrage process helps to keep an ETF’s price in line with the value of its underlying portfolio. With multiple APs watching most ETFs, ETF prices typically stay in line with the value of their underlying securities. This is one of the critical ways in which ETFs differ from closed-end funds. With closed-end funds, no one can create or redeem shares. That’s why you often see closed-end funds trading at massive premiums or discounts to their NAV: There’s no arbitrage mechanism available to keep supply and demand pressures in check. The ETF arbitrage process doesn’t work perfectly, and it pays to make sure your ETF is trading at fair value. But most of the time, the process works well.

JANUARY 2018 15

15

 

tion of the value of ETF shares traded;

in the primary market, liquidity is more

a function of the value of the underly-

ing shares that back the ETF. When placing a large trade—on the scale of tens of thousands of shares—investors are sometimes

able to circumvent an illiquid second- ary market by using an AP to reach through to the primary market to “create” new ETF shares. Unfortunately, most of us aren’t trading tens of thousands of shares at

 

For individual stocks, liquidity is about trading volume and its regularity—more is better. For ETFs, there’s more to consider.

time, so we’re stuck trading in the

secondary market. Remember that, to assess secondary market liquidity, you should be looking at statistics such as average spreads, average trading volume, and premiums or dis- counts (does the ETF trade close to its net asset value?). It’s really only if you’ll be trad- ing close to 50,000 shares or more at a time that these statistics are no longer the most relevant in assess- ing liquidity. For those big trades, the liquidity of the ETF’s underlying secu- rities is the most important factor. After all, to “create” 50,000 shares, the AP must first submit a pre- specified basket of the ETF’s underly- ing securities—a creation basket—to the ETF. There is a direct relationship between the underlying liquidity of an ETF and its primary market liquidity, because in order to create primary market liquidity, the AP must trade in the underlying market—the easier an AP can access the underlying market, the more efficiently she can create and redeem ETF shares. If you trade this size regularly, a good first step is to contact the ETF issuer itself and request the capital markets desk. One of the main goals of the issuer’s capital markets desk is to ensure that investors enter and exit funds at fair prices. They can also be a great help in providing market impact estimations, underlying liquidity analysis and connecting investors to liquidity providers.

a

AN ETF ISN’T A STOCK ETFs are often lauded for their liquidity and single-stock trading characteristics. Truth is, they’re similar. If an ETF doesn’t trade a certain number of shares per day (e.g., 50,000), the fund is illiquid and should be avoided, right? Wrong. It’s a plausible assumption from a single-stock perspective, but with ETFs, we need to go to a level deeper. The key is to understand the difference between the primary and secondary liquidity of an ETF.

PRIMARY MARKET VS. SECONDARY MARKET Most noninstitutional investors transact in the secondary market—which means investors are trading the ETF shares that currently exist. Secondary liquidity is the “on screen” liquidity you see from your brokerage (i.e., volume and spreads), and it’s determined primarily by the volume of ETF shares traded. However, one of the key features of ETPs is that the supply of shares is flex- ible—shares can be “created” or “redeemed” to offset changes in demand. Pri- mary liquidity is concerned with how efficient it is to create or redeem shares. Liquidity in one market—primary or secondary—is not indicative of liquidity in the other market. Another way to make the distinction between the primary market and the sec- ondary market is to understand the participants in each. In the secondary market, investors bargain with each other or with a market maker to trade the existing supply of ETP shares. In contrast, investors in the primary market use an “autho- rized participant” (AP) to change the supply of ETP shares available—either to offload a large basket of shares (“redeem” shares) or to acquire a large basket of shares (“create” shares). The determinants of primary market liquidity are different than the determinants of secondary market liquidity. In the secondary market, liquidity is generally a func-

KEY TAKEAWAYS

• There are two levels of ETF market liquidity

• Primary market liquidity is dependent on authorized participants

• Secondary market liquidity is dependent on investors and market makers

Understanding ETF Liquidity

16 16 ETF.com/ETF Report

 

STOP-LIMIT ORDER

A

stop-limit order combines stop

and limit orders in what seems like

a

very useful automated process.

Once an ETF’s share price hits the stop price, the trade activates and is executed as a limit order (meaning,

it doesn’t fill until it reaches the limit price or better). For example, for a sell-stop-limit order with a stop price of $5 and a limit price of $4.50, your order activates as soon as the ETF’s price falls to $5. But your shares are only sold if they’re above $4.50. That means everything is fine if the price is moving by small incre- ments, like a penny or two, but there are significant potential drawbacks. If the price drops to $4.49 from

Whether you trade a single ETF share at a time or thousands, how you order trades matters. Three main order types exist:

large size, whether in shares or in market value,” said Blair duQuesnay, chief investment officer and principal of New Orleans-based ThirtyNorth Investments. “You want to make sure the order you’re putting in isn’t going to move the price.”

market order, limit order and stop order. Here are the pros and cons of each.

STOP ORDER

 

A

stop order is a market order that only

$5.00, your order will have been activated by the fall to $5.00 (the

 

activates if the ETF in question reaches

MARKET ORDER

particular price (the “stop price”). A sell-stop order for $5/share, for example, only activates if the ETF’s share price hits $5, after which your shares then sell for whatever the best available market price may be. A sell-stop order is sometimes referred to as a “stop loss” order, because using one ostensibly pro- tects your profits from further losses. (However, there’s nothing about a stop-loss order that saves you from

a

stop part), but it won’t fill (the limit part). And if the price is in full-on free fall and it gaps down to, say, $3.00 or even $1.00, your order will not have gone through, and you’ll

market order is an order to buy or

sell an ETF right now. The order exe- cutes immediately, at whatever the best available price may be. With a market order, speed out- ranks price. That’s fine for highly liq- uid, high-volume ETFs, but it can be a recipe for disaster for volatile or less liquid funds.

A

be

left holding shares you probably

don’t want. However, as with a limit order,

you may not find someone willing

to

pay your limit price. Further, ETFs

LIMIT ORDER

don’t always move incrementally. If the price spikes or plunges, your stop price might be triggered but the limit order might never be filled. If, in our above example, the ETF price gapped down to $3, the stop- limit order will still activate, but the limit order can’t execute until the ETF’s price rises back above $4.50. Thus, the trade won’t execute—and never will, so long as the ETF stays below $4.50. Market orders are usually safe if you’re mostly trading large, liquid ETFs. If you want to protect against potential downside risk, however, a limit order is usually safer. And stop orders should always be used with care lest you get caught in an arbi- trary pricing movement.

A

limit order establishes a maximum

losing money due to bad execution.) Like limit orders, stop orders establish boundaries over what prices you are and aren’t willing to accept. That’s helpful if you can’t or don’t want to track the market minute by minute, but you still need protection from sudden swings. Keep in mind that your stop price

isn’t your trading price. The stop price

or minimum price at which you’re willing to trade an ETF. The order only executes if the ETF’s share price meets that target (or better). A buy limit order for $5/share, for example,

means you’ll only buy if the ETF hits $5 or below. With limit orders, you can set boundaries over trades to ensure you don’t pay more or receive less for shares than you want. But they aren’t guaranteed to execute. If, per our example, the ETF’s price never falls to $5, then your limit order would never execute and you’d never get your shares. Still, “a limit order is a good idea any time you’re trading a particularly

is

just a trigger—once the trade acti-

vates, it then becomes a market order. Furthermore, if an ETF grows volatile, your stop order might trigger before you want it to. This is espe- cially true for illiquid markets, where ETF prices can sometimes drift from net asset value for hours at a time before ultimately correcting.

The Different Types Of Trades

JANUARY 2018 17

17

ETF Costs Beyond The Expense Ratio

PREMIUMS/DISCOUNTS ETF premiums and discounts are exactly as they sound. An ETF trades at a premium when its mar- ket price exceeds the sum total of all the prices of its underlying holdings. An ETF trades at a discount when the reverse is true, and the ETF’s price falls below that of its underly- ing holdings. By themselves, premiums and discounts don’t cost you anything. If you buy and sell your shares at the same 0.50%, then the net effect on your returns is zero. Premiums and discounts only cost you if they change between the time you buy and the time you sell. If that 0.50% premium instead becomes a 0.50% discount, then you’ll lose 1% total on the round trip (assuming no price change). ETF critics like to sound the alarm over premiums and discounts, but they’re actually normal. Most ETFs regularly carry small premiums or discounts, which arise organically from the supply/demand pressures that govern all marketplaces. (They can also emerge in other situations, such as when an ETF’s trading hours don’t match those of its underlying securities, as with some interna- tional funds.) Plus, should premiums and dis- counts ever grow too large, ETFs have a built-in mechanism to realign prices with value through the cre- ation/redemption process and the authorized participants that drive it.

TALLYING COSTS What cost affects you most depends on which kind of investor you are. Expense ratios impact buy- and-hold investors far more than active traders, who in turn are more impacted by commissions and bid/ ask spreads. Premiums/discounts, though, are a wild card that can either help or hinder, depending on their value at trading time.

An ETF’s expense ratio is an easy-to-understand, flat annual fee that helps you weigh the relative expense of one fund versus another.

But expense ratios alone don’t tell you the full story about how much an ETF really costs. To own any given fund, you’ll pay much more than just an annual management fee, including

TRADING COMMISSIONS A commission is what your broker- age takes for making your trade. You pay this fee every time you buy and sell shares, no matter how big or small your trade (though sometimes a discounted rate is offered to more frequent traders). Commissions depend on a vari- ety of factors, including the broker- age you select, what kind of account you hold and whether you order in person, over the phone or online. One thing’s certain, though: The more frequently you trade, the more you’ll pay in commissions, and that can erode your bottom line. The good news is that many bro- kerages—such as Charles Schwab and TD Ameritrade—now offer com- mission-free ETF trading for certain funds. Still, exclusions sometimes apply, so make sure you read the fine print before investing.

BID/ASK SPREADS Technically, an ETF’s market price

is not singular. Two prices actually matter: the price at which you can find a buyer to take your shares, and the price at which a seller will give them to you. These are the “bid” and “ask” prices, respectively, and the difference between them is known as a “bid/ask spread.” The bid is usually lower than the ETF’s current share price, while the ask is usually higher. You’ll pay the full spread on every round-trip trade you make; meaning, the more fre- quently you trade shares, the more that bid/ask spreads will cost you. Several factors dictate the size of an ETF’s bid/ask spread, including the liquidity of the underlying secu- rities, how expensive it is for fund managers and market makers to off- set risk, and the total supply/demand of actual ETF shares. But like commissions, bid/ask spreads are unavoidable. You pay the current bid when you enter a fund and the current ask when you exit it. No exceptions.

18 18 ETF.com/ETF Report

Understanding

Securities

Lending

Securities lending is a fairly simple process that can generate extra returns for ETF investors, but it also introduces extra risk—however minimal. The logic behind securities lending is this: An equity ETF will typically hold thousands of shares of various stocks. If there is a short-seller out there who wants to borrow those stocks—and agrees to post collateral and pay the ETF a fee for doing so—why not lend them out and make a little extra dough? Generally speaking, securities-lending activities are positives for shareholders and contribute to tighter index tracking and better overall returns. They are not without some risks; while we believe they’re generally minor, they’re nonetheless worth considering.

RISKS OF SECURITIES LENDING You’d think the biggest risk in securities lending is that the short-seller you lent shares to goes bankrupt. Fortunately, industry practice is for borrowers to provide collateral exceeding the value of the loaned securities by a set margin. So while a busted counterparty is a pain, it’s not immediately costly. The costs come in if the borrower is a short-seller (it usually is) and the secu- rity that they shorted rallies strongly in a single day, the borrower defaults and the provided collateral is insufficient to cover the cost of reacquiring the security. Remember, collateral balances are only settled (at best) daily. Even that is small-fry, however. The real risk with securities lending is that when ETF issuers receive cash col- lateral, they don’t just sit on it—they put it into money market securities to earn some small amount of interest on the cash. Where firms get into trouble is when these collateral investments go bankrupt, such as when Lehman Brothers went under. It’s unlikely, but it has happened.

HOW PROFITABLE IS SECURITIES LENDING? It depends. Just as prices in the rest of the economy are subject to the forces of supply and demand, so too are securities-lending premiums. Securities that are in high demand in the loan market command higher premi- ums. ETFs that hold these in-demand securities can earn a significant premium lending out portfolio holdings. Premiums tend to fluctuate as certain sectors, mar- kets or countries fall in and out of favor with short-sellers. When these factors align perfectly, ETFs can earn huge premiums for lend- ing securities. Historically, some ETFs (those in solar in 2013, for instance) have

paid dividends amounting to a yield as high as 5-7%, despite the fact that none of their underlying holdings paid dividends. In these cases, the ETF gen- erated sufficient revenues from secu- rities lending alone to enable a hefty dividend for its investors. Let’s keep things in perspective though; most ETFs don’t earn such lofty premiums for lending their secu- rities. While they certainly provide a tail wind for ETFs, the effect of secu- rities-lending revenue is usually rela- tively muted and generally serves to offset expenses rather than generate significant outperformance. It’s worth noting that, rather than distributing securities-lending rev- enue as dividends, the usual course of business is for ETFs to invest the extra revenue in its portfolio holdings. In this case, investors reap the rewards via fund performance rather than divi- dend payments. The takeaway is that securities lending introduces some risk to ETF portfolios—much of which has been mitigated by issuer policies. Mean- while, the benefits of securities lend- ing range from negligible to highly significant.

3

RISKS OF SECURITIES LENDING

• Borrower defaults

• Insufficient collateral

• Collateral investment bankruptcy

JANUARY 2018 19

19

Legal Structures, Regulations & Taxes

Investors spend hours research- ing funds for expense ratios and spreads, trying to save a few basis points here and there. But often, not enough time is spent researching a fund’s structure and the associated tax implications, which can translate into hundreds or even thousands of basis points. An ETF’s taxation is ultimately driven by its underlying holdings. Since funds are structured differently according to how they gain exposure to the underlying asset, an ETF’s tax treatment inherently depends on both the asset class it covers and its particular structure. A fund’s asset class can be clas- sified in one of five categories: equi- ties; fixed income; commodities; cur- rencies; and alternatives. For tax purposes, exchange- traded products come in one of five structures: open-end funds; unit investment trusts (UITs); grantor trusts; limited partnerships (LPs); and exchange-traded notes (ETNs). Many commodity and currency funds that hold futures contracts are regulated by the Commodity Futures Trading Commission as commodity pools, but they’re classified as LPs for tax purposes by the IRS. There- fore, “limited partnership” is used to refer to the structure of these funds with regard to taxation. This five-by-five matrix—five asset classes and five fund struc- tures—defines the potential tax treat- ments available in the ETF space.

EQUITY & FIXED-INCOME FUNDS Equity and fixed-income ETFs cur- rently operate in three different struc- tures: open-end funds, UITs or ETNs.

ALTERNATIVE FUNDS Alternative funds come in one of three structures: open-end funds, LPs, or ETNs. (Alternative funds seek to provide diversification by combining

MAXIMUM CAP GAINS TAX RATE

 

asset classes or investing in nontradi- tional assets.)

STRUCTURE

LONG TERM

SHORT TERM

Open End (40 Act)

20%

39.60%

MAXIMUM CAP GAINS TAX RATE

 

UIT (40 Act)

20%

39.60%

STRUCTURE

LONG TERM

SHORT TERM

Grantor Trust (33 Act)

N/A

N/A

Open End (40 Act)

20%

39.60%

Limited Partnership (33 Act)

N/A

N/A

UIT (40 Act)

N/A

N/A

ETN (33 Act)

20%

39.60%

Grantor Trust (33 Act)

N/A

N/A

 

Limited Partnership (33 Act)*

27.84%**

27.84%**

COMMODITY FUNDS Commodity ETFs come in one of four structures: open-end funds, grantor trusts, LPs, or ETNs.

ETN (33 Act)***

20%

39.60%

*Distributes K-1 **Max rate of blended 60% LT/40% ST ***Exception is ticker “ICI”

MAXIMUM CAP GAINS TAX RATE

 

STRUCTURE

LONG TERM

SHORT TERM

TAXATION OF DISTRIBUTIONS Besides taxes on capital gains incurred from selling shares of ETFs, investors are also subject to pay taxes on periodic distributions, which can be dividends paid out from the underlying stock holdings, interest from bond hold- ings, return of capital (ROC) or capital gains—which come in two forms: long- term gains and short-term gains. Dividend payments from ETFs are usually paid out monthly, quarterly, semiannually or annually. There are two kinds of dividends that investors should be aware of: qualified divi- dends, and nonqualified dividends. Qualified dividends are dividends paid out from a U.S. company whose shares have been held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Importantly, this refers to the shares held by the ETF itself, and not the

Open End (40 Act)

20%

39.60%

UIT (40 Act)

N/A

N/A

Grantor Trust (33 Act)

28%

39.60%

Limited Partnership (33 Act)*

27.84%**

27.84%**

ETN (33 Act)

20%

39.60%

*Distributes K-1 **Max rate of blended 60% LT/40% ST

CURRENCY FUNDS Currency ETFs come in one of four structures: open-end funds, grantor trusts, LPs, or ETNs.

MAXIMUM CAP GAINS TAX RATE

 

STRUCTURE

LONG TERM

SHORT TERM

Open End (40 Act)

20%

39.60%

UIT (40 Act)

N/A

N/A

Grantor Trust (33 Act)

39.60%

39.60%

Limited Partnership (33 Act)*

27.84%**

27.84%**

ETN (33 Act)

39.60%

39.60%

 

*Distributes K-1 **Max rate of blended 60% LT/40% ST

20 20 ETF.com/ETF Report

 

How Transparent Are ETFs?

holding period of investors in the ETF. Investors should keep in mind that while monthly distributions from bond ETFs are often called “dividends,” inter- est from the underlying bond holdings aren’t considered qualified dividends, and are taxed as ordinary income. Funds can also pay out distribu- tions in excess of the fund’s earn- ings and profits, called ROC. ROC is generally nontaxable and reduces the investor’s cost basis by the amount of the distribution.

One of the key benefits of ETFs is that they offer better transparency into their holdings than competing mutual funds. The ability to verify your positions on a daily basis (in most cases) is a big plus. By law and by custom, mutual funds are only required to disclose their portfolios on a quarterly basis—and then only with a 30-day lag. In between reporting periods, inves- tors have no idea if the mutual fund is invested according to its prospectus, or if the manager has taken on unwanted risks. Mutual funds can and do stray from their described targets—a phenomenon known as “style drift”—which can negatively impact an investor’s asset allocation plan. ETFs are far more transparent. By custom, most ETFs disclose their full portfolios on public, free websites every single day of the year. If you go to www.ishares.com, for instance, you can find the complete holdings of almost every ETF in the world. You can see regularly updated ETF portfolios here at ETF.com, too. There is no law requiring that ETFs disclose their full portfolios every day. But even for those that disclose less frequently, there is a catch. ETF issuers each day publish the lists of what securities an authorized participant must deliver to the ETF to cre- ate new shares (“creation baskets”), as well as what shares they’ll get if they redeem shares from the ETF (“redemption baskets”). This—combined with the ability to see the full holdings of the index an ETF is aiming to track—provides an extremely high level of disclosure even for those few ETFs that fall short of the daily-disclosure ideal. Of note: All “actively managed” ETFs must, by law, dis- close their full portfolios every day. They are actually the most transparent of all ETFs.

MEDICARE SURCHARGE TAX Effective Jan. 1, 2013, singles with an adjusted gross income (AGI) of more than $200,000, and those married filing jointly with an AGI of more than $250,000, are now subject to an addi- tional 3.8% Medicare surcharge tax on investment income, which includes all capital gains, interest and dividends. This new tax is levied on the lesser of net investment income or modified AGI in excess of $200,000 single/$250,000 joint. Therefore, for investors in the highest tax brackets, their “true” tax rates on long-term capital gains and qualified dividends can reach 23.8% (20% capital gains plus 3.8% Medicare tax). Disclaimer: We are not professional tax advisors. This article is for informa- tional purposes only and not intended to be tax advice. Tax rules can change. Indi- viduals should always consult with a pro- fessional tax advisor for details about the tax implications of investment products and their personal taxes. Pending legisla- tion could materially affect the informa- tion in this article.

 

KEY TAKEAWAYS

• Mutual funds publicly disclose holdings quarterly; ETFs typically do so every day but don’t have to

• Active ETFs must publicly disclose holdings daily

• All ETFs must disclose holdings daily to APs

JANUARY 2018 21

21

 

Reputation Risk: From the perspective of advisors, avoiding funds at high risk of closure can help avoid egg-on- your-face phone calls to clients after recommending a fund that’s now closing: “Remember that great ETF I told you “

about? About that,

Reinvestment Risk: When an ETF delists or liquidates, it creates reinvestment risk for its investors—not to mention the extra and unnecessary burden associated with reinvesting.

Once you receive your cash-equivalent NAV, you’ve got to find somewhere else to put it, which could mean repeating the entire process that landed you in the ETF to begin with.

 

Like any business, even low-cost ETFs need to generate revenue to cover their costs.

Plenty of ETFs fail to garner the assets necessary to cover these costs and, consequently, ETF closures happen regularly.

Tax Burden: Since investors must either sell their shares or receive cash equivalents of NAV, they’re forced to realize any capital gains. Realizing capital gains earlier than planned can create an unanticipated tax burden.

In

fact, a significant percentage of ETFs are always at risk of

closure. There’s no need to panic though: Broadly speaking,

 

ETF investors don’t lose their investment when an ETF closes.

CLOSURE RISK FACTORS It’s relatively easy to predict likely candidates for closing, and a little homework can be good insurance.

A

closure can, however, be inconvenient and costly.

The good news is that for each high-closure-risk ETF out

 

Low Assets Under Management: Low AUM is one of

there, there is almost always a larger, more viable product available to suit your investment needs.

WHAT HAPPENS WHEN AN ETF CLOSES? Once the decision to delist or liquidate an ETF has been made, a prospectus supplement will state the ETF’s last trad- ing date and its liquidation date (if it has one). At this point, or soon after, “business as usual” ceases, and the fund halts creations as it prepares to convert to cash. This causes ETF performance to diverge from the perfor- mance of its underlying index. During this period, the ETF issuer will continue to publish indicative net asset value (iNAV) throughout the day, and it should still be referenced when buying or, more likely, selling the ETF. It’s generally advisable to sell any remaining shares you may be holding before the last day of trading.

DELISTING VS. LIQUIDATION When an ETF liquidates, investors generally receive cash distributions equal to NAV, so even if you fall asleep at the wheel, you’ll receive the fair value of your shares. Over the years, there’ve been a few instances where the process wasn’t smooth, but exceptions aside, liquidation is likely to be a less costly and cumbersome affair than delisting. When an ETF delists without liquidating its portfolio, investors who fail to sell their shares before the last trading date will be forced to trade over the counter—generally more complicated and costly.

DOWNSIDE OF CLOSURES Even if the delisting and closure goes smoothly, it can still be hugely inconvenient, for a few reasons.

the best indicators of closure risk. Funds with hundreds of millions of dollars are too profitable to close. The only problem with using AUM as an indicator of fund-closure risk is that you’re ruling out far too many ETFs. There are hundreds of ETFs with low AUM that do not close each year—and some of them are great products. Still, as a general rule of thumb, once a fund surpasses the $50 million mark in AUM, it’s far less likely to close.

Issuer Strength: Surprisingly, even more important than AUM in predicting fund closure is the strength of its issuer. Indeed, most ETF closures historically are the result of entire companies getting out of the ETF business, not big issuers simply closing ETFs that are slow out of the gate. Consequently, when evaluating whether a low-AUM fund is at risk of closure, consider the strength of its issuer as well as the issuer’s history and general culture surrounding closures.

Fund Rank In Segment: If a particular ETF is the least popular (by AUM) among 10 ETFs that offer similar exposure, it’s more likely to close than a similarly unpopular ETF that’s the only ETF offering exposure to a particular sector/country/strategy. Essentially, unpopular funds in oversaturated markets are at greater closure risk than unpopular funds offering unique exposure.

IN SUM Ultimately, don’t let media headlines about ETF closures invoke fear because, first and foremost, ETF investors usually don’t stand to lose when an ETF closes. Secondly, funds at risk of closure are largely easy to identify, which is to say that it should be easy for you to avoid the high-risk funds.

Managing & Avoiding ETF Closures

22 22 ETF.com/ETF Report

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Bonds are great. They offer safe, steady and predictable returns that have low correlations to stocks, making them an excellent way to balance higher-risk equities in a portfolio. But for the average investor, investing in individual bonds is next to impossible.

 

DOWNSIDES OF BUYING BONDS Investing in single bonds is difficult for many investors, due to:

Poor market transparency. Bonds trade over-the-counter (OTC), meaning there’s no single exchange on which they trade and no official agreed-upon price. The market is dif- ficult to navigate, and investors may find they receive widely different prices from different brokers for the same bond.

Poor liquidity. Bonds vary widely

Bond ETFs do not mature. Individual

in

their liquidity. Some bonds trade

bonds have a fixed, unchanging date at which they mature and inves-

tors get their money back; each day invested is one day closer to that result. Bond ETFs, however, maintain

daily, while others only trade weekly,

or even monthly—and that’s when markets work perfectly. In times of market distress, some bonds may stop trading altogether.

a

constant maturity, which is the

 

weighted average of the maturities

WHAT ARE BOND ETFs?

of

all the bonds in its portfolio. At

A

bond ETF is a bond investment in a

any given time, some of these bonds may be expiring or exiting the age range that a bond ETF is targeting (e.g., a one- to three-year Treasury Bond ETF kicks out all bonds with less than 12 months to maturity). As a result, additional bonds are contin- ually being bought and sold to keep the portfolio’s maturity constant.

stocklike wrapper. A bond ETF tracks an index of bonds and tries to repli- cate its returns. Though these instru- ments hold bonds and only bonds,

High markups. Broker markups on bond prices can be substantial, espe- cially for smaller investors; one U.S. government study found that mark- ups on municipal bonds can soar as high as 2.5%. Between these mark- ups, bid/ask spreads and the price of the bonds themselves, the cost to invest in individual bonds can add up—fast.

they trade on an exchange like stocks, giving them some attractive equity- like properties.

DIFFERENCES BETWEEN BONDS & BOND ETFs Bonds and bond ETFs may comprise the same basic investments, but exchange- trading changes the behavior of bond ETFs in several important ways:

Bond ETFs are liquid even in illiquid markets. The tradability of single bonds varies widely. Some issues trade daily, while others can trade as little as once a month. In times of stress, they may not trade at

BONDS VS. BOND ETFs

24 24 ETF.com/ETF Report

all. In contrast, bond ETFs trade on an exchange, meaning they can be bought and sold at any time during market hours, even if the underlying bonds themselves are not trading at the time. This has very real effects. For example, one source found that, on average, high-yield corporate bonds trade fewer than half the days each month; meanwhile, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) trades millions of shares each day.

prices are published publicly on the exchange and updated every 15 sec- onds during the trading day.

You can lose money if interest rates rise. Interest rates change over time. When they do, the value of bonds

may fall, and selling those bonds

More frequent income. Instead of

coupon payments every six months, bond ETFs usually pay interest monthly. Though the value may vary from month to month, monthly pay- ments give bond ETF investors a more regular income stream to use or reinvest.

can lead to losing money on your initial investment. With individual bonds, you mitigate the risk by just holding on to a bond until maturity, when you’ll be paid its full face value. Bond ETFs don’t mature, however, so there’s little you can do to avoid the sting of rising rates.

BOND ETF DRAWBACKS

Bond ETFs pay out monthly income.

There are two main downsides to bond ETFs.

You aren’t guaranteed to get your

BONDS OR BOND ETFs? For most investors, buying individual bonds is out of the question. Even if

One of bonds’ biggest benefits is that they pay out interest to investors on

a

regular schedule. Usually, these

 

it weren’t, bond ETFs offer diversity, liquidity and price transparency that single bonds can’t match, with the added benefits of intraday tradability and more frequent income payments. Bond ETFs do carry some additional risks, but all in all, they’re probably a better and more accessible option for the average investor.

coupon payments happen every six months. But bond ETFs hold many different issues at once, and at any

money back. Because bond ETFs never mature, they never offer the same protection for your initial investment the way that individual bonds can. In other words, you aren’t guaranteed to get your money back at some point in the future. However, some ETF providers have begun issuing ETFs with specific matu- rity dates, which hold each bond until they expire and distribute the proceeds once all bonds have matured. Guggen- heim, for example, offers 20 invest- ment-grade and high-yield corporate

given time, some bonds in the portfo-

lio

may be paying their coupon. As a

result, bond ETFs usually pay interest monthly, rather than semiannually; the value of this payment can vary from month to month.

BOND ETF ADVANTAGES Bond ETFs offer many advantages over single bonds:

   

Diversification. With an ETF, you can own hundreds, even thousands, of bonds in an index at a purchase price significantly less than what it would

bond target-maturity-date ETFs under its BulletShares brand, with maturities at different years (2017, 2018 and so on); iShares offers 17 target-maturity-

   

be

to invest in each issue individually.

date bond ETFs.

It’s institutional-style diversification

at retail prices.

 

BOND VS. BOND ETFs

 

Ease of trading. No more wading

through the opaque OTC markets to haggle over prices. You can buy and sell bond ETFs from your regular brokerage

 

BONDS

BOND ETFs

• Have a specific, set

• Never mature*

account with the click of a button.

 

maturity date

• Often more liquid than their

Liquidity. Bond ETFs can be bought

• Have poor liquidity

underlying securities

and sold at any time during the trad- ing day, even in overseas or smaller markets where individual issues might trade much less frequently.

• Usually pay coupon

• Usually pay out interest

 

semiannually

monthly

• Have poor market

• Transparent and

   

transparency; broker

easy trading

Price transparency. With a bond ETF, there’s no more uncertainty over what your investment is worth: ETF

 
 

markups

   

*With the exception of target-maturity bond ETFs

JANUARY 2018 25

25

Managed by the portfolio team at Dimensional Fund Advisors

Joel P. Schneider

Lukas J. Smart, CFA

Fund Advisors Joel P. Schneider Lukas J. Smart, CFA Decades of academic research behind every ETF
Fund Advisors Joel P. Schneider Lukas J. Smart, CFA Decades of academic research behind every ETF

Decades of academic research behind every ETF

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you could pay to buy the bond, so there’s a “natural” depression in the reported NAV of all bond ETFs. For all of these reasons, it’s not uncommon that a highly liquid bond ETF can serve as price discovery for the true fair value of the basket of bonds it holds. In other words, the market price of the bond ETF can be a better approximation of the aggre- gate value of the ETF’s underlying basket bonds than its own NAV. Therefore, large premiums and dis- counts do not necessarily signal any mispricing in the ETF.

ETFs typically trade at something close to “fair value.” That is, if you calculated the intraday value of all the securities an ETF holds, that would roughly align with the price of the ETF.

PRICE DISCOVERY & THE ETF WRAPPER The idea of price discovery— where the ETF’s market price is actually “ahead” of its NAV and is the best representation of fair value—shows up in other corners of the ETF world. For example, imagine a Japanese equity fund. The underlying stocks trade in Tokyo during their day, but the ETF trades throughout the U.S. trading day. Negative Japan news occur- ring in the morning here in the U.S. after the Tokyo market closes will depress the ETF share price, but its NAV will be unchanged, producing a large discount on that day. To be clear, large premiums and discounts can’t be safely ignored in all cases, and ETF share prices aren’t always in the right when they don’t match NAV. Sometimes large premiums and discounts signal that the ETF itself trades poorly and is therefore a lousy price-discovery vehicle. Still, the relative illiquid- ity of the bond market means that bond ETF premiums and discounts can’t be relied upon blindly. One general rule: A bond ETF is likely to be an efficient price- discovery vehicle—and therefore indicate that any large premiums and discounts aren’t a sign of trou- ble—if the ETF’s shares trade with great frequency and high volume.

The process that keeps ETFs trading at “fair value” is the creation/ redemption mechanism (explained on page 14). If, at any time, the price of the ETF deviates from the price of the underlying portfolio, institutional investors can swoop in and arbitrage the difference.

There are various ways and places that this near-perfect relationship gets upset. The most high-profile— and important—is in fixed income. Fixed-income ETFs—particularly in times of stress—can trade to mas- sive premiums or discounts to their net asset values (NAVs). The question this article aims to answer is: Is this a problem with the

traded price might not be current at all. Second, they don’t trade on an exchange: Most bond trades are individual “over the counter” agree- ments between two parties. Third, bonds come in much greater vari- ety than stocks; for example, Exxon has many bond issues, each with different maturities and coupons, and each requiring its own price.

ETF or a problem with the underly- ing bond market?

 

BOND MARKET IS DIFFERENT Compared with stocks—like those in the S&P 500, which trade throughout the day on the NYSE and Nasdaq—bonds are relatively illiquid, and their true price is harder to know with certainty. For example, shares of Apple are fungible, so the last price at which a share was traded is a very good representation of the current value of every Apple share. The bond market is different. First, bonds trade much less frequently than stocks—so the last

The market price of the bond ETF can be a better approximation of the aggregate value of the ETF’s underlying basket bonds than its own NAV

Fourth, ETF issuers generally rely on bond pricing services for “fair” value estimations of their holdings; these estimations are based on the current selling price the fund might receive were it to start selling its bonds immediately. That fire-sale price will always be less than what

Fixed-Income ETFs During A Panic

28 28 ETF.com/ETF Report

ETFs let investors express a vast number of view- points—including if an investor expects prices
ETFs let investors express a vast number of view- points—including if an investor expects prices
ETFs let investors express a vast number of view- points—including if an investor expects prices

ETFs let investors express a vast number of view- points—including if an investor expects prices to fall, or wants to magnify a return.

the risk they’re taking on a daily basis, says Todd Rosenbluth,

director of ETF and mutual fund research for CFRA. These funds often are designed to have returns two or three times their benchmark on a daily basis. Meanwhile, inverse ETFs allow investors to easily short an index if they believe the price will fall. But the vehicles used to place these trades—leveraged and inverse ETFs—often have poor returns. “They’re intended to move more aggressively than the broader market that they’re representing. If the trend flips, you can get hurt very quickly. You can make money very quickly, and it’s usually the getting hurt very quickly that investors tend to not see coming,” Rosenbluth said.

DAILY RESETS ERODE RETURNS The problem investors run into with these funds occurs when people hold them for more than a day or two, say Rosenbluth and Brett Manning, senior market analyst at Briefing.com. Because they reset daily, arithmetic works against buy- and-hold investors, Manning says. Manning used a hypothetical example to explain the long-term drag for leveraged performance. If an index on Monday is at 10, on Tuesday rises to 11 and on Wednesday falls back to 10, a double-leverage long ETF would rise to 12, but then fall to 9.82. It rose 20% on Tuesday, but fell 20% on Wednesday. Because a 20% drop from the higher number

EXPOSURE

EXPOSURE EXPOSURE BEFORE AFTER LEVEL RESET RESET INDEX 100 -2X ETF 100 -200 -200 INDEX
EXPOSURE
EXPOSURE
BEFORE
AFTER
LEVEL
RESET
RESET
INDEX
100
-2X ETF
100
-200
-200
INDEX UP 10%
INDEX
110
ETF LOSES 20%
-2X ETF
80
-220
-160
INDEX DOWN 10%
INDEX
99
ETF GAINS 16%
-2X ETF
96
-144
-192
DAY 3
DAY 2
DAY 1

leads to a larger nominal decline, the investor loses money.

Conversely, in a double-leverage short using the same index, the investor’s ETF would fall to 8, but only rise to 9.46, because the rise is off a smaller number. The same mathematical problem arises in a market that is range-bound, Manning notes. Even in range-bound markets, leveraged and inverse ETFs eat away at long-term returns because the moves are asym- metrical. Because the moves are magnified, the declines from higher levels are compounded, and the rebounds don’t get investors back to par because it takes more of a rally to make up the losses. So when prices drift around in range-bound markets, it’s a little like death from a thousand cuts because

it’s a little like death from a thousand cuts because MARKET DIRECTIONS CHANGE QUICKLY Some investors

MARKET DIRECTIONS CHANGE QUICKLY Some investors like to use leveraged/inverse ETFs when they see a market that has a strong directional trend, such as the drop in the oil market in late 2014 and early 2015. But part of the poor performance of these funds exemplifies how quickly strong directional market trends can change, Rosenbluth and Manning say. “You may have a thesis, but you have to be an expert in understanding price moves, and these are geared to a retail investor who doesn’t have a lot of time to formulate those ideas. The payoff is not going to be that way. If they get lucky, it’s like winning the lottery. But if you don’t get out in time, you can quickly lose gains,” Manning said. Because of the volatile nature of these ETFs, many bro- kerage platforms don’t allow them for advisors to use to put forward trades, Rosenbluth said, “because they’re more akin to gambling than investing.” Rosenbluth and Manning say these ETFs are really designed more for frequent trading, or to try and time the market. Still, they cautioned investors using them. “They can serve a purpose, but they can also be some- thing that causes investors to lose money faster than they anticipated,” Rosenbluth said.

but they can also be some- thing that causes investors to lose money faster than they

Leveraged ETFs allow investors to take a chance to enhance ADVERTISEMENT investors usually don’t break even.

The Problem With Inverse/ Leveraged ETFs

Institutional Rock Star

Oldest U.S. ETF started as a trading tool for institutions. So it remains.

By Lara Crigger

ASSETS IN SPY, 1993-2017 YTD

AUM ($M) 300,000 250,000 200,000 150,000 100,000 50,000 0 ‘93 ‘94 ‘95 ‘96 ‘97 ‘98
AUM ($M)
300,000
250,000
200,000
150,000
100,000
50,000
0
‘93
‘94 ‘95
‘96
‘97
‘98
‘99
‘00
‘01
‘02
‘03
‘04 ‘05
‘06 ‘07
‘08 ‘09
‘10
‘11 ‘12
‘13 ‘14
‘15
‘16 ‘17

Source: Bloomberg. Data as of 12/4/17

The SPDR S&P 500 ETF (SPY), which turns 25 this month, is The Clash of investing:

counterculture and revolutionary for its time, now a favorite of those in business suits and corner offices the world over. This first U.S.-listed—and still the larg- est at the global level—ETF was unlike any- thing that came before it. Eventually it would come to upend decades of accepted financial wisdom, bending the investment paradigm around it. Thanks to SPY, and the ETF revolu- tion it kick-started, investors stopped think- ing of the markets in terms of inefficiencies to exploit, and began dividing it into risks and exposures, with allocations to each. Money management was never the same again. “SPY transformed the way investors thought about investing,” said Jim Ross, executive vice president of State Street Global Advisors and chairman of the Global SPDR Business. “I can’t say that was even a twinkle in our eye 25 years ago.” Although SPY was never intended to be more than a trading tool for institutions, it quickly became a must-have fund for all market participants, from hedge funds to mom-and-pops. And though SPY has ceded market share in recent years to its lower- cost competitors, its unrivaled liquidity and name recognition prove there’s plenty of life left in this Casbah to rock.

FIXING A STOCK MARKET CRASH With over $250 billion in assets, SPY is by far the largest U.S. ETF; it’s nearly double the size of the next-largest fund, the iShares S&P

largest U.S. ETF; it’s nearly double the size of the next-largest fund, the iShares S&P 30 

500 ETF (IVV). But when SPY first launched, nobody—not even its originators—expected it to become the juggernaut it is today. “The folks working on SPY thought there might be three or four ETFs in the U.S.,” in total, says Ross. SPY was the brainchild of Nate Most and Steven Bloom, the two-person product development team at the American Stock Exchange who, in the 1980s, were tasked with reverse-engineering a product that could have withstood the 1987 Black Mon- day stock market crash. They devised a concept based on “ware- house receipts”—documents that show proof of ownership over a quantity of stored commodities. To shift ownership, commodity traders would exchange these receipts instead of moving product from warehouse to warehouse. Most and Bloom wondered if something similar might work for equity markets:

Stocks could be “warehoused” in a unit investment trust (UIT), shares of which investors could trade as much as they liked, without impacting the underlying stocks or incurring trading costs for fellow investors. “It would offer all the instant access of futures, but backed by something physi- cal,” said Eric Balchunas, senior ETF ana- lyst for Bloomberg Intelligence. Though individual elements of the concept weren’t new, the idea of an index- based UIT trading intraday on an exchange was. Most and Bloom’s idea took over five years to get off the ground, and several

banks and fund companies passed on it, including Wells Fargo Nikko, which even- tually became Barclays Global Investors and then iShares. Then, in 1990, AMEX approached State Street, which agreed to serve as trustee to the new UIT. Its backing of the product gave SPY the credibility it needed to be taken seriously by large institutions, the primary intended user.

redemption mechanism, which involves the in-kind exchange of a fund’s underly- ing securities for shares of the ETF, and vice versa. Special market makers known as “authorized participants” could make money by arbitraging the differences in dollar value that arose between SPY’s shares and its underlying securities. Doing so also benefited the ETF by pushing its net asset value closer to the value of its under- lying stocks, thus ensuring SPY would trade near fair value throughout the day. Creation/redemption was initially incorporated to keep costs in SPY low. But it also shifted SPY’s trading costs in a way that made it more transparent and inves- tor-friendly than either futures or mutual funds. That made it especially appealing to institutions, which began to use SPY instead of futures as an overnight hedging vehicle; or in place of mutual funds to gain inexpensive large-cap diversification. Fortuitously, creation/redemption also ended up being more tax efficient than mutual funds, as redemptions could occur using in-kind exchanges of securities instead of selling off stock for cash and gen- erating capital gains. Unlike with a mutual fund, unwinding a SPY position didn’t mean a tax hit to investors left in the fund. “With mutual funds, it was disrup- tive to remaining shareholders if a market timer was constantly moving in and out of your fund,” said Kevin Quigg, former

SPY LAUNCHES & STUMBLES On Jan. 22, 1993, SPY received its initial seeding: $6.53 million—a paltry sum today—and began trading a week later. It debuted with a splash: On its first day, SPY traded just over 1 million shares. The fund grew quickly. By the end of the summer, the fund had $270 million in assets, with daily volume of at least 100,000 shares. Volume, and assets, climbed higher every day. It wasn’t all smooth sailing for SPY, however. In 1994, a year after SPY launched, the ETF saw net outflows instead of inflows, a troubling sign for a brand- new investment product. But those flows quickly reversed in 1995, and SPY hit its first $1 billion in assets that year. It then doubled in size almost every year until the dot-com crash. The “SPDR,” or “spider” as it was called, had found its legs.

SPY’S SECRET SAUCE SPY’s secret sauce, and ultimately the

secret sauce of all ETFs, was its creation/

Global Head of SPDR ETF Sales Strategy

the secret sauce of all ETFs, was its creation/ Global Head of SPDR ETF Sales Strategy
the secret sauce of all ETFs, was its creation/ Global Head of SPDR ETF Sales Strategy

JANUARY 2018 31

1ST CREATION ALMOST DIDN’T HAPPEN

Not many people know the world’s first S&P 500 ETF was almost an S&P 499 ETF.

“The night before filing, somewhere between all the cutting and pasting, we had lost a secu- rity,” said Jim Ross, executive vice president of State Street Global Advisors and chairman of the Global SPDR Business. Though it’s hard to imagine today, with thou- sands of ETF creations and redemption orders occurring simultaneously throughout the trad- ing day, someone, at some point, had to build the first creation unit. Someone had to make sure the plumbing SPY ran on actually worked. And it almost didn’t. “It was a brand-new process. We were fig- uring this out on the fly,” said Ross. Ross, then a fresh-faced State Street employee, had joined the company’s SPY team just months before launch. He helped usher SPY through its final, first-of-its-kind prepara- tions: Whereas other unit investment trusts created new shares in cash, SPY was designed to create in-kind, with securities, which required extra steps. At 4 p.m. the day before filing, State Street had to take a creation unit’s worth of the secu- rities in the S&P 500 Index, price it, then have the financial statements audited by Pricewater- houseCoopers overnight, so they’d be ready to file with the SEC at 9:30 the next morning. At some point in all those steps and print- outs, they lost a security. “Literally the auditor is trying to add up the portfolio, and it’s not adding up, because there were only 499 securities,” said Ross. To find the missing security—”I don’t even remember which one it was anymore,” said Ross—meant frantically combing through the pricing document, page by page, security by security, at 11:30 p.m. They eventually found the missing stock, and the initial seed audit and registration went off without a hitch. But Ross never forgot how it almost all fell apart before it began. “Today it all happens instantaneously, elec- tronically and very straightforward,” he said. “But then, although we had tested it a lot, hon- estly, we were still just hoping it would work.”

Group and current chief strategist for ASCI Funds. “Not only could you do that with SPY and it wouldn’t be frowned upon, it was beneficial to the other shareholders, because it created liquidity.”

RIAs, ONLINE BROKERAGES BOOST ADOPTION As SPY grew larger, so did its appeal to the investment community out- side of institutional traders. In large part, that was driven by the online brokerage, which came of age in the dot-com boom and made security trading open to everybody, not just broker-dealers or large institutions. Online brokerages peeled back the curtain before stock-picking and “deconstructed active management,” says Quigg, thus encouraging SPY’s adoption by retail investors and the growing fee-only RIA community. “Suddenly, technology made it very easy for you to buy a stock, or an ETF,” he added. “With SPY, you could take more control over your book of business.”

WORLD’S MOST LIQUID SECURITY Today SPY is the most liquid and well-traded security in the world, with less-than-a-penny spreads and an average daily volume of 53 million shares. Nothing else even comes close: AAPL, the world’s most-traded stock, has an average daily volume of 28.6 million shares. SPY still has a devoted institu- tional following: According to 13-F filings, 70% of SPY’s ownership is by institutions, such as J.P. Morgan Chase (13%), Bank of America (7.7%) and Goldman Sachs (4.6%). “For any institutional investor, SPY’s pretty much the go-to,” said Bloomberg’s Balchunas. That’s in no small part a quirk of its structure. As a UIT, SPY must replicate its index exactly, and can’t reinvest any dividends—meaning it

provides purer exposure to its index than competing ETFs, at a cheaper price than futures. “SPY trades very consistently with how you’d see futures trade,” said SSGA’s Ross. “Institutions that trade a lot appreciate that.” Yet SPY has as many uses as it does users: transition manage- ment, risk management, and of course, good ole-fashioned large- cap exposure. SPY also has the deepest and most liquid options market in the world. “SPY is like a Swiss army knife,” noted Balchu- nas. “It means a lot of things to a lot of different people.”

SPY IN FEE WARS SPY has an expense ratio of 9 basis points, making it more than twice as expensive as IVV and the Vanguard S&P 500 ETF (VOO), at 4 basis points each. As such, the two have steadily eroded market share from SPY, which saw net outflows of $6.7 billion through early December this year, while overall ETF inflows have shat- tered old records. Whereas SPY once represented more than 60% of all assets in the ETF marketplace, today the fund only accounts for 7.5%. SPY, which debuted with an expense ratio of 0.20%, has also had its share of price-drops over the years; in fact, the ETF structure was designed to be a low-cost alterna- tive to other trading instruments, like futures. Yet State Street isn’t worried about SPY’s future, because for its main users—institutions—SPY’s total cost of ownership is often substan- tially lower than the competition. “Depending on what your holding period is, the cost of buying and selling can overwhelm the benefit of expense ratio,” said Ross. “[Institutions] are more concerned about liquidity, spread and consistency of markets than what is a very small basis-point

difference” in expense ratios.

difference” in expense ratios.
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SMART BETA CORNER

MANAGING RISK WITH FACTORS

Factor diversification can help lower downside risk

FACTORS Factor diversification can help lower downside risk By Larry Swedroe THE “HOLY GRAIL” OF INVESTING

By Larry Swedroe

THE “HOLY GRAIL” OF INVESTING IS THE SEARCH FOR INVESTMENT STRATEGIES THAT CAN DELIVER HIGHER EXPECTED RETURNS WITHOUT INCREASED RISK, OR THE SAME EXPECTED RETURN WITH REDUCED RISK. In our 2014 book, “Reducing the Risk of Black Swans,” my co-author Kevin Grogan and I showed how, for 20 years, our firm, Buckingham Strategic Wealth, has been using what we refer to as the science of investing (evidence from peer- reviewed academic journals) to help investors build more efficient portfolios—portfolios that not only have delivered higher risk-adjusted returns, but have significantly reduced the negative impact of rare events known as “black swans.” The “secret sauce” was adding exposure to factors (such as size and value) that provided a unique/independent source of excess return. In addition, these factors should be persistent across long periods of time, pervasive across the globe and asset classes, robust to various definitions, imple- mentable (meaning they survive transaction costs), and have logical risk- or behavioral-based explanations for why we should expect the premium to continue. By adding exposure to factors that not only provide higher expected returns but also uncorrelated returns, investors can lower their portfolio’s exposure to market beta and increase their exposure to safe bonds. In other words, they can lower their allocation to equi- ties because the equities they hold have higher expected returns. As the following example shows, the result has been, at least historically, more efficient portfolios.

35 YEARS OF DATA Due to data limitations, we’ll examine the 35-year period from 1982 through 2016. We will look at two portfolios, A and B. Portfolio A has a typical allocation of 60% S&P 500 Index/40% five-year Treasury notes. Portfolio B will hold 25% stocks and 75% five-year Treasury notes. With U.S. stocks representing roughly half of the global equity market capitalization, we will split the equity allocation equally between U.S. small value stocks (using the Fama-French U.S. Small Value Index) and international small value stocks (using the Dimensional International Small Cap Value Index). (See Figure 1.) As you can see, while Portfolio A produced an annualized return 0.6 percentage points higher than Port-folio B (10.3% versus 9.7%), it did so while experi- encing volatility 3.1 percentage points greater (10.3% versus 7.2%). In relative terms, Portfolio A’s annual- ized return was only 6% greater than Portfolio B’s, while the volatility it experienced was 43% greater. In addition, Portfolio B had fewer events in the “tails” of the return distribution (said another way, it had both fewer extremely good and fewer extremely bad return years). While Portfolio A had 11 years with returns greater than 15%, Portfolio B had nine. And while Portfolio A had just a single year with a loss of

greater than 15%, Portfolio B never experienced a loss that large. Moving the hurdle to years with 20% gains/losses, we see that Portfolio A had seven years with returns greater than that level, and no years with losses of that size, while Portfolio B had just two years of gains that large. Moving the hurdle to the 25% level, both Portfolio A and Portfolio B had two years with returns in excess of that amount and no years with losses that great. The best single year for Portfolio A was 1995, when

it

returned 29.3%. The best single year for Portfolio

B

was 1985, when it returned 28.0%. Note that while

Portfolio B has just 25% in equities, its best year was almost as good as the best year for Portfolio A, which has 60% in equities. On the other hand, Portfolio A’s worst single year was 2008, when it lost 17.0%. The worst single year for Portfolio B was 1994, when it lost just 1.2%. What’s more, while Portfolio A experienced five years of negative returns, Portfolio B experienced just three. Portfolio B was not only the more efficient port-

folio, it offered much greater downside protection. Thus, Portfolio B should be greatly preferred by risk- averse investors, especially those in the withdrawal phase of their investment careers, when the order of returns increases in importance.

SUPPORT FOR FACTOR DIVERSIFICATION Louis Scott and Stefano Cavaglia, authors of the study “A Wealth Management Perspective on Factor Premia and the Value of Downside Protection,” published in the Spring 2017 issue of the Journal of Portfolio Man- agement, provide support for the benefits of factor diversification. The focus of their study, which examined four factors (value, size, momentum and quality), was to determine if factor diversification improved terminal wealth, and if it improved the odds of retirees in the withdrawal phase not outliving their portfolios. Figure 2, which did not come from the study, shows the annual correlation of returns of the four factors in U.S. equities for the period 1964 through 2016. Observe the negative correlations of the value, momentumand quality factors to market beta. Even the size factor does not have a high correlation to market beta. These low/negative correlations should provide the dual benefits of diversification and down- side protection. To test their hypothesis, Scott and Cavaglia con- sidered a baseline investment strategy comprising a passive, fully invested exposure to global equities over a 20-year horizon. They then examined the effect of adding an overlay of factor premiums on the distribu-

35 YEARS OF DATA

FIGURE 1

PORTFOLIO A

PORTFOLIO B

Annualized Returns/Standard Deviation (%)

10.3/10.3

9.7/7.2

Years with Returns Above 15%/Below -15%

11/1

9/0

Years with Returns Above 20%/Below -20%

7/0

2/0

Years with Returns Above 25%/Below -25%

2/0

2/0

Worst Year Return/Best Year Return (%)

-17.0/29.3

-1.4/28.0

Number of Years With Negative Return

5

3

Portfolio A: 60% S&P 500/40% five-year Treasury notes. Portfolio B: 12.5% Fama-French U.S. Small Value (ex-utilities) Index/12.5% Dimensional International Small Cap Value Index/75% five-year Treasury notes.

JANUARY 2018 35

SMART BETA CORNER

LOW/NEGATIVE CORRELATIONS

   

FIGURE 2

FACTOR

BETA

SIZE

VALUE

MOMENTUM

QUALITY

BETA

1.00

0.28

-0.23

-0.18

-0.52

SIZE

0.28

1.00

0.01

-0.13

-0.52

VALUE

-0.23

0.01

1.00

-0.21

0.04

MOMENTUM

-0.18

-0.13

-0.21

1.00

0.27

QUALITY

-0.52

-0.52

0.04

0.27

1.00

Source: Larry Swedroe

tion of terminal wealth. They used utility functions to quantify the hedging benefits of factor premiums to the baseline investment strategy. Their data set covers the period November 1990 through December 2012. The authors used a bootstrapping technique (rather than a Monte Carlo simulation) to simulate returns in a way that preserved the autocorrelation observed in markets. They used the bootstrap simula- tions to generate alternative histories for the market and the four factor premiums. They then used these histories to generate ter- minal wealth distributions from investing $1 across alternative investment strategies. The alternative investment strategies they considered were an invest- ment in the global equity market, an investment in the global market complemented by an overlay in a risk premium (each factor considered independently), and an investment in the market complemented by an overlay of an equal-weighted (1/N) allocation to each factor premia.

In the case of a single factor, the overlay is $1 invested in the long side of the premium and $1 invested in the short side. In the case including all four factors, each factor has $0.25 invested in the long side and $0.25 invested in the short side. The portfo- lios were rebalanced monthly. Figure 3 shows the terminal wealth at various percentiles of performance. For example, while $1 invested in the global market grows to a median value of $4.17 after 20 years, the fifth percentile of termi- nal wealth shows a value of $1.06, the first percentile shows a loss of 44%, and the top percentile (the 99th) shows an increase of more than twentyfold. Note that with the sole exception of the first per- centile of the portfolio that includes the global mar- ket plus the size factor overlay, the outcomes are improved. That particular outcome is due to the pro- cyclical nature of the size factor. However, results are quite different when we look at the portfolio with the quality factor overlay. This should not be surprising, because quality tends to out- perform in negative market environments. That said, the downside protection did not come with an offset- ting reduction in terminal wealth at any percentile. In all cases, relative to the global market portfolio, the 1/N diversified portfolio produced dramatically superior results, enhancing both downside protection and terminal wealth in good environments.

WHAT IF FACTOR PREMIUMS DECLINE? Given that research has shown factor premiums tend, on average, to shrink by about one-third post-publica- tion, Scott and Cavaglia then considered what would

TERMINAL WEALTH AT VARIOUS PERFORMANCE PERCENTILES

FIGURE 3

GLOBAL MKT

 

GLOBAL

GLOBAL

GLOBAL

GLOBAL

GLOBAL

& PREMIA

PERCENTILE

MKT

MKT & SMB

MKT & HML

MKT & UMD

MKT & QMJ

PORTFOLIO

0.01

0.56

0.53

1.16

1.19

2.46

1.52

0.05

1.06

1.09

2.27

2.65

3.62

2.68

0.10

1.46

1.52

3.20

4.07

4.44

3.60

0.25

2.46

2.67

5.56

7.96

6.25

5.65

0.50

4.17

4.86

9.97

16.13

8.96

9.10

0.75

7.01

8.62

16.94

32.34

12.56

14.45

0.90

10.56

13.72

12.96

56.30

16.88

20.92

0.95

13.02

18.32

34.68

79.38

19.87

25.93

0.99

20.30

30.85

55.97

147.53

26.76

36.65

Source: Scott and Cavaglia, 2017

happen if the factor premiums shrunk to half the historical levels. As Figure 4 shows, the portfolio of factor premiums continues to mitigate most of the unfortunate tail (the lower 5%) of the cases in which the investor’s terminal wealth is lower than at the starting point while improving ter- minal wealth in almost all other cases—the 1/N overlay portfolio has higher terminal wealth in all percentiles, and avoids a loss even at the first percentile. The authors also performed an interesting test. They compared the performance of a port- folio fully invested in global equities managed by an investor with market-timing skill set at 10% (they could accurately forecast 10% of bear markets, a high hurdle given the lack of evi- dence supporting the view that bear markets can be forecasted) with the performance of a strategy fully invested in global equities and an overlay of equal-weighted factor premiums. They found that the distribution of termi- nal wealth across all percentiles is greater for the factor premiums strategy than for the skill- based strategy. In other words, the factor pre- miums strategy dominates the skill-based one, creating a very high hurdle for active manage- ment in terms of ability to time markets.

DOES FACTOR DIVERSIFICATION MAKE THE ROAD LESS BUMPY? Scott and Cavaglia next tested to see if the factor portfolio allowed investors to “sleep better,” per- haps improving their ability to stay disciplined and avoid panicked selling. They noted that the median value of the drawdowns for a strategy fully invested in the market was 0.43 (a loss of 43%), suggesting investors will be exposed to at least one sizable, nasty event on their journey to achieving their retirement goals. The authors found that the overlay portfolio can smooth the ride, providing smaller draw- downs at every percentile, even with the 50% haircut to the premiums applied. Scott and Cavaglia also considered the utility of the downside protection. The research shows

TERMINAL WEALTH WHEN FACTOR PREMIUMS SHRINK

FIGURE 4

GLOBAL MKT

 

GLOBAL

GLOBAL

GLOBAL

GLOBAL

GLOBAL

& PREMIA

PERCENTILE

MKT

MKT & SMB

MKT & HML

MKT & UMD

MKT & QMJ

PORTFOLIO

0.01

0.56

0.48

0.75

0.55

1.59

1.00

0.05

1.06

0.97

1.48

1.32

2.40

1.76

0.10

1.46

1.37

2.08

2.01

3.03

2.38

0.25

2.46

2.44

3.60

3.99

4.23

3.78

0.50

4.17

4.41

6.36

8.23

5.99

6.15

0.75

7.01

7.85

11.03

16.19

8.49

9.65

0.90

10.56

12.86

17.53

28.37

11.40

14.11

0.95

13.02

16.86

22.90

38.70

13.55

17.29

0.99

20.30

27.51

36.21

70.31

18.55

24.96

investors are, on average, risk-averse. There- fore, they are willing to “buy insurance” (accept lower expected returns) to protect against downside losses. Using utility functions, with varying degrees of risk aversion, they found that, in all cases, the value of downside protec- tion provided by the factor overlay portfolio (benchmarked against the market P&L) is eco- nomically large and significant, emphasizing the factor overlay portfolio’s protection against individuals’ aversion to losses.

SUMMARY Scott and Cavaglia showed the distribution of terminal wealth of a market portfolio strategy can be significantly enhanced via an overlay that allocates capital equally across the four premiums they studied. In particular, the factor exposures help to mitigate downside risk. Importantly, their sim- ulations demonstrated that, even if the means of the premiums were halved, their drawdown mitigation properties would be preserved. Finally, they showed that active asset allo- cation strategies require significant market- timing skill to outperform a passive factor-pre- mium-based overlay strategy. Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

registered investment advisors throughout the country. Source: Scott and Cavaglia, 2017 FACTOR EXPOSURES HELP TO

Source: Scott and Cavaglia, 2017

FACTOR EXPOSURES HELP TO MITIGATE DOWNSIDE RISK

JANUARY 2018 37

I N R E V I E W By Heather Bell November was a great

IN REVIEW

By Heather Bell

November was a great month for

sector ETFs, with the consumer cyclicals sector leading the way with an average increase of 5.58%, while the technology sector was the worst performer, with an average increase of 0.74%. The SPDR S&P Retail ETF (XRT) was up 10.68%, while the iShares U.S. Broker-Dealers & Securities Exchanges ETF (IAI) was up 6.33% and the SPDR S&P Homebuilders ETF (XHB) was up 5.97%. Only two funds were in the red for the month: The iShares North American Tech-Software ETF (IGV) was down 0.37% and the iShares U.S. Telecommunications ETF (IYZ) was down 0.2%. In terms of flows, the Financial Select Sector SPDR Fund (XLF) pulled in the most, at $1.5 billion, while the Consumer Discretionary Select Sector SPDR Fund (XLY) pulled in $723.8 million and the SPDR S&P Retail ETF (XRT) fund pulled in $530.9 million. The Technology Select Sector SPDR Fund (XLK) lost $635.8 million, while the Health Care Select Sector SPDR Fund (XLV) lost $376.9 million and the Energy Select Sector SPDR Fund (XLE) lost $348.2 million.

Energy Select Sector SPDR Fund (XLE) lost $348.2 million. T o p I n fl o
T o p I n fl o w s

Top Inflows ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

 

TICKER

NET FLOWS

AUM ($M)

 

Financial Select Sector SPDR

XLF

1,515.6

31,599.7

Financials

Cons Discr Select Sector SPDR

XLY

723.8

12,848.6

Consumer Cyclicals

SPDR S&P Retail

XRT

530.9

869.9

Consumer Cyclicals

Vanguard REIT

VNQ

396.8

35,191.1

Real Estate

iShares U.S. Real Estate

IYR

352.6

4,425.6

Real

Estate

T o p O u t fl o w s

Top Outflows |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||

 

TICKER

NET FLOWS

AUM ($M)

Technology Select Sector SPDR

XLK

-635.8

18,688.1

Technology

Health Care Select Sector SPDR

XLV

-376.9

17,289.8

Health Care

Energy Select Sector SPDR

XLE

-348.2

16,353.9

Energy

iShares US Financial Services

IYG

-106.6

1,509.3

Financials

SPDR S&P Metals & Mining

XME

-97.3

675.3

Basic Materials

Sector

Performance

NOVEMBER 2017

BASIC MATERIALS

CONS. CYCL.

CONS. NON-CYCL.

ENERGY

FINANCIAL

HEALTH CARE

INDUSTRIAL

REAL ESTATE

TECH

 

TELECOM

 

UTILITIES

 

BROAD

BROAD

BROAD

BROAD

BROAD

BROAD

BROAD

BROAD

BROAD

 

BROAD

 

BROAD

 

XLB

XLY

XLP

XLE

XLF

XLV

XLI

IYR

XLK

 

IYZ

 

XLU

1.00%

5.06%

5.56%

1.77%

3.48%

2.90%

4.07%

2.51%

1.44%

 

-0.20%

 

2.73%

MINING

HOMEBLD

FOOD

EQUIP.

BANKS

BIOTECH

DEFENSE

BROAD

INTERNET

 

BROAD

 

BROAD

 

XME

XHB

PBJ

IEZ

KBWB

IBB

PPA

VNQ

FDN

VOX

 

VPU

0.79%

5.97%

3.78%

1.09%

3.33%

0.57%

2.49%

2.64%

1.40%

2.47%

2.82%

 

MEDIA

 

EXPLOR

BANK&IN

MED.DEV

TRANSPO

 

SEMIS

   

PBS

XOP

IAI

IHI

IYT

XSD

2.13%

4.21%

6.33%

3.04%

5.54%

0.47%

 

RETAIL

   

SERVICES

PHARMA.

ENGINEER

 

SOFTWARE

   

XRT

IYG

IHE

PKB

IGV

10.68%

3.70%

1.98%

4.56%

-0.37%

 

LEISURE

     

EQUIPMENT

         

PEJ

XHE

4.05%

4.01%

         

SERVICES

         

IHF

4.93%

///////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////

KEY:

-

KEY: - 0 ≤ 0.9 +
KEY: - 0 ≤ 0.9 +
KEY: - 0 ≤ 0.9 +
KEY: - 0 ≤ 0.9 +
0 ≤ 0.9
0
≤ 0.9
KEY: - 0 ≤ 0.9 +
KEY: - 0 ≤ 0.9 +
KEY: - 0 ≤ 0.9 +

+

Source: Bloomberg. Data from 10/31/2017-11/30/2017. ETFs chosen to represent each sector based on the most liquid ETF in each segment of the ETF.com ETF Classification System.

 

≤-5.0

-3.0 ≤-4.9

-1.0 ≤-2.9

-0.1 ≤-0.9

≤ 2.9

≤ 4.9

≥ 5.0

 

0.1

1.0
3.0

Why buy a single stock when you can invest in the entire sector?

BENEFITS INCLUDE:

- S&P 500 Components

- The all-day tradability of stocks

- The diversification of mutual funds

- Liquidity

- Total transparency

- Expenses - 0.14%**

ADVERTISEMENT
ADVERTISEMENT

XLV

*Components and weightings as of 10/31/17. Please see website for daily updates. Holdings subject to change.

HEALTH CARE Sector SPDR ETF Top 10 Holdings *

Company Name

Symbol

Weight

Johnson & Johnson

JNJ

12.01%

Pfizer

PFE

6.72%

Unitedhealth Group

UNH

6.58%

Merck & Co

MRK

4.84%

AbbVie

ABBV

4.62%

Amgen

AMGN

4.10%

Medtronic

MDT

3.52%

Bristol-Myers Squibb

BMY

3.26%

Gilead Sciences

GILD

3.14%

Abbott Laboratories

ABT

2.56%

THE NEXT CHAPTER IN INVESTING

ABT 2.56% THE NEXT CHAPTER IN INVESTING ™ Visit www.sectorspdrs.com or call 1-866-SECTOR-ETF An

Visit www.sectorspdrs.com or call 1-866-SECTOR-ETF

An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, which contains this and other information, call 1-866-SECTOR-ETF or visit www.sectorspdrs.com. Read the prospectus carefully before investing.

The S&P 500, SPDRs®, and Select Sector SPDRs® are registered trademarks of Standard & Poor’s Financial Services LLC. and have been licensed for use. The stocks included in each Select Sector Index were selected by the compilation agent. Their composition and weighting can be expected to di er to that in any similar indexes that are published by S&P. The S&P 500 Index is an unmanaged index of 500 common stocks that is generally considered representative of the U.S. stock market. The index is heavily weighted toward stocks with large market capitalizations and represents approximately two-thirds of the total market value of all domestic common stocks. Investors cannot invest directly in an index. The S&P 500 Index figures do not reflect any fees, expenses or taxes. Ordinary brokerage commissions apply. ETFs are considered transparent because their portfolio holdings are disclosed daily. Liquidity is characterized by a high level of trading activity. Select Sector SPDRs are subject to risks similar to those of stocks, including those regarding short-selling and margin account maintenance. All ETFs are subject to risk, including possible loss of principal. Funds focusing on a single sector generally experience greater volatility. Diversification does not eliminate the risk of experiencing investment losses. **Gross & Net Expenses are the same – 0.14%. ALPS Portfolio Solutions Distributor, Inc., a registered broker-dealer, is distributor for the Select Sector SPDR Trust.

ALPS Portfolio Solutions Distributor, Inc., a registered broker-dealer, is distributor for the Select Sector SPDR Trust.

COMMODITIES

November was a mixed month for

commodities, with industrial metals taking the hardest hits. The best-performing ETF was the iPath Bloomberg Cotton Subindex Total Return ETN (BAL), up 6.69%, while the United States Oil Fund LP (USO) was up 5.16% and the ETFS Physical Palladium Shares (PALL) was up 3.33%. The other end of the spectrum was dominated by industrial metals, with the iPath Bloomberg Nickel Subindex Total Return ETN (JJN) falling 11.09%, followed by the iPath Bloomberg Aluminum Subindex Total Return ETN (JJU), down 5.97%, and the PowerShares DB Base Metals Fund (DBB), down 3.27%. In terms of flows, the PowerShares DB Commodity Index Tracking Fund (DBC) pulled in $209.3 million, more than any other commodity ETF, while the iShares S&P GSCI Commodity Indexed Trust (GSG) gained $36.9 million and the iPath Bloomberg Commodity Index Total Return ETN (DJP) pulled in $22.2 million. The fund with biggest outflows was the SPDR Gold Trust (GLD), which lost $450.2 million. USO, despite its strong performance, lost $230.9 million, and the PowerShares DB Agriculture Fund (DBA) lost $46.1 million.

PowerShares DB Agriculture Fund (DBA) lost $46.1 million. I N R E V I E W

IN REVIEW