etf’s


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The revolution was not, in fact, televised.  A simple press release filled the bill instead. This morning, BlackRock released its ETF Pulse Survey, a look at the pace of exchange traded fund adaptation across different demographics.  The survey of individual investors found that only 27% of baby boomers (aged 52 to 70) own ETFs, compared to 42% of millennials (21 to 35) and 37% of “silvers” (aged 71 or older). Martin Small, head of BlackRock’s iShares unit in the U.S., surmised that boomers: “May still be holding onto a stock-picking mentality. They may not realize that ETFs are as easy to trade as stocks and available in virtually every market segment imaginable. As a result, many pre-retirees and investors in their early years of retirement may be overlooking the ETF revolution.”
Much as crypto-currencies run the gamut from relatively established first movers like bitcoin to ICO’s such as “Lehman Brothers Coin” (Almost Daily Grant’sJan. 19), so does the exchange-traded fund realm range from the simple (such as the SPDR S&P 500 ETF Trust, or SPY on NYSE Arca, which today crossed the $300 billion in assets under management for the first time), to the exotic.
For a demonstration of the latter, we turn to the BMO Rex Microsectors FANG+ Index 3x Levered ETN (FNGU on NYSE Arca) and its evil twin, the FANG+ Inverse Leveraged ETN (FNGD on same), which debuted yesterday.   Bloomberg Intelligence harkened the vehicle’s debut with the apt headline: “Leveraged FANG ETNs Aim to Bring Volatility to Bored Traders.”  The ETN will charge a 95 basis point expense ratio (10 times the SPY), while the underlying FANG+ Index comprises equal weighted holdings of Facebook, Inc., Apple, Inc., Amazon.com, Inc., Netflix, Inc., and Alphabet, Inc., (nee Google), as well as Alibaba Group, Baidu, Inc., Nvidia Corporation, Tesla, Inc., and Twitter, Inc,.
Eagle-eyed readers will spot that those leveraged securities are classified as ETNs, or exchange traded notes, rather than the conventional ETFs.  The Wall Street Journalexplained the difference on Feb. 5, 2017:
Both ETFs and ETNs track the price of things like baskets of stocks, bonds or commodities, but they do so differently. ETFs own a portion of the assets they track – an S&P 500 ETF, for instance, owns stocks that are included in the index. ETNs don’t own a portfolio of assets. They are simply debt issued by banks that promise a return to the investor linked to the performance they track.
Indeed, the registration statement filed with the SEC states that: “The notes are unsecured [and] . . . do not guarantee any return of principal.”   As for the leverage factor, the document carries the following disclaimer: “The notes are riskier than securities that have intermediate- or long-term investment objectives, and may not be suitable for investors who plan to hold them for a period other than one day or who have a ‘buy and hold’ strategy . . . Investors should actively and continuously monitor their investments in the notes, even intra-day.”
The May 19, 2017 analysis in Grant’s (“Loaded for bear”) took a different tack in describing these products which evidently require a day trader’s attention (and attention span): “Take every known principal of long-term investment success, negate those precepts and multiply the negative by leverage. That would be one aspect of the 4X, 3X or 2X story.”  Why?   Biff Robillard, co-founder of Bannerstone Capital Management LLC, explained the problem:  To make money in leveraged ETF’s, one must correctly predict not only the direction of prices, but of their realized volatility as well.
Not the implied volatility, and not the VIX per se, [but] the actual volatility that the underlying entity driving valuations will experience going forward. You have to have an opinion about that. High volatility reduces, even reverses, returns on leveraged ETFs.
The piece then goes on to demonstrate a hypothetical example:
Say that you own $100 of a thrice-leveraged ETF. On day one, the underlying index moves up by 5% – your fund as gains three times $5; it’s worth $115. Next day, the index falls by 5%; oops, your fund is now worth $97.75. Repeat across 10 days – alternating up 5% and down 5% – and you would finish with $89.23, down by 10.8%. Over the same course of choppy trading days, an unlevered fund would have lost only 1.2%.
So too, does the leverage mandate pose the potential to exacerbate market volatility, should this period of historic serenity be interrupted:
In a conventional margin account, leverage ratios fall as the value of portfolio assets rise. Not so here. An ultra ETF keeps its leverage constant by boosting its indebtedness – drawing on its swap arrangements – as the value of its assets appreciates. To bulk up in a rising market and sell down in a falling one is a technique that recalls the misadventures of portfolio insurance [an aggravating factor in the 1987 stock market crash].
For its part, BlackRock has steered clear of leveraged ETFs. CEO Laurence Fink told the audience at a Deutsche Bank-hosted investor conference in 2014 that: “We’d never do one. They have a structural problem that could blow up the whole industry one day.”  That prompted a rejoinder from Trevor Hewes, spokesman for ProShares, which offers many such products: “Leveraged ETFs are well regulated, transparent products and there is no credible evidence that they have any harmful effect on the markets or our industry.”
For our part, we wonder about the soundness of ETFs as a whole, not just the plainly perilous leveraged variety.  Recall the increasingly distant (in terms of time elapsed and market environment) events of Aug. 24, 2015, a steep sell-off that left the S&P 500 lower by as much as 5.2% intraday and 3.9% by the close.  In that session, even straightforward ETFs were severely dislodged, with the SPY falling by nearly 8% intraday.  The S&P 500 equal-weighted index dropped by as much as 4.6%, while the Guggenheim S&P 500 equal-weight ETF sank by as much as 43%, before finishing in the red by just 4%.
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The flow of capital into passive investment strategies has intensified into a veritable deluge. Last week, BlackRock, Inc. reported third quarter net inflows of $96.1 billion, bringing its year-to-date influx to $264.3 billion, and easily surpassing 2016’s take of $202.2 billion. ETF industry assets, under its iShares umbrella, posted 32.1% year-on-year gains in the third quarter.
BlackRock’s primary competitor Vanguard Group is seeing an even more pronounced surge in popularity, attracting a net $291.7 billion in new funds for the first three quarters of 2017 to put John C. Bogle’s not-for-profit enterprise on pace to eclipse last year’s inflows of $323 billion. Count current Vanguard chairman and CEO F. William McNabb among those surprised by the prodigious 2017, in an interview last Tuesday with The Wall Street Journal he noted that “last year was one that I never thought we’d see again.”
The potent force of momentum — shown here in the dual form of the longstanding bull market and growing popularity of indexation strategies — plays a starring role in the cash pile up.  So too does a helpful nudge from regulators.  Both in Europe (in the form of MiFID II regulations set to take effect in 2018) and in the U.S. (with the Department of Labor’s fiduciary rule requiring increased disclosure on commissions), investors are being herded to lower cost products.  On BlackRock’s second quarter conference call in July, chairman and CEO Larry Fink cited the government paradigm: “We’re seeing regulatory changes change the ETF environment. We do believe we’re seeing accelerated flows because of MiFID II, because of the movement toward the fiduciary rule in the United States.”
First you get the assets… BlackRock‘s five year stock price. Source: The Bloomberg
The bourgeoning popularity of indexation isn’t translating into better economics for its architects. To the contrary: Judging by recent moves from smaller industry players such as State Street Global Advisors and Charles Schwab, a full-on price war is underway.  Last week, Barron’s reported that Charles Schwab launched the Schwab 1000 Index ETF, which covers 90% of the entire U.S. equity market according to the company, at an expense ratio of just five basis points (by comparison, institutional cash equity trading commissions used to frequently top 10 basis points). This morning, State Street responded in kind, slashing its own fees on 15 separate ETFs.  For its SPDR Portfolio Total Stock Market ETF, three basis points is the new expense ratio, down from 10 basis points.
The capital gusher into ETFs and other passive instruments corresponds with the almost-robotic upward march in the stock market.  A dispatch in Bloomberg Businessweek detailed the somnolent environment at the midtown prime brokerage desk of Credit Suisse Group AG.  Noting the absence of client reaction to the escalating tensions with North Korea in August, Credit Suisse’s global head of risk advisory Mark Connors marveled that: “Two rockets flew over the land mass of Japan and nothing happened. There were no calls. That’s absolutely crazy.”
Fueled by unprecedented conditions such as negative nominal interest rates in large swaths of Europe and sustained central bank asset purchases despite the absence of recession in any major economy, the bull market continues apace.  The severe dislocations of many ETFs relative to their underlying net asset values seen back on August 24, 2015 (in which one-fifth of all equity ETFs experienced price movements of 20% or more, compared to just 4% of individual stocks, according to Bob Rice of New York-based Tangent Capital) begs the question of what becomes of the passive uprising if and when conditions do shift.
As always, the timing of any such potential sea change remains a mystery. Daniel Wiener, editor of the Independent Adviser for Vanguard Investors, says: “I don’t think there’s much that changes these flows until we have a negative market. I can’t tell you when that happens, but when it does there will be a lot of very surprised investors.”

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Asymmetry in the market deals with probabilities and expectations. Probability is nothing more than a math calculation that tries to deal with uncertainty or the unknown, which is of course the future.

Volatility is low. Lower than it has been for, well almost forever. Articles are being written on how low volatility is, what it means, is this a new paradigm, etc.

Obviously this is a time to buy volatility, that should it return, could provide that asymmetrical outcome sought. My favourite target in these circumstances are yield hogs. These chaps buy high yield, mostly junk, for the returns as against say treasuries.

With volatility so cheap…you can buy volatility a long way into the future, to allow time to work in your favour, for pennies. That will be my trade on Monday when the markets re-open. My candidate is prepared.

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Greece. I have no idea what will finally eventuate, but you have to think that the country continues to exist in some form and that its productive businesses continue. So you buy Greece now, while the blood is in the street.

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IN THE SEARCH FOR THE NEW and different indexes that will power a new and different ETF, back-testing plays a critical role. Index providers, including S&P, Dow Jones, MSCI, Russell, Zacks and others can index just about anything. You want to rank the companies in the S&P 500 by earnings growth, then take the 50 top firms and weight them equally? Weight them by market capitalization? Go long the top 50 and short the bottom 50? They can build it. And then they back-test it. Indexes that look good in hindsight have a shot to become ETFs. Those that don’t, don’t.

Given our quantitative roots, we are sympathetic to the fact that backtests are often used as an input into making investment decisions. But past returns, as we all know, do not predict the future. And we think backtested results may be particularly problematic today. Very little fundamental data for US equities extends back more than 30 years, but the last 30 years were a period generally accompanied by two related phenomena: increasingly easy monetary policy and falling interest rates. In particular, the wave of liquidity and stimulus provided in the wake of the Tech Bubble coincided with unprecedented levels of credit expansion, rising asset correlations and record earnings volatility.

I’m not really posting this for the returns, it just gives a quick guide to what ETF’s are available.