Closed-End Funds Issues - Case Study Example

Name: Course: College: Tutor: Date: EXCHANGE TRADED FUNDS Introduction Exchange traded funds (ETFs) are investment funds listed in indexes much more like stocks but the ETFs are broader in that they consist more assets such as stocks, bonds and commodities. They are the most popular of exchange traded products and their trading rotates around their net asset value. They are a preferred mode of investment given their attraction of low taxes, low turnover, low costs and their similarity to stocks. Davis, documents that ETFs are more of companies and have to be registered with the Securities and Exchange Commission (2006). ORIGIN OF ETFS ETFs originated from mutual funds; mutual funds have been in existences as long ago as when the USA was fighting for its independency from the Great Britain. Mutual fund investment idea revolves around the fact that the funds are put in some investment that has the potential to succeed. The idea is normally used by investors currently who put their funds into successfully revolutionalized nations with developing and upcoming potentials. Mutual funds were developed after an economic crisis between 1772 and 1773. Financial crises have been the key evolution factors that have seen the face of mutual funds change over time to the point of “giving birth” to ETFs. There were major transitions in the investment market from mutual funds in closed-end funds form, in 1890s to the open-end funds in early 1900s. The concept of ETFs came about in 1976, following a write-up of an article, “The Purchasing Power Fund: A new type of Financial Intermediary”. In between the 1980s and 1990s, there was a sudden increased interest in mutual funds and stock investments especially among the Americans and the investment concepts were evolving fast and developing. At around this period, the idea of ETFs was also picking up following events around 1987 that saw a drop and crumble of the stock markets. Ferri and Phillips, report that the 1987 decline in stocks markets was one of the worst in time and that it was due to program trading; a certain automated system that did trade stocks and futures in blocks. There seemed to have been an irreversible error that saw big stock indexes such as Dow Jones crumble in a day by more than 20% (2009; p10-11). Several events followed the 1987 error based falls; there was general decline in liquidity powers especially as commanded by large investment institutions hence stocks were closed-on and off temporary and sometimes permanently but this didn’t seem to solve the problem either and the stocks were finally closed and a better alternative of exchange trading was being sought. Closed-end funds have their own disadvantages, the first being that because their market price is dependent on the demand and supply and less on their net assets value (NAV) hence when markets fail, it is not a very safe mode because at such times, the closed-end funds tend to be severely discounted to its NAV. Hence they cannot be relied upon as hedges against rapidly falling prices and more often the investors sell their stocks at a loss; no shares can be redeemed from the selling investors when the funds are discounted. For such reasons, investors were seeking a better trading method that would safeguard their funds from risks. This was the origin of ETFs which slowly became popular, because the mutual funds and stocks seemed to have their own weaknesses that investors thought could be solved by more stable fund systems such as ETFs. ETFs were fully adopted and became a reality in 1993 when the first ETFs were introduced in the American Stock market; the ETFs tracked indexes such as SPDRs and S&P 500, soon after the ETFs were open and were traded by World Equities Benchmark Shares. The idea became widespread and by early 2000s, many investors banked on ETFs and according to Anderson et al, by 2008, there were about 600 ETFs worth 600billion USD (2009). THE OPERATION OF THE ETF MARKET Introduction ETF markets are run by investors and closely monitored by financial stability authorities. ETF markets are operated more or less like ordinary stocks but there unique aspects such as their provision for diversification, low cost ratio and are tax efficiency are put into consideration. Most ETF markets tend to remain “plain vanilla”- as described by the Financial Stability Board (2011), in that it has specific line of products that have been diversifying over time and now are in different varieties, complexities and that are dynamic-change from one market to the other and across regions hence this evolution also changes the ways in which the market is operated. Given their nature of tracking an index continuously and hence continuos fund exchange, they are preferable to mutual funds-that are traded daily and redeemable by the day- since they combine the cost benefit and diversification element of index-linked funds with highly liquid and tradable individual stocks hence creating room for lots of innovations. In addition the “plain vanilla” nature of ETFs provides another arm to better performance because it provides a different investment opportunity for individual stocks. As such the ETFs have grown so popular and their approximate value has grown from $600 billion in 2008 to $1.2 trillion in 2010. This means there are a lot of dynamics and complexities involved in ther operation and as such there have to be good management/monitoring systems to ensure stability and sustainability of the ETFs. Operation of ETF markets vary from one country to another based on the most common structures of ETFs in that particular country. For instance, in USA, the “plain vanilla”- equity products are the most common- these are physical ETFs- that basically focus on growing funds through reorganizing-purchase and replication-of the physical securities baskets on which the index is based on such as provided by S&P 500 stocks and other large asset indexes; the transactions as noted by Ramaswamy, involves the market-maker and ETF sponsor in a primary market (2011; p3). Another common structure is the synthetic ETFs which are common in European markets and in some Asian countries; it is more of an institutional based investment whereby banks cater for these ETFs through an asset management section. Different country markets operate differently, as noted by Condon and Westbrook, there is market fragmentation (2011) much because of the country’s investment culture and partly due to the regulations concerning investments. For instance in the US, regulations are more stricter ensuring balance between institutional based investments and retail investments while in Europe and some of the Asian countries, regulations are liberal and open for choice hence institutional investments are more of preferred by the investors themselves. Market operations and legal structures: USA versus Europe As mentioned above market operations are shaped depending on the legal structures of a country. In the USA, ETFs are considered as a company and therefore must be registered under the companies ACT. Markets are run based on closed-end funds than on open-end funds; implying that shares may be traded on a daily basis but not on their net asset value (NAV), they attract redemption charges but not in cash form but rather in security form as ETFs. Shares are traded by market-makers, in blocks- not as individual shares sold directly to the investors- and then the shares are sold or bought on secondary markets by the individual investors based on the shares NAV but without a redeemable fee. So basically, the regulatory legal system in the USA aims at limited redeem-ability while maintaining the original ETFs format, the physical structures “plain vanilla” which allows for replication of the underlying index. In addition, in the USA, the legal structures are firmer, ensuring that all the ETFs registered under the companies ACT have at least 80% of their asset securities bearing the name of the funds and further the companies are expected by the Securities and Exchange Commission to review their approaches to risk assessment all the time. On the other hand in Europe, the legal structures governing ETFs is more flexible as compared to that in the USA and shares tend to be traded more of like mutual funds whereby collective investments that are based on transferable securities are common with new market assets being benchmarked. But some investments take the “plain vanilla” form but replication is basically of synthetic nature. This liberal legal structure is also picking up in some Asian countries. Market operations: Synthetic versus physical structures The synthetic structure as identified earlier in the introduction is adopted more by European countries. The major reason why most investors go for this structure is because it brings out the low cost aspect of ETFs more clearly. Indexes tend to be narrow based in organization but ensure trading is widened hence great replication of the benchmarked securities and therefore reduced costs; the method is favorable for new market assets and other less market indices. The synthetic structures also safeguard ETF returns in volatile market situations such that results are consistent despite the changes. These protections lacks in use of physical structures whereby ETFs are traded daily as closed-end funds; as noted by Ramaswamy, first its difficult to track performance of new market assets that are broad based and in case of changes in markets, the fund is not protected and ETF returns are not guaranteed, they can deteriorate sharply depending on the nature of market change (2011; p4). THE TYPES OF ETF PRODUCT AVAILABLE TO INVESTORS Introduction ETFs have been a single product for long-as the “plain vanilla” equity product. But overtime ther have been great changes due to advancement in technology and rapid globalization and ETFs exist as a variety of products. Various writers document different products but the most common include:- commodity ETFs, Index ETFs, Bond ETFs, Currency ETFs/ETCs, leveraged ETFs and Actively managed ETFs. Commodity ETFs These investments are based on valuable commodities such as gold, metals and futures. Gold exchange-traded funds are the most common of this category, the idea of trading gold originated from India in 2002. The Gold Bullion Securities and Silver exchange-traded funds were among the first to be launched on ASX in 2003 and NYSE in 2006 respectively. Commodity exchange-traded funds are more like index funds but they track non-security indexes, because they invest in non-securities/commodities, they are not controlled by legal structures such as the need to be registered as a company under the companies ACT of USA, although they have to operate within certain regulations by regulatory bodies such as the US Securities and Exchange Commission review regulations and the Commodity Futures Trading Commission. Commodity ETFs are based on the physical structure whereby commodities are traded through the market maker-ETF sponsor pattern and investors gain access to commodities- but not cash- on-exchange during marketing. Commodity ETF investments are in most cases long-term investments and quite expensive ones because of expenses such as storage and safety. They are also unpredictable because being future based, various uncertainties may occur such as change in prices of commodities hence affecting the returns expected. But its not that commodity ETFs are so risky as compared to trading regular shares; in both cases risks may be available. Commodity ETfs are equally simple to trade and efficient and they also involve a range of commodities in which one can choose to invest; metals, energy, agricultural products, oil and many others. Index Funds Most ETFs fall under this category, and there are several indexes to choose from. Basically index funds invest in securities and use replication to grow the market index and track the performance of an index using its portfolio. Index funds have quite a large share in investments, in 2008, index ETFs were worth about $600 billion. The investments included assets and bond ETFs. Some investment companies opt to invest 100% of their funds in securities and benefit through replication while other companies may invest 80% or more of their funds in securities and the remaining percentage in assets such as futures. Differentiation at the funds placement and investment is what makes the whole difference in performance exhibited by various indexes. According to Nyaradi, investors and traders should learn to narrow down their scope to certain ETFs that may be classified as major. Some of the major ETFs identified by Nyaradi include:- 1) SPDR S&P 500- is an index that lists 500 largest US domestic stocks and is often a benchmark for the US stock 2) Diamond trust series (DIA)-Tracks the Dow Jones indexes as well as 30 of America’s largest companies 3) Power Shares QQQ-tracks the largest 100 stocks that are financially unrelated on the NASDAQ index 4) iShares MSCI emerging markets index- rates emerging market stocks 5)I Shares Russel 2000- show investment patterns for 2000 small companies hence giving investors information on which they base their choice for investment in any of the 2000 companies (2010;p35). Bond ETFs This is an example of a fixed-income ETF, Nyaradi says that it is a more stable form of investment as compared to trading in stocks (2010;p35) and given the unpredictability of the current market- sudden economic changes and generally volatile market- investors are shifting their focus from stocks to bond ETFs. It is a safer form especially during economic recession but can be unsafe especially due to high trading commissions especially whn a third party is involved in the trade, that is a third party buys and sell the bonds to an investor at higher trading commission; in this case the investor may lose a great deal. Actively Managed ETFs This is a fairly new type of ETFs, introduced in the USA in 2008. They are a more transparent form of ETFs as they are expected by the US Security and Exchanges Commission to publish their trading results on their websites everyday. There are lots of challenges involved in such a transparent nature of investment, the investor gets to read possible risks in advance hence may shy away from the particular company. But on the other hand investors get the right feel of the market tide and may be more cautious just in case there are some indicators for change. Leveraged ETFs These are a fairly risky class of ETFs to deal with and in most cases, as described by direxion shares, it is an investment for the strong; possibly the origin of the two sub-types -the bear and bull leverage ETFs. It is prone to risks in short periods of time and therefore calls for investors who are well versed and who understand leverages well (p2) such as knowledge of derivatives, equity swaps and rebalancing. Generally leverage ETFs aim at giving a magnification of the real market situation. The Bull ETFs for instance tries to give twice or thrice a picture of an index such as Dow Jones Industrial average (DJIA) or S&P 500. An inverse of the bear ETF may strive to do the opposite of the bear, that is, present the DJIA in a lesser magnification on the negatives; if the bear does a magnification of ×2 or ×3 then the inverse bear will do a -×2 or -×3. Trading futures carefully may help reduce the risk involved in leverage ETFs. Other ETFs Other common ETF types include currency ETFs and exchange-traded grantor trusts. The currency ETFs tracks major currencies under their varied Currency indexes. The first ETF of such nature was introduced in 2005 by Rydex investments in New York and since then various companies have launched similar ETFs with the most recent in 2009- the ETF Securities that tracks G10 currencies and other USDs. An exchange-traded grantor trust tracks a special range of stocks that are neither index nor actively managed such as Holding Company Depositary Receipts, or HOLDRs; they are ETTs to some investors since they share most qualities such as low cost, tax efficiency and low turnover but some individuals think they are a separate class of investments and not ETFs. THE RISKS AND OPPORTUNITIES OF ETFS Introduction The main objective of investing is to gain, ETFs are not an exception, the investors are concerned and are ready to do anything to enhance their performance even when times are not so promising. If put in the right basket, funds, assets, bonds and other sorts of investment can fetch good returns but if a slight mistake is made, such as failure to read the “investment weather” signs properly, great losses are the resultant feature. This section will therefore discuss some of ther risks and benefits/ opportunities that come with ETFs. Benefits/Opportunities of ETFs Many individuals argue that ETFs are the safest way to evade risks in the investment world; this thought is supported by Richard, who emphasizes the need for diversification to prevent bearing the blunt of unavoidable risks. Richard says, “Exchange-traded funds provide marvellous opportunities to spread the risk among a multitude of stocks.” (2003;p14). Of course some investors may not see the need to diversify their investments since they may feel that their investment markets are less volatile than others, but there is no island and changes can occur, for instance, in the world market that can end up affecting the domestic stock markets. In addition investors need to understand that markets have their own regulatory mechanisms in that when a market is less volatile the price-earning ratios are high and where risks are greater, the price-earning ratios are lower hence balancing all the markets. No one is absolutely safe and there is need to invest in an alternative that offers diversification and ETFs are such options. ETFs also offer low cost opportunities this is because they are less exposed to demands such as redemptions and shareholder purchase costs. Most of the ETFs are also not actively managed hence lower costs. For instance, in 2008, the average total expense ratio of equities in Europe is 49bp while that of mutual funds is 120bp (Fitzrovia). ETFs of whichever type-actively managed or index funds have transparent portfolios which show all their activities including pricing whereby investors and traders access the information and area able to know what securities are held by a particular fund.Just like stocks, ETfs are also flexible in their buying and selling prices and can also be sold any time of the day allowing investors to fetch the best of open market prices. ETFs are highly liquid in that before the end of a selling cycle, investors are allowed access to their assets through the primary and secondary market system hence one can buy or sell securities as per their wish. ETFs are easy to use, there is nothing complicated in their exchange, they do not need any special processes and no need for opening new accounts. Risks of ETFs While the diversity of products and hence growth of ETF markets presents open options to investors, there are challenges that come with the changes in the market size, the major challenge is the complexity and opacity brought about by new elements (Financial Stability Board). For instance the branching of ETFs from the original “plain vanilla” to the other products such as commodity ETFs, fixed-income ETfs and others, presents new risks and challenges since the liquidity aspect is narrowed and presented in lesser transparent ways. On the other hand there are new ways in which the ETF markets operate including segmentation based on synthetic and physical structures-described in earlier sections. The intensive security lending approach utilised in the synthetic structures presents new challenges. Certain types of ETFs that are more flexible to redemptions may be driven to pints of duress especially in times of shortage when there is less liquidity and hence the institutions such as banks involved may end bearing the brunt of such needs. Hence there is need for the new opportunities presented by growth in ETF markets and the new financial approaches to be monitored closely for risks that may arise. Increase in Opacity and complexity There are many products that have come into place some of which have raised some controversial questions as to whether their invention may be more disastrous than it can be beneficial. A good example is that of leveraged ETFs and their inverses-introduced earlier under the “types of ETFs section”. Another class of ETFs “speculative grade corporate loans” has also been recently unveiled. There is need to study the new innovations for potential risks they may be posing to the investor and markets in general; this is the opacity part. The complexity lies in the synthetic approach that is become increasing popular in Europe and Asia, as discussed in earlier sections, it is a type of structure that is little off the original physical structure meant to be used in trade of “plain vanilla” products. The synthetic structure relies on banks’ management arms whereby the bank sells shares to investors and gets funds in return, the funds are then but in a pool basket and exchanged (swapped) with returns from indexes-by the same bank. The bank is the key provider of exchange services in this case and some of the banks are private; investors may have not thought of what may occur if in the slightest mention the bank losses it in a way or two-all their investments will be at stake. It is also obvious that these banks are not rendering these exchange services for free therefore the most active banks gain most; who wouldn’t wish to make extra coins in the hard business market? The swapping and exchanges become like a contagious disease and hence unnecessary competition and rivalry between banks arise. Hard decisions have to be made by the banks at certain points such as when there is a looming financial crisis and on the outside, no companies are will to offer liquidations at certain expected levels; some banks may end up making risky decisions such as meeting the investors liquidation needs using bank resources which may mean some other crisis for the bank itself. On the other hand, making collateral selections that match the index assets may be challenging and the problem may be complexed further by the fact that some banks may not be transparent enough in their trading exercises. The synthetic structure is also risky in case of inverse-leverage ETFs or shorts, since there are no standard collateral given to the investors and any decision made by the bank is independent of the investors. After all regulations are not so tight to ensure that the service providers are registered as companies like in the USA where the physical ETF structure is dominant; the banks are therefore not legible and may not be taken to task in case of a mistake that can lead to hitches in the investment line, the investors may also have little to do in such cases. There is need therefore for some formal processes that take procedural guidance role in selection of collaterals, and matchs them to certain assets as well as need to strengthen regulatory frameworks to protect investors in such open systems. Market liquidity Risks ETFs unlike equities present redemption during market liquidity in form of assets. Investors are left to access their assets but have no touch with hard cash. In situations where there is sell-off of some form of unwinding, it may be difficult to meet the huge demand of investors drooling for cash. Possibly there is need for consideration of incentives to the investors at some points before the sell-offs or the unwinding so as to reduce the numbers in need of liquidation. This way the ETFs are safeguarded in terms of prices and the risks that service providers are exposed to-such as described in section above- will be minimized. Other Risks Other risks that an ETF investor may face include the spread risk, tax risks, tracking error risk and label risk-these are according to Hougan. Label risks refer to the fact that ETFs may be a bit technical in that what you see is not what is underneath- an index name may be misleading and when one unveils the truth, its all different from the impression created by the name. For instance when one sees MSCI ex Japan, one may think most if its investments are in Asian countries but surprisingly a larger percentage of its investments are in New Zealand and Australia. Tax risks come in exceptional cases of ETFs, naturally ETFs have better tax costs as compared to mutual funds but the challenges come with the new ETF products such as commodity ETFs and currencies; these groups are not taxed as equities and given their nature-future trading-their value may not be certain yet an investor is expected to remit 28% tax because like commodity ETFs are considered collectables. The tracking-error as elaborated by Hogan is more or less the same as the error in collateral selection and matching the collateral with appropriate assets as described in the section above. CONCLUSIONS ABOUT ETFS AS AN INVESTMENT TOOL The transition from Mutual funds may have been a journey started during dark ages-periods of economic recession and economic uncertainties but the struggles have not been in vain. A tool that is worth the weight its being accorded was the end product and its evident that ETFs have transformed the face of investment as they have given investors an alternatives to vulnerable stocks that helps them round up the many unpredictable risks presented in the markets. It may be unfortunate or advantageous that the investment markets are fragmented in a way that various countries have their own systems of operating ETF markets, but from a critical perspective, it the same approach that was presented together with the “plain vanilla” package remained to be the only form of operating the ETFs may be the investments would still be a great difficult. The fragmentation has led to diversity hence enrichment of the EFT market operations. The only worry is supposed to be the risks that the new methods present but as discussed in sections above, each and every risk has a way of being managed. It may only call for a keen approach towards issues and increased collaboration among key stakeholders including governments who have a great role in defining regulations as well as ensuring the investments are run in a way that protects the investors’ securities. Otherwise the ETF tool is highly useful and beneficial and its benefits are essentially greater and submerge the challenges that may be threatening investors to shy away from using the ETF too. It is a favourable tool to ensure that one’s investments are safely widespread in a way that will ensure great returns and a safeguard to risks that may arise as a result of uncertainties, advancement in technology and the rapidly globalizing world. References Anderson, C. Seth., Born, A. Jeffrey. and Schnusenberg, Oliver. Closed-End Funds, Exchange Traded Funds, and Hedge Funds: Origins, Functions and Literature. New York, USA: Springer Science+ Business Media LLC. 2010. Print Condon, C. and Westbrook, J. Vanguard to Sell Exchange Traded Funds in Europe in Challenge to BlackRock. N.p. 2011. Web Davis, Os. A Brief History of Exchange Traded Funds. N.p. 2006. Web Direxion Shares. Understanding Leveraged Exchange-Traded Funds: An Exploration of the associated risks and benefits. Direxion. N.p. 2007. Print Ferri, A. Richard. and Philips, Don. The ETF Book: All You Need to Know About Exchange Traded Funds. New Jersey, Canada: John Wiley and Sons. 2009. Print Financial Stability Board. Potential Financial Stability issues arising from recent trends in exchange-traded funds (ETFs). N.p. 2011.Print Fitrovia. In: Markit Magazine. Spreading the Word. N.p. 2008. Print. Hougan, Matthew. ETF Investment Risks. N.p. 2011. Web. Nyaradi, John. (2010). Super Sectors: How to Outsmart the Market Using Sector Rotation and ETFs. New Jersey, Canada: John Wiley and Sons. 2010. Print Ramaswamy, Srichander. Market Structures and systemic Risks of Exchange-traded Funds. BIS Working papers. 2011. Web Richards, M. Archie. All about exchange-traded funds. McGraw-Hill Companies. 2003. Print. Read More