Exchange-Traded Funds - Case Study Example

Applied Portfolio Management: Exchange-Traded Funds Student’s Name: Instructor’s Name: Course Name and Code: University: Date of Submission: Applied Portfolio Management: Exchange-Traded Funds Introduction The popularity of Exchange-Traded Funds has increased greatly in the contemporary world as investors become increasingly savvy; mostly due to their low costs. ETFs are said to offer great investment opportunities due to their ease of diversification, tax efficiency and low expense ratios among other factors. All this is possible while maintaining ordinary stock features such as short selling, limit orders and options. ETFs also allow for flexibility because there are no limits of what one should invest. Being economically easy to acquire, hold and dispose, they are useful in market timing investment strategies. ETFs however have their limitations in that they tend to be highly volatile and they may attract high trading commissions especially where there is need to keep selling and buying, as in the case of leveraged ETFs. There are also dangers of market deviations and tracking errors that may affect ETFs. The choice on whether to invest in ETFs however lies with the investor and this may be assured through a comprehensive understanding of what ETFs entail. This paper seeks to explore the subject of exchange-traded funds; with an aim of establishing whether they are effective investment options to consider. Exchange-Traded Funds (ETFs) The exchange- traded funds are investment funds that are traded on stock exchanges, just like stocks. The ETFs are known to hold assets such as commodities, stocks or bonds. They trade close to their net asset value. It is possible to buy and sell ETFs throughout a trading day when the stocks exchanges are open. The origin of exchange traded funds dates back to 1989. The first exchange – traded funds happened due to the market crash of 1987 (Jim et al. 2002, p. 127). The origin of ETFs The origin of ETFs is rooted in the Index Participation Shares that were traded on the American and Philadelphia Stock Exchange. This product however did not last long because the Chicago Mercantile exchange succeeded in discontinuing sales in the USA. After this Toronto Index participation shares started to trade a similar product on the Toronto stock Exchange in the year 1990. The product proved to be very popular, thus attracting the United States to try the same trade and product (Richard & Don 2009). The American Stock Exchange embarked on trying to develop a product that would satisfy the Security Exchange Commission regulations in the USA in order to benefit from the promising trade (Gastineau 2002, p. 32). In 1993, the Standard & Poor's Depositary Receipts which were designed and developed by the exchange executives Steven Bloom and Nathan Most were introduced to the market (Carrel 2008, p. 14). The fund which was commonly known as SPDRs or ‘spiders’, developed to become the world’s largest ETF. Another ETF was introduced in May 1995 and was known as MidCap SPDRs. Soon after, a series of ETFs were developed, including Barclays plc’s WEBS (World Equity Benchmark Shares) in 1996. WEBS was an innovative ETF as it gave easy access to foreign markets. WEBS were set out as a mutual fund as opposed to SPDRS which were in the form of unit investment trusts. Sector Spiders were introduced in 1998 by State Street Global Advisors. These were followed by others such as Dow Diamonds in 1998, Cubes in 1999 and iShares in early 2000 (Wiandt and McClatchy, 2002, p. 82). Barclays Global Investors played a significant role in the development of ETFs because in the year 2000, Barclays put a strong emphasis on education as well as ETF distribution in order to ensure that the investment alternative reached the long-term investors. Barclays’ iShares surpassed the asset of all the ETF competitors in Europe and the U.S within 5 years. With the sale of Barclays to BlackRock and the entry of Vanguard Group into the ETF market, an increased proliferation of the ETFs market has been witnessed. The Investment Company Institute website notes that by September 2010, 916 ETFs existed in the United States; with assets worth $882 billion. The operation of the ETF market ETFs work through offering an undivided interest to investors in the form of pooled assets of securities and are thus considered highly similar to mutual funds (Wiandt & McClatchy 2002, p. 6). An ETF consists of assets such as stocks, bonds or commodities which have been pooled together to provide a viable investment. Unlike mutual funds however, shares in an ETF may be traded all through the day just like normal stocks in the securities markets. An investor can only work well with EFTs if he/she understands its internal operations. The EFTs has advantages over the traditional mutual fund in that, they offer tax advantages, and they have unique costs and are flexible. ETF as an instrument of finance offers fascinating insight into the modernity of money world. ETF is highly advantageous in that some of the costly buying and selling are sidestepped in the underlying stocks that constitute the target index. This process of sidestepping allows some investors in avoiding transaction costs and also in delaying some of long- term capital gain in US (Jim et al. 2002, p. 76). Sidestepping of normal cash-for- stock is done in a way that the ETF shares get traded in place of the underlying stock they represent. Initially the process seems crude, the involvement of specialized players who perform the intricate tasks thus making ETFs become instruments that are efficient for buying and selling in a whole market (Richard & Don 2009, p. 26). The inner workings of ETFs run from the simplest form to the complex one. Costs associated with ETFs depend on the transactions. Notably, since ETFs trade on an exchange, the transactions involved are basically expected to attract a brokerage commission. This depends on the brokerage and the plan that the customer chooses. The commission cost thus has an impact on the overall investment. An ETF comes into existence when there is an entire portfolio that is usually an index gets placed in trust (Gastineau 2002, p. 16). The realized portfolio is not sold but instead literally bartered ,assuming the nature of minted ETF .the generated kind of private paper market trade is efficient in sidestepping some of the costs in the open- market that are used in securities buying and selling. It qualifies to become a financial agreement that is sanctioned and also monitored closely by the Securities and Exchange Commission (SEC). Once in existence, the ETF share circulates freely thus enhancing any investor in any part of the world to buy it. Once bought the Exchange Traded Fund share can be sold in the next minute or can also be held for a period of a decade depending with the investor’s decision on the share. In the open markets, the ETF is alive and freely accessible thus becoming a flexible trade (Jim et al. 2002, p. 104). When the ETFs are compared with mutual fund one is able to understand easily the internal operations of the ETFs. The process of Traditional mutual funds as they grow and also how they shrink is: 1. The investor transfers in some cash to the mutual fund 2. Now the mutual fund manager is enabled to but stocks using the cash transferred 3. After the purchase of stocks, the investors request the redeeming of the shares 4. The mutual fund sells stock and then gives cash to the investors. In the mutual fund, the investor and the manager relate directly. The fund distributors act as middlemen. The latter serves as custodians who ensure that the funds are invested properly and shares also are credited properly. There are two distinct features in mutual funds: The stocks in an individual company are bought and also sold or traded by the mutual funds that are both for redeeming and the changes to the underlying index. For the mutual fund, there is recording of capital gains for investors. In the case of ETFs the process of redeeming reverses the one of creation. The ETF is always calculated at the close of trading day as the shares get delivered to the custodian. During settlement, the securities that comprise the index and a cash component that can be negative or positive get delivered to the AP when the fees for nominal transaction have been deducted. Creations and redeeming get effected at the closure of the markets (Jim et al. 2002, p. 87). Types of ETF product available to investors Index ETFs This is the most common form of EFT. These EFTs are in the form of index funds which hold securities and then work towards replicating the stock market index’s performance (SEC 2011). In order for the index fund to track how an index performs, it seeks to hold in its portfolio either the index’s contents or a representative sample of the index’s securities. Some of the index ETFs may invest all their assets impartially in the index’s underlying securities. This form of investment is called replication and it involves investing 100 percent of the assets. In other indexes however, only a representative sample is used, such that 80% to 95% of the assets are invested in the underlying index’s securities while the remaining 5-20% is invested in other holdings such as options, futures and swap contracts among others. It is also possible for the index EFTs to invest only a small percentage of the underlying securities in what is known as aggressive sampling (Fuller, 2008, p. 2). This mostly occurs in indexes whose underlying securities are in the count of thousands. There are special index ETFs known as inverse ETFs or leveraged ETFs. Leveraged ETFs These ETFs make use of investments in derivatives in a bid to obtain a return corresponding to the multiple of, or the inverse (opposite) of the index’s daily performance. Leveraged ETFs seek to achieve returns which are more sensitive to movements in the markets. Leveraged ETFs have a disadvantage in that during rebalancing of the ETFs, they tend to have a significant level of costs when the markets are volatile (Wang 2011, p. 1). This is because in order to maintain a fixed leverage ratio, the fund manager incurs trading losses since he has to purchase when the index climbs and sell when it goes down. A significant level of the fund could therefore be wasted in trading losses, thus leading to poor returns. Commodity ETFs/ETCs As suggested by the name, these are ETFs that make use of investments from commodities such as futures and precious metals. Gold exchange-traded funds were among the first commodity EFTs to exist (Spence 2004). Commodity ETFs can be considered as a form of index funds, only that they are track non-security funds. Given that Commodity ETFs do not invest in securities, they are not they are not regulated or listed as investment companies. ETCs (Exchange-traded commodities) refer to investment modes such as asset backed bonds which track underlying commodity index performance, based on a single commodity. They are traded like normal shares just like ETFs on their own dedicated section. Commodity ETFs are said to be simple and efficient to use because they trade just like shares. Further, they provide investors with a range of commodities and commodity indices that is ever increasing, such as metals, energy and agriculture. Bond ETFs These are ETFs that invest in bonds. These forms of ETFs thrive when there are economic recessions because during these times, investors tend to shift their money from the stock market and invest them in bonds (Carrel 2008, p. 14). This is because the bonds are considered to be more stable than the securities, hence a good way to cushion the investors from the effects of the recession. Bond ETFs are also well known for the advantage of reasonable trading commissions. This may however be offset negatively if the bond ETFs are bought and sold using a third party (Investopedia 2011). Bonds are normally held until maturity such that there is typically no active secondary market available to them. This insinuates that the bond ETF architect must ensure that it is closely monitored and that its respective index is tracked in a cost effective manner since the bond market lacks liquidity (Investopedia 2011). Interest on bond ETFs is paid monthly while any capital gains are given out annually in the form of dividends. Bond ETFs have an advantage in that they are available globally. Actively managed ETFs These are ETFs that are based on transparency and whose security portfolios are available on their websites and updated daily (SEC 2008, p. 14621). The full transparent nature associated with actively managed ETFs is considered risky for investors because market participants are more likely to take part in arbitrage activities which could impact on the value of the ETFs (SEC, 2011). Actively managed ETFs remain largely unpopular and have thus been less successful than other forms of ETFs. Exchange-traded Grantor Trusts They are also referred to as exchange – traded baskets. They are distantly related to the ETFs but have the essential ability of instant trading. Exchange-traded grantor trust shares represent an investor’s direct interested in some form of constant ‘basket’ of stocks from a specific industry (Devcic 2011). They give their investors a direct link to the stocks. The investors trade their shares in hundreds. For a small fee the investors can create or redeem the underlying securities. Management Investment Company The management Investment Companies does resemble a mutual fund. The companies are managed by a fund manager as the name suggests. The manager is in charge of coordinating activities in the fund that includes setting policies to be followed in the index, payment of dividends, special selection of distributors and administrators. In this type of ETF, the manager may charge a relatively higher fee but due to flexibility, he can maximize performance through loaning securities so as to reduce cash drag (Index, Jim & Will 2002, p. 59). This action reduces costs. The fund is allowed to lend some of its holdings so as to realize extra profits and this befits the fund’s investors. Unit investment trusts The unit investment trusts have almost the same operations with the management investment companies, only that they are less flexible. The reason behind selection of unit investment trust structure getting incorporated in ETFs is that it was relatively cheap and manageable (Richard & Don 2009, p. 106). In comparison with the management investment company, these funds lack some of the advantages like the immediate reinvesting of the dividends and lending securities and also use of derivatives in management of portfolio. The key difference in management investment companies and unit investment trusts is the less involving managerial discretion with the UITs. There is a rigid following of target index and paying out dividends not reinvesting them (Richard & Don 2009, p. 108). The risks and opportunities of ETFs  There are a number of risks associated with ETFs, hence the reason why investors must be extremely careful when making investments. It is highly important to consider the disadvantages of ETFs before making a decision to invest in them. The main risks associated with ETFs can be described as follows: Volatility EFTs are considered more volatile and may therefore fall and rise faster than other investments such as index mutual funds (Maeda 2008, p. 50). Further, ETFs bear additional risk in case of sector downturns. This renders EFTs more risky to invest in because their returns may not be assured to their volatile nature. This also insinuates that the investor needs to take more time in managing the ETFs in order to ensure that they bring the desired results. Inactivity It is notable that some ETFs are not as actively traded as others; either depending on the sector or the region in which they are traded (Kennedy 2011; Maeda 2008, p. 64). Accordingly, the returns on some of the investments may be lower than expected. This calls for the need to do a background check in order to ensure that the ETFs that the investor chooses are profitable enough. Instead, investors may opt to invest in managed funds which are expected to generate higher activity. Trading commissions EFTs have a risk on return because of the cost of trading commissions involved (Maeda 2008 p. 51). In the case of leveraged ETFs for example, a significant amount of costs are incurred in the process of rebalancing the ETFs and this may be very costly to the investor (Maeda 2008 p. 51). These trading expenses decrease investors’ returns. Commissions can however be minimized using online brokers in order to get lower security buy-and-sell commissions. Security market deviations SEC (2001), notes that the efficacy of ETFs is dependent on the effectiveness of the arbitrage mechanism because their share price must be able to track the net asset value. Deviations are likely to be witnessed in the daily closing price and net asset value of ETFs. While these deviations are mostly less than 2%, such deviations are likely to be more pronounced in ETFs that track various foreign indexes (SEC 2001). Market turbulence could also lead to more deviations, exceeding 10% in severe cases. Such deviations are expected to impact on the returns of the ETFs through making them more volatile. This in turn places the ETFs investor at a risk. Tracking error It is possible for ETFs to miss their intended targets as a result of tracking errors. These are likely to occur due to the proliferation of ETFs that target exotic investments or areas where there is less frequent trading (Salisbury 2009). Examples include emerging stock markets and commodities that are based on future-contracts. A study conducted by Morgan Stanley in 2009 about EFT returns indicated that EFTs missed their targets for 2009 by 1.25 percentage points on average. This was a significant error as compared to the average of 0.52 percentage points recorded in 2008 (Salisbury 2009). This therefore insinuates that ETFs could be risky for investors due to the possibility of tracking error which may misguide investors leading to losses. Risky exotic products The case of leveraged ETFs has gained a significant level of coverage, with many financial experts criticizing the ETFs which have gained significant popularity in the recent past. One of the most significant criticisms of leveraged ETFs is that while they make use of borrowed funds to invest. These are obtained from swaps, futures and options (Seekingalpha 2007). Due to the volatility of the market however, the value of assets in the fund are expected to change from time to time, such that the total debt is no longer equal to the asset value. This throws off the leverage ratio such that a corrective action is required everyday in order to bring the leverage ratio to its original point. Such rebalancing increases expenses due to the numerous transaction costs, thus leading to losses on investment. Seekingalpha (2007) notes that most investors take up leveraged ETFs in the hope of getting twice the daily return but they are misled because this is not the case. Increased buying and selling activity could lead to increased volatility and this may impact on possible returns. Leveraged ETFs are therefore considered risky investments and their recent growth threatens possible gains by investors. Risky trade practices The trade in ETFs has been known to cause the emergence of risky trade practices such as arbitrage and speculation. In the recent past, there has been a controversy on short-selling that has impacted on ETFs and which puts investors at risk. It has been established that the use of ETFs in short-selling often leads to more shares lent as opposed to those in issue. According to Christopher (2011), short-selling occurs in a situation where an ETF is borrowed and used to bet on the fall of an underlying index. This ETF can be borrowed by another party and if the process repeats itself, this leads to a situation in which there are more shares out on a loan as compared to what they have on issue. While financial experts maintain that the ETFs market cannot collapse because of short-selling and that it actually promotes faster price discovery and enhances market efficiency, others maintain that an EFT could collapse due to high short interest levels (Christopher 2011). Opportunities ETFs are said to offer great investment opportunities due to their ease of diversification, tax efficiency and low expense ratios. The ease with which they can be trades and managed also provides investors with an opportunity to gain through ETFs. ETFs provide investors with the opportunity to trade throughout the trading day. According to Gastineau (2002, p. 8) the fact that they may be bought or sold the entire trading day gives investors the opportunity to change their investment position quickly whenever there are news that may impact on the investment unlike in mutual funds. The various opportunities associated with ETFs can be described as follows: Variety ETFs exist for a variety of market indexes and this gives investors an opportunity to choose from a variety of ETFs. Examples include NASDAQ composite, Dow Jones Industrials, real estate investment trusts (REITs), small and large companies and even gold (Kennedy 2011). If an investor has researched a particular market or has adequate knowledge about the market, it is possible to effectively profit from ETFs. Easier trading opportunities The stock-like features of ETFs make them highly beneficial to investors because they are easy to trade and similar trades as those practiced in stocks can be practiced on ETFs. It is possible to shorten or buy ETFs on low margins as well as use a limit order (Maeda 2008, p. 17). In addition, investors can put in as little money or as much money as they wish because there exists no minimum investment requirement. This presents an opportunity for both small-scale and large-scale investors to gain from the ETFs. The easy procedures also make the ETFs attractive and so is the ability to use an agent who is paid at a commission for expert services (Laurence, Neal & Andrew 2008, p. 147). Tax advantages ETFs are structured to enhance tax efficiency and are therefore attractive to investors. They offer the investor an opportunity to save on taxation and thus realize their capital gains as soon as they sell their shares. This is unlike mutual funds whose capital gains are taxable to shareholders. Dellva (2001, p. 118), however notes that tax advantages are of no benefit to investors who are already tax exempt or investors using tax-deferred accounts. Low expense ratio As compared to mutual funds, ETFs have a lower expense ratio as well as shareholder-related expenses (Dellva 2001, p. 112). Further, investors in ETFs need not invest in cash contributions or maintain cash reserves for redemptions. Brokerage expenses are also low and significantly subsidized. It is possible to find that commission costs for ETFs are quite low because a significant number of brokerages offer discounts on the brokerage commission (Laurence, Neal & Andrew 2008, p. 147). Where low or no-cost operations exist therefore, ETFs can be said to be highly competitive. This means that ETFs save investors significantly in terms of costs involved, thus providing them with an opportunity to get more returns from investment. Conclusion The working of ETFs is of great importance for investors to understand before they can make any commitment in the investment tool. This is because there is dire need to weigh the risks associated with ETFs against the opportunities in order to make an informed choice. This paper establishes that while ETFs are a good investment option, there are considerable risks involved. ETFs are a potentially effective investment tool for people who seek an easy to manage investment and who wish to undertake huge investments. This denotes that as opposed to opting for mutual funds, risk-averse investors may choose ETFs instead. As indicated in this discussion, ETFs are not only easy to manage, purchase and trade due to the capability of trading as costs but they are also less costly due to the tax benefits and low expense ratio. They also have an advantage in that they do not require the investor to maintain cash reserves for redemptions. Additionally, they promise to reward the investor considerably if they are well managed. Accordingly, I consider ETFs appropriate for investment. It would however be imperative for the investor to consider the risks involved when investing in ETFs. This especially concerns the volatility of the instruments and the possibility of poor returns due to inactivity. The investor must also be careful when investing in high risk ETFs such as leveraged derivatives because they could lead to significant losses in invested capital. It can however be established that there is no investment without risks and that what is important is to ensure that the investment is well managed in order to mitigate the risks. Reference List Carrel, L 2008, ETFs for the Long Run, John Wiley & Sons, New York. Christopher, FT 2011, EFT short-selling controversy rumbles on, Viewed April 29, 2011, http://discussions.ft.com/alchemy/forums/etfcentral/etf-short-selling-controversy-rumbles-on Dellva, W 2001, Exchange-Traded Funds not for everyone, Journal of Financial Planning, 14(4), 110-124. 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