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Keeping on track with Exchange Traded Funds

Keeping on track with Exchange Traded Funds

Alternative investment product challenges tradition

The Bahamas Investor Magazine
July 3, 2008
July 3, 2008
David Ramirez

Exchange traded funds, known as ETFs or “trackers”, are a relatively new kind of investment product created in the early 1990s as an alternative to traditional stock and bond investments. In simple terms it is an investment fund that tracks an index made up of stocks or bonds or currencies or commodities. As an ETF tracks a particular index, there is practically no active investment management involved.

An ETF is listed in a stock exchange and trades like a common stock throughout the trading day. The investor may buy or sell, at the market, with price limits, stop orders, or may even sell short and in specific cases, trade call or put options if these are available on the ETF.

In the traditional portfolio management field a prescribed asset allocation of cash, bonds and stocks would typically use individual companies and bond issues, whether corporate or government, in order to diversify the portfolio. This optimal asset mix would provide for an achievable return objective while at the same time reducing volatility. It is worth noting that in recent years alternative investments, or hedge funds, and commodity investments also complement the traditional asset allocation.

Although selecting individual company names, or stock picking as it is known in the industry, remains the core activity behind portfolio construction, more and more investment practitioners and investors in general are recurring to trackers as a choice of preference for asset allocation decisions.

It could be argued that, in essence, ETFs are in direct competition with single company stocks, bonds and mutual funds for the hearts and minds of investors.

Structure of an ETF
The creation of an ETF begins when an “authorized participant”, typically market makers and large institutional investors, assembles a particular basket of stocks and sends it to a specially designated custodian bank for safekeeping. These baskets are normally quite large, sufficient to purchase 10,000 to 50,000 shares of the ETF in question. The custodian verifies that the basket represents the requested ETF and forwards the “created” ETF shares back to the authorized participant.

Once the authorized participant obtains the ETF shares from the custodial bank, it is free to sell these shares in the open market. ETF shares are then bought and sold freely among investors on the exchange in which they are listed.

Redemption is simply the reverse. An authorized participant buys a large block of ETFs on the open market and sends it to the custodian bank for “redemption” and in return receives the equivalent basket of individual stocks. These stocks can now be sold in the market.

The basics of ETFs
Exchange traded funds are found in many different shapes and forms. At the broadest asset class level, an investor has access to stock ETFs, bond ETFs, currency ETFs and commodity ETFs.

Stock ETFs are further segmented into sectorial funds (eg biotechnology, energy), regional funds (eg Europe, emerging markets), country specific funds (eg Brazil), style funds (eg value vs growth, long vs short) or market capitalization funds (eg large-cap, mid-cap, small-cap, micro-cap). There are also funds with contrarian strategies providing the inverse return of the underlying index.

Bond ETFs provide exposure to different credit rating bonds or yield curve positioning strategies. Typical funds provide exposure to US Treasury bonds along different maturity buckets (eg one to three years, three to seven years, seven to 10 years or long maturities, 10-20 years), exposure to US Treasury inflation index funds (TIPS) or exposure to US Treasury short strategies. In the corporate fixed income sector some funds provide exposure to investment grade bonds, high yield bonds, emerging market bonds, among others.

Currency ETFs provide exposure to currency pair strategies typically in reference to the US dollar. Funds provide exposure to the pound sterling, the Canadian dollar, the euro, the Japanese yen, the Mexican peso, the Swedish krona, the Swiss franc, all versus the US dollar. A fund even provides a US dollar bearish strategy against a basket of currencies. Interestingly enough, an investor can also gain exposure to a carry-trade strategy through a fund purchasing high interest rate currencies (long) while selling (short) low interest rate currencies.

Commodity ETFs provide exposure to soft commodities such as grains, hard commodities such as base metals and precious metals such as gold and silver. Some funds also provide exposure to oil, natural gas and livestock.

It is important to highlight that each fund may be offered in different currencies, typically US dollar, euro, Swiss franc, pound sterling and/or be listed in different exchanges around the world. So it is evident that the alternatives in the ETF investment universe are simple to understand, interesting and perhaps sufficient to meet most investors’ needs. ETFs offer, quite frankly, an accessible perspective to global investing.

Despite their rapid growth, ETFs still claim a relatively small share of investors’ dollars. In a recent study, Chicago research firm Morningstar says there is about $419 billion in ETFs compared to about $7.5 trillion in the roughly 6,500-plus conventional stock and bond mutual funds.

Stock ETFs can be grouped by region according to which stock exchange they are listed on. Examples of benchmark stock ETFs include: in the Americas, PowerShares QQQ listed on NASDAQ GM and SPDR Trust Ser 1 on the American Stock Exchange; in Europe/Africa, iShares IFTSE 100 on the London Stock Exchange and INDEXCHG-DAXEX on the Frankfurt bourse; and in Asia/Pacific, Shanghai SSE50 Index Fund listed in Shanghai and Polaris TTT in Taiwan. As with a common stock, some stock ETFs have more liquidity than others indicated by their daily trading volumes.

Asset allocation strategies
As mentioned earlier, ETFs are becoming more widely used in the asset allocation process mainly as a result of the diversification it provides, but also due to its trading simplicity, ease of understanding and cost advantage. ETFs are bought on a commission basis just like any other stock but they do not carry front load sales fees similar to a typical mutual fund, and the annual expenses are much more competitive than an average actively managed mutual fund. And there is no investment minimum as the investor can purchase one share.

The benefits from a cost standpoint are clear. The benefits from the investment strategy point of view are even more convincing as an investor can build a diversified investment portfolio mainly with ETFs.

It all begins with the investment objective to be achieved, the reference currency of the portfolio and the level of risk the investor is willing to take. The next step is to research ETFs at the broadest asset class level and select those meeting the investment criteria, with liquidity or trading volume being an important point to consider. Remember, an investor can choose from value and growth funds, market capitalization funds, sector funds, individual country and regional funds, treasury and corporate bond funds, currency funds and commodity funds.

If the market volatility and macro-economic environment is challenging, as is currently the case, the investor can rebalance his portfolio and make it tactically more defensive by favouring those ETFs that would gain from this environment (think bonds, commodities) while reducing exposure to those ETFs that stand to be most negatively affected (think stocks). The value added of ETFs has reached an even more sophisticated level in that investors can trade inverse funds, a “contrarian” fund whose investment strategy is the opposite of the reference index, and therefore hedge their exposure.

Hypothetical example
In order to better understand the uses of ETFs and its different investment strategies, a simplified example would illustrate the asset allocation concept using these types of products. This example is not intended as an investment strategy but only as a hypothetical investment portfolio.

Let’s assume we have an investment portfolio with a balanced asset allocation assigning 10 per cent to cash, 40 per cent to bonds, 40 per cent to stocks and 10 per cent to commodities.

In the cash and bond allocation segment we select exposure to the short-to-mid US bond yield curve and also to inflation protected bond ETFs through Vanguard short-term bond ETFs, iShares Lehman 3-7 Year Treasury and iShares Lehman US Treasury Inflation ETF. The idea here is to protect against a steepening yield curve and to cover against inflation expectations.

In the equity allocation segment we select exposure to stock indexes in the US, Europe, Japan and emerging markets through SPDR Trust series 1 (which tracks the S&P 500 Index), PowerShares QQQ (tracking the Nasdaq 100 Index), Lyxor ETF DJ Euro Stoxx 50 (tracking the 50 largest companies in Europe), iShares MSCI Japan Index fund which provides exposure to the Japanese market and iShares MSCI Emerging Market Index which provides exposure to 23 countries such as Russia, China, Brazil and Mexico. In this segment we seek to diversify exposure to stock indices by adopting a global strategy.

In the commodities allocation segment we select exposure to gold, oil, agriculture through StreetTracks Gold Trust, US Oil Fund LP, PowerShares DB Agriculture. Gold is selected as a safe-haven investment play which also benefits from inflation expectations. Exposure to oil and agriculture also provides additional diversification.

All of the above selected ETFs are priced in US dollars except the Lyxor ETF DJ Euro Stoxx 50, which is priced in euros.

As can be seen from this simplified example, the capabilities for structuring a more detailed investment portfolio with ETFs are numerous, interesting and widely accessible to investors. And if a portfolio of ETFs is not what the investor is after, then these products can be utilized to enhance portfolio diversification, or to implement sector rotations or simply for hedging strategies. The applications are endless.

ETFs and The Bahamas
The domestic capital market in The Bahamas is still in its developing stage. Traditional commercial bank financing, whether through bilateral lending or syndicated loans, still remains by far the main funding tool for the private sector.

At present, ETFs are not available in the domestic stock market of The Bahamas. Domestic investors can gain exposure to the 19 listed stocks by purchasing the individual companies in the exchange or through investments in a few open-ended mutual funds offered by local money management firms.

Notwithstanding this reality affecting the domestic market, ETFs are widely traded from The Bahamas specifically in the offshore financial services sector. A distinction must be made between the offshore financial sector and the domestic sector due to foreign exchange control regulations in place. A domestic investor can only access the international capital markets with prior foreign exchange control approval issued by The Central Bank of The Bahamas and after paying a hefty premium tax on the investment. The latter tax has the unfortunate effect of detracting from the economic feasibility of said investment. An offshore investor does not have any of these restrictions.

In the offshore sector, only approved and regulated financial services providers dealing with offshore assets are able to provide an investment platform from The Bahamas. It is through this arrangement that offshore investors can access these products available on the international capital markets and it is through this platform that many trades are placed on a daily basis, many of them involving ETFs.

In recent days however, domestic investors have been provided with an opportunity to access international equity markets via a structured product provided by a local money management firm. This placement in Bahamian dollars has a maturity of 3.5 years; the initial invested capital is 100 per cent protected at maturity but the source of expected capital growth is provided by a 100 per cent participation in the price increase of an equally weighted basket of four stock indices. The basket is composed of the iShares MSCI Emerging Markets Index (an ETF–ticker: EEM), the S&P 500 Index, the Dow Jones Euro Stoxx 50 Index and the Nikkei Index. Given the novelty of this product and because of its limited supply, the demand was overwhelming and the product therefore was oversubscribed.

Likewise, another local investment management company has recently launched a global equity mutual fund issued in Bahamian dollars but investing in a selection of listed global stocks, diversified by sector and style, and a selection of international fixed income securities. Again due to the novelty of the product, the issue was also oversubscribed.  It is important to clarify however that the equity or bond exposure is not gained via ETFs but rather this example is presented to highlight the great interest which exists in the country for this type of investments.

Both of these issues were recently launched and marketed to domestic investors with prior approval from the corresponding regulatory authorities. From the investment point of view these alternatives provide excellent diversification advantages to domestic investors who are already, and typically, overexposed to traditional and limited investment opportunities available in the country, namely bank-fixed deposits and real estate.

David Ramirez
David Ramirez, a CFA charter-holder and current vice-president of the CFA Society of The Bahamas, has been involved in the international financial services industry for the last 14 years.  A graduate of INCAE, Instituto Centro Americano en Administration de Empresas, Costa Rica, with a masters in business economics, David is currently employed as a portfolio manager at Pictet Bank & Trust Ltd.

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