Category Archives: ETF

Exchange Traded Funds

ETF Report – May 2013

Please find our latest ETF report here: http://www.scribd.com/doc/146146105/Lighthouse-ETF-Report-2013-May

As a new feature, the report also looks at mutual fund flows.

Summary:

  • Risk appetite has begun to cool off
  • International equity ETF’s are seeing significantly less inflows than domestic equity ETF’s in absolute dollar terms (but similar inflows relative to their asset base)
  • Emerging market equity ETF’s experienced significant outflows
  • Inflows into high-yield bond ETF’s have cooled off considerably, with the leading junk-bonds ETF (JNK) losing 16% of its assets over the past four months
  • Interest in precious metal-related ETF’s remains low; GLD saw the largest outflow of all ETF’s we cover for the second month in a row and has lost 35% of today’s assets over the past five months
  • A prudent or contrarian investor would use the opportunity to shift positions into more defensive ETF’s

ETF-Report April 2013

Please find our latest ETF-Report here: http://www.scribd.com/doc/141248746/Lighthouse-ETF-Report-2013-April

 

Conclusions:

  • Current risk appetite remains high
  • International equity ETF’s are seeing less inflows than domestic equity ETF’s in absolute dollar terms but higher inflows relative to their asset base
  • Emerging market equity ETF’s are still outpacing those investing broadly in international equities but have experienced a significant slow-down
  • Inflows into high-yield bond ETF’s have cooled off considerably
  • Interest in precious metal-related ETF’s remains low; in April, GLD saw the largest outflow of all ETF’s we cover
  • A prudent or contrarian investor would use the opportunity to shift positions into moredefensive ETF’s

ETF Report – March 2013

Please find our latest ETF Report here: http://www.scribd.com/doc/133857690/Lighthouse-ETF-Report-2013-March

Conclusions:

  • Current risk appetite remains high
  • International equity ETF’s are seeing less inflows than domestic equity ETF’s in absolute dollar terms but higher inflows relative to their asset base
  • Emerging market equity ETF’s are still outpacing those investing broadly in international equities but have experienced a significant slow-down
  • Inflows into speculative bond ETF’s have cooled off considerably
  • Interest in precious metal-related ETF’s remains low
  • A prudent or contrarian investor would use the opportunity to shift positions into more defensive ETF’s

ETF Report – February / March 2013

Please find our latest ETF Report here

Summary:

  • Current risk appetite is high
  • International equity ETF’s are seeing similar inflows to domestic equity ETF’s in absolute dollar terms and higher inflows relative to their asset base
  • Emerging market equity ETF’s are outpacing those investing broadly in international equities
  • Inflows into speculative bond ETF’s have ended
  • Interest in precious metal-related ETF’s is very low
  • A prudent or contrarian investor would use the opportunity to shift positions into more defensive ETF’s

 

PS: The report is based on February data for monthly analysis and the period March 2012 – February 2013 for 12-months rolling data.

Going forward I will name reports according to the last month of data included (for example, the next report, including data from March 2013, will be called “March 2013″ and be published in April).

September data reveals increased risk appetite among ETF investors

Tracking flows in and out of major exchange-traded funds (ETF) can reveal investors’ risk appetite.

The 23 largest ETF’s by assets under management represent approximately 50% of all US ETF assets.

In September, the largest inflows in percent of assets were registered by domestic equity (SPY), gold mining stocks (GDX) and high yield bonds (HYG):

Source: IndexUniverse.com, own calculations. Note: we eliminate the performance effect on AuM, hence end-of-month AuM will differ from actual numbers (which include performance effect).

Largest outflows relative to assets were seen by Inflation-protected Treasuries (TIP), Nasdaq (QQQ) and 2x inverse S&P 500 (SDS).

We smooth out monthly noise by grouping ETF in asset classes and looking at flows cumulative over the last twelve months:

You will notice the dollar amount flowing into international equities coming close to the one for domestic equities, and risky bonds attracting almost as many dollars as “safe” bonds. This is an expression of investors’ risk appetite. In “risk-off”-times, investors seek to repatriate investments (rather domestic equities than international) and prefer the safety of Treasury bonds over high-yield or junk bonds.

By looking at growth in percent of assets, the picture becomes even clearer:

Risk appetite is then calculated on the basis of various ratios (all on 12-month rolling data):

% risky bonds: net flows into HYG, JNK relative to TLT, TIP, BND, LQD, MUB

% international equities: EFA, EEM, VWO versus SPY, VTI, IVV, DIA, QQQ, IWR

non-investment grade versus investment grade: HYG, JNK versus LQD

emerging markets equities versus developed markets equities: EEM, VWO versus EFA

Short equities versus long equities: SH, SDS versus SPY, VTI, IVV, DIA, QQQ, IWR.

CONCLUSION:

While US investors are less keen on international relative to domestic equities, choices within the international equity asset class and short versus long point towards a high risk appetite.

Within fixed income, risk appetite, while not at record levels, is rising since May/June as investors flock towards riskier bond ETF’s and corporates rather than Treasuries.

Volatility ETFs’ crazy churn

Two volatility ETFs (VXX and UVXY) are having almost half of the trading volume in the world’s largest ETF (SPY). How come?

First, the facts:

SPY is heavily traded (19% of assets daily turnover) compared to IVV (also referring to the S&P 500).

But then come the volatility ETFs. Tiny VIXY (assets $145m) turns itself over 2x per day.

Why are those long-volatility ETFs so popular, given they are wasting assets in an environment with a steep volatility-futures curve (source VixCentral):

(Ceterus paribus short-term long-vola ETF’s will suffer monthly roll-losses of 11% or roughly 0.5% per trading day)

The most likely explanation is that volatility-ETFs offer leverage without the need for margin:

On August 9, 2012, SPY had a trading range of 60bps. VXX offered 220bps, topped by UVXY with 440bps.

Tiny moves in the equity market can be amplified by using volatility ETFs (not that I would endorse this). It’s leverage without leverage for the day trader.

What a week

Looking at asset class performance during the week August 1-5, 2011:

Horrible week for the Dax index, US REITs (Real Estate Investment Trusts) and Emerging Markets. I had wondered why the Dax managed to perform so well despite Euro zone troubles. It is a pretty cyclical index, and usually outperforms the US indices – in both directions. Foreign investors make up a larger percentage. Hence in a crisis, when large international investors recoil towards their home markets, the selling hits the Dax more than, for example, the S&P 500.

Let’s look at US equity sectors:

As you would expect, cyclical sectors (-9%) underperformed defensive sectors (-5%). Mid caps (-10%) did worse than small caps (-9%) and large caps (-6%). Somehow surprising is the fact that value stocks (-7%) did not do better than growth stocks (-7%). This is an effect often observed in a crash: investors anticipating a slow down in the economy shifted into defensive sectors, making them more expensive relative to its own history and the market average. In a global sell-off, they feel the same brunt.

Fun with inverse ETFs

I love Exchange Traded Funds (ETF). In theory. In practice they are being abused by issuers and traders alike (see Beware of systemic risk in ETF). But that’s another topic. Today let’s take a look what can happen with inverse ETF through the compounding effect.

I like inverse ETF (i.e. SH) on the stock market, because if I am wrong (market goes up), my problem gets smaller (ETF goes down). If I had sold short the market (i.e. SPY or via futures) my problem would get bigger.

Of course this “advantage” comes at a certain cost in form of a potential performance drag. To make it clear, let’s look at 4 simple examples:

 

Example A: Index drops 10%, then fully recovers on day 2 (+11.11%). The inverse ETF however ends ups on a level 2.22% lower than on day one. Why? The increase on day 1 is 10 points (or 10%), but the decrease on day 2 (11.11%) is 12.22 points in absolute terms, since the percentage drop is calculated based on a higher base (11.11% of 110 = 12.22).

Example B: Index rises 10%, then retraces fully on day 2 (-9.09%). The inverse ETF drops 10%, then recovers 9.09%. The ETF ends up 1.82% lower. Why? The %-increase is calculated on a lower basis (90), yielding only an 8.18 point (9.09% of 90) increase on day 2.

Example C and D look at identical percentage changes with opposite direction. In example C, the index first drops, then recovers (example D the opposite). In both cases, the ETF and the index end up having the same percentage changes from day 1 to day 3.

Conclusion: In a sideways market, the inverse ETF will have performance drag. For levered (twice, triple) ETF the effect will be magnified.

The levered ETF (i.e. SDS) has another disadvantage: it even has performance drag in a sideways market if the daily ups and downs are identical in percentage terms. Here, we let the S&P 500 decline 1%, then go up 1%, etc. for 460 days:

Over the course of 2 years (approximately) SPX and SH perform similar, while SDS underperforms.

Now let’s do same with 5% down, followed by 5% up days:

The levered inverse ETF gets atomized (-90%). While investors in levered ETF wish for high volatility in the short term (provided they got the direction right) it clearly hurts them in the longer term.

Now, let’s look at a sideways market in absolute terms: 2% down, 2.04% up the following day:

The numbers speak for themselves; SH and SDS both suffer badly.

But now let’s say the S&P 500 index goes to 400, as some people (including myself) believe (a normalization of corporate profit margins and a 10 times earnings multiple almost gets you there without a stretch). The market does it by declining 1%, followed by a 0.5% increase the following day:

Whoopsie! Compound growth starts showing up. Why? Theoretically, the index can decline 1% each day for an infinite amount of time (even at SPX 400 it can go down another percent).

And what would happen if this 1% down, 0.5% up pattern goes on for 5 years?

Anybody who had bought just one SDS would be multi-millionaire! Of course, with the SPX at 2 points markets would have stopped functioning for a long time.

 

ETF: Beware of systemic risk

This is a topic I should have paid more attention to earlier: systemic risk in ETFs (Exchange Traded Funds). Here are my thoughts in a few bullet points:

  • ETFs are a great idea. They allow diversification at minimal cost to the investor (especially compared to mutual funds).
  • Unfortunately, the financial  industry is in the process of pushing the limits on how ETFs can be abused.
  • Warnings on systemic risk have been issued by the IMF, BIS and G20.
  • Here are some of the risks:
  1. Synthetic replication: The ETF does not actually purchase the promised investment exposure (e.g. gold), but “replicates” the exposure synthetically by entering swap agreements with an investment bank. Should the bank go belly up, there is no exposure. “Paper gold” might not be enforceable.
  2. Funding: many ETFs are actually structured derivatives (zero coupon bonds with derivatives attached) allowing the issuer to use investor’s money for their own funding purposes. The investor has, as seen with Lehman “guaranteed” equity-linked certificates, an issuer risk.
  3. Securities lending: ETFs generate income through securities lending. This creates counterparty and collateral risk in case the counterparty goes bankrupt and the securities are not retrievable.
  4. Rehypothecation: Hypothecation is the practice where a borrower pledges collateral to secure a loan. Rehypothecation is a practice where a bank or other broker-dealer re-uses the collateral pledged by its clients as collateral for its own borrowing. In 2007, rehypothecation accounted for half the activity in the “shadow” banking system. Because the collateral is not cash it does not show up in conventional balance sheet accounting. Prior to the Lehman collapse, the IMF calculated that US banks were receiving over $4 trillion worth of funding by rehypothecation, much of it sourced from the UK where there are no statuary limits governing the reuse of a client’s collateral. It is estimated that only $1 trillion of original collateral was being used, meaning that collateral was being rehypothecated several times over.

Conclusion:

  • Abuse of ETFs by the issuer (and possibly by high-frequency traders) is obvious.
  • It is not only possible but likely that one day an ETF will fail because of counterparty or collateral issues.
  • This could lead to a panic reaction, leading to a situation where even physically backed ETFs could trade at a discount to NAV (net asset value).
  • This means that for our client portfolios we will not use ETFs going forward (except if the client explicitly wants to do so). One exception is the precious metals area, where the transaction and storage costs are too high to invest directly in physical gold. There are a few physically backed ETFs (e.g. by Sprott Asset Management in Canada) we have enough confidence in to invest (it is not without reason they trade at a premium to NAV).
  • It is debatable if ETF’s should be used to establish a short market position (e.g. as a hedge). Leveraged ETF’s are shown to be guaranteed losers over time. Even ETF’s aiming to replicate inverse daily price changes have suffered performance drag over longer periods of time. Their advantage: if the investor is wrong in his assumption his position gets smaller, not larger (as in a “real” short position via futures or short sale).
  • Current holdings, like in mining stock ETFs, will gradually be exchanged into the 3-7 largest underlying holdings. We still have to figure out if those holdings will be equally weighted or market capitalization weighted.

As uncomfortable as giving up ETFs might be, I am afraid this is in the best interest of our investors.