ETF Tricks From Forbes Asia

I read this in the recent Forbes magazine and I found it is quite interesting. This is an article written by Michael Maiello on Exchange Traded Funds (ETF) in the US. An ETF is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange, thus experiencing price changes throughout the day as it is bought and sold.

Since it trades like a stock whose price fluctuates daily, an ETF normally does not have its net asset value (NAV) calculated every day like a mutual fund does.

By owning an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order. One of the most widely known ETFs is called the SPDR (Spider), which tracks the S&P 500 index and trades under the symbol SPY in the US market and the STI ETF 100 which had recently undergone a stock split to become STI ETF, which tracks the STI index in Singapore.

The article discussed about some new opportunities and new hazards in this fast-changing arena. Like dandelions after a spring rain, ETFs are cropping up everywhere. Last year alone, there are some 253 launches. There are now 612 ETFs in the US, sponsored by 19 money managers, according to State Street, which manages the Spider ETF among others.

How do you choose among this vast welter? One place to start is the recommended Best Buys list extracted from the magazine as shown below.

The Best Buy formula for actively traded funds puts equal weight on costs and performance. But since ETFs are passive (usually tracking a stock index), past performance does not tell you anything useful. So the ETF Best Buys are the ones with the lowest costs in each of seven different categories of portfolios. Here the costs are defined as the sum of annual expenses and one-fifth the average bid/ask spread observed on a recent trading day.

An ETF is a cross between a closed-end fund (with a fixed number of shares outstanding) and an open end (whose sponsor continually sells shares to newcomers while cashing out departing customers).

An ETF has a fairly rigid portfolio mix. It trades, like a closed end, with a bid-and-ask spread on a stock exchange, and when you buy or sell it you run up a brokerage commission. Shares are created and extinguished in response to demand. They are created when a brokerage firm assembles a basket of constituent stocks and hands that in, getting ETF shares in return. Shares are extinguished in a reverse process that ends with the broker selling constituent stocks.

Beyond The Index

Trust manufacturers of financial products to make simple things complicated. The original ETFs tracked broad indexes like the S&P 500, however the newest aim at narrow sectors, such as banks (with a bad showing in 2007) and oil (windfalls gains of late). International ETFs are popular and enjoying since price gains; 31 overseas ETFs started in 2007.

Lately, ETF managers have hired companies like S&P and Zacks to create custom indexes for them. One such batch of ETFs was launched by Power-Shares and based on something called “Intellidexes”. These ETFs screen for stocks using 25 factors ranging from valuations to growth rates.

The PowerShares Dynamic Market ETF, the first one, has outstripped the S&P 500 since 2003 debut, scoring an annual return 14.3% return versus the S&P’s 12%. Its portfolio of 100 stocks is rebalanced quarterly, turning over the portfolio once a year, on average. The rules for picking stocks are cryptic, but this fund is an open book compared with an open-end fund. An open-end does not have to reveal its portfolio until its next semiannual report; the ETF discloses the stocks in the basket daily on the PowerShares Web site.

Some of these creatures are rather clever and so far have not slipped up. Take the Claymore/Sabrient Insider ETF, a basket of 100 stocks (adjusted quarterly) that corporate insiders are buying heavily. Since the ETF’s September 2006 debut, it is up 17% versus 13% for the S&P 500.

The newest iteration is the actively managed ETF, although it is unclear whether the US Securities & Exchange Commission (SEC) will approve the notion. The agency up to now has preferred that ETFs follow some kind of index. Bruce Bond, chief executive at PowerShares, says regulators have warned him about comparing his ETFs too closely with an actively managed portfolio.

Pending SEC approval, the proposed PowerShares Active Mega-Cap will behave just like a quant mutual fund, where various formulas kick out stock picks so the company claims that a large part of it is passively managed. Human managers will have some role, supposedly secondary.

Exchanged Traded Commodities

ETF does not necessarily have to own shares. It can own commodities or commodities contracts – the StreetTracks Gold Shares is sitting on $16.8 billion worth of gold bars in bank vaults. In the case of a curious pair of oil-related ETFs, MacroShares Oil Up and MacroShares Oil Down, the funds own, essentially, contracts with one another. They were invented by Robert J. Shiller, a Yale University economist.

The MacroShares, which first appeared in November 2006, together hold a $60 million portfolio of short-term US Treasury bonds. When the price of oil goes up, MacroShares Up gets a larger claim on the portfolio; as the price declines, it cedes value to its partner fund. Buying either half of the fund is like going long or short an oil contract on a commodities exchange.

Unlike most ETFs, which tend to trade at prices very close to their net asset values, these two years veer off. In response to popular demand, the oil-up shares were recently trading at a 9% discount to their $33.11 NAV, while the oil-downs were at 46% premium to their $10.10 NAV. (The combined $40.01 share price, however, was very close to the combined $40.45 NAV)

An advantage to the ETF as a way of speculating on commodities: it is available in small doses. An oil future on the Nymex has a contract size of 1,000 barrels, worth $99,000. Another advantage is that the ETFs do not get expire, so you can make one trade and sit on the position indefinitely. The disadvantage of these ETFs is their rapacious 1.6% expense ratio.

Dollar Cost Averaging

A popular if somewhat overrated way of investing is to buy a fixed dollar amount of an asset at regular intervals over a long period of time. You buy, say, $500 of an index fund every month for ten years. No-load funds are ideal for this style of investing, ETFs less so, because of the brokerage commissions make the ETF option at least plausible these days. Scottrade charges only $7 a trade. Bank of America offers 30 free trades per month to any customer with $25,000 in a BofA account.

If you are interested in trading ETF, you can start with the Singapore STI ETF. You can find more information here. You can also read about Gold as Investment from Wikipedia.