Exchange traded funds (ETF) guide

Senior Analyst Rob Lee explains ETF basics

Exchange-traded funds (ETF)

An ETF is an investment vehicle on stock exchanges, they hold assets such as stocks or bonds and is valued approximately at the same price as the net asset value of its underlying assets. Most ETF’s are index tracking and are attractive because of their low cost, tax efficiency and stock like features.

Large institutional investors, authorised participants, actually buy or sells the shares of an ETF to/from the fund manager normally in large blocks for long term investment or more typically as market makers on the open market. Individual investors using retail brokers trade ETF shares on this secondary market.

The ETF offers public investors an interest in a pool of securities and other assets similar to mutual funds although the shares in an ETF can be bought or sold throughout the day like stocks on an exchange through a broker.

Investment uses

ETF’s provide diversification, low costs and tax efficiency of index funds while holding onto the features of ordinary shares. ETF’s can be utilities for long term investment or asset allocation and for frequent trading using market timing investment management.

Low costs are found due to the vehicle not having an actively managed element and because ETF’s are buffered from costs of having to buy and sell securities to accommodate purchases and redemptions of share holders.

Flexibility for buying and selling at current market prices any time of the day, unlike mutual funds and unit trusts, as a publicly traded security their shares can be purchased on margin and sold short enabling hedging, stop orders and limit orders.

Divesification, ETF’s inherently provide exposure across the entire index, industry sector, bond indexes or commodities.

Types of ETF

Index ETF: Attempts to track the index by holding in its portfolio either the contents of the index or a sample of securities in the index.

Commodity ETF (ETC Exchange Traded Commodities): Invest in commodities such as precious metals and futures. Commodity ETF’s are index funds tracking non-securities indexes.

ETC’s trade just like shares, are simple and efficient and provide exposure to an ever-increasing range of commodities and commodity indices, including energy, metals, softs and agriculture. However, it is important for an investor to realize that there are often other factors that affect the price of a commodity ETF that might not be immediately apparent; for example, buyers of an oil ETF such as USO might think that as long as oil goes up, they will profit roughly linearly. What isn’t clear to the non-professional investor is the method by which these funds gain exposure to their underlying commodities. In the case of many commodity funds, they simply roll so-called front-month futures contracts from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.

Bond ETF’s: Exchange-traded funds that invest in U.S. Government bonds are known as bond ETF’s. They thrive during economic recessions because investors pull their money out of the stock market and into U.S. Treasuries.

Exchange-traded grantor trusts: An exchange-traded grantor trust share represents a direct interest in a static basket of stocks selected from a particular industry.

Leveraged ETF’s: Leveraged exchange-traded funds (LETF’s), or simply leveraged ETF’s, are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETF’s.

Tax efficiency

ETF’s in the United Kingdom are protected from capital gains tax by placing them in an individual savings account (ISA) or self-interest personal pension.

Trading

Perhaps the most important benefit of an ETF is the stock-like features offered. Since ETF’s trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement).

For example, an investor in a mutual fund can only purchase or sell at the end of the day at the mutual fund’s closing price. This makes stop-loss orders much less useful for mutual funds, and not all brokers even allow them. An ETF is continually priced throughout the day and therefore is not subject to this disadvantage, allowing the user to react to adverse or beneficial market condition on an intraday basis. This stock-like liquidity allows an investor to trade the ETF for cash throughout regular trading hours, and often after-hours on ECN’s (Electronic Communication Network). ETF liquidity varies according to trading volume and liquidity of the underlying securities, but very liquid ETF’s such as SPDR’s (Standard & Poor’s Depositary Receipts tracking the S&P 500) can be traded pre-market and after-hours with reasonably tight spreads. These characteristics can be important for investors concerned with liquidity risk.

Another advantage is that ETF’s, like closed-end funds, are immune from the market timing problems that have plagued open-end mutual funds. In these timing attacks, investors trade in and out of a mutual fund quickly, exploiting minor variances in price in order to profit at the expense of the long-term shareholders. With an ETF (or closed-end fund) such an operation is not possible—the underlying assets of the fund are not affected by its trading on the market.

Investors can profit from the difference in the share values of the underlying assets of the ETF and the trading price of the ETF’s shares. ETF shares will trade at a premium to net asset value when demand is high and at a discount to net asset value when demand is low. In effect, the ETF is providing a system for arbitraging value in the market. As the initial costs are one-off, the ETF vehicle offers some cost advantages over other forms of pooled investment vehicles.

What is Financial Spread Betting?

Financial Spread betting is one of the most exciting and fastest growing ways of speculating on the movement of an underlying share or index and for many investors it has become a flexible and cost efficient alternative to trading ordinary shares.

Advantages of Spread Betting

* No Stamp duty is payable (saving 0.5% compared to a traditional share purchase.

* Tax Free Profits: Profits on spread betting are not subject to capital gains tax.

* No direct commissions or fees are paid to the spread betting company.

* You can profit from falling or rising markets.

* They are traded on margin therefore bets can be placed with a relatively small initial outlay.

* A single account can give you Access to far greater range of financial markets.

* You can limit your risk using a “Stop Loss”.

* The ability to place very small bets, some companies let you place a trade of as low as 1p per point.

* Tax Laws are subject to change.

Drawbacks of spread betting

Financial spread betting is less suited to the long term investor,if you hold a bet open over a long period of time the costs associated increase and it may be more beneficial to have bought the underlying asset. You have no rights as an investor, including no voting rights and you will not benefit from dividends.

From Rob Lee of AiMS Trading Club and Forex training courses

London Hertfordshire Bedfordshire Cambridgeshire UK

Is Obama stealing your equity returns?

I picked this up in the longroom on the FT.com from Robert Johnson Ph.D, CFA and Scoot B. Beyer Ph.D CFA and Gerald R. Jensen Ph.D CFA.

In short (pun intended), these guys researched the relationship between security returns and year of the US presidential term. From 1969 to 2009 during each year of the four-year presidential term the returns for large cap equities averaged 5.0%, 4.6%, 22.9% and 8.5% respectively. Over 40 years the S&P500 returns in the second year of presidential cycle are significantly lower that the average return.

This phenomenon magnifies in small firms with returns on small-caps at 7.6%, 0.8%, 31.6% and 13.6%, respectively.

I’m not saying you will see disappointing equity returns by the end of the year but the study does provide a historical context.

Beta pairs bullish

The USD was slightly weaker in Asian session, as risk appetite returned. Wall Street was able to rally on the back of higher than expected inventory build, which pushed crude to $80.13bbl. Asian regional indexes were able to buck yesterday’s poor performance and recoup most of their losses, with the Shanghai composite climbing 1.3% at the time of writing.

US auctions continue to be well received, with 10yr notes auction going off without a hitch, after which yield moved higher. Interestingly, China’s hike in reserve ratio, which initially was deemed negative, has now taking on a softer tone with participants agreeing that allowing an asset bubble grow and then burst would be anti-productive. Overall within FX, high beta pairs have taken on a bullish sheen, lead by commodity currencies and the AUD.

TR/J CRB – Commodities snapshot

Focus: Commodities analysis

In the news:

Grain prices dip after forecast for record crops FT.com

The price of gold fell early Tuesday in London commodity news center

US farmers plant less wheat, lowest since 1913 Charlotte Observer

Commodity snapshot: Gold -2.0%, Copper -3.2%, Brent crude -2.4%

TR/J CRB: Commodity Index benchmark basket visual

Dow Transports 52 week high

After breaking resistance in December, the Dow Transports consolidated a few weeks and then broke to a new 52-week high this week. Volume has also been strong since early December as many up days occurred with above average volume. And finally, broken resistance turned into support around 4090-4000.

Range 4,191.32 – 4,261.59

52 week 2,134.21 – 4,265.61

Open 4,261.59

Vol / Avg. 13.87M/18.96M