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.

Stock market investment: Alpha, Beta and stuff

Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers’ performances. Often, the return of a benchmark is subtracted in order to consider relative performance, which yields Jensen’s alpha.

The alpha coefficient (α_i) is a parameter in the capital asset pricing model (CAPM). It is the intercept of the Security Characteristic Line (SCL). Alternatively, it is also the coefficient of the constant in a market model regression.

It can be shown that in an efficient market, the expected value of the alpha coefficient is zero. Therefore the alpha coefficient indicates how an investment has performed after accounting for the risk it involved:

• α_i < 0: the investment has earned too little for its risk (or, was too risky for the return)
• α_i = 0: the investment has earned a return adequate for the risk taken
• α_i > 0: the investment has a return in excess of the reward for the assumed risk

For instance, although a return of 20% may appear good, the investment can still have a negative alpha if it’s involved in an excessively risky position.

Besides an investment manager simply making more money than a passive strategy, there is another issue: Although the strategy of investing in every stock appeared to perform better than 75 percent of investment managers, the price of the stock market as a whole fluctuates up and down, and could be on a downward decline for many years before returning to its previous price.

The passive strategy appeared to generate the market-beating return over periods of 10 years or more. This strategy may be risky for those who feel they might need to withdraw their money before a 10-year holding period, for example. Thus investment managers who employ a strategy which is less likely to lose money in a particular year are often chosen by those investors who feel that they might need to withdraw their money sooner.

The measure of the correlated volatility of an investment (or an investment manager’s track record) relative to the entire market is called beta. Note the “correlated” modifier: an investment can be twice as volatile as the total market, but if its correlation with the market is only 0.5, its beta to the market will be 1.

Investors can use both alpha and beta to judge a manager’s performance. If the manager has had a high alpha, but also a high beta, investors might not find that acceptable, because of the chance they might have to withdraw their money when the investment is doing poorly.

These concepts not only apply to investment managers, but to any kind of investment.

A coefficient measuring a stock’s relative volatility to a market index, such as the S&P 500 Index. A manager with a Beta greater than 1.0 is more volatile than the market, while a manager with a Beta less than 1.0 is less volatile than the market.

“An important measure of a stock’s (or a portfolio’s) volatility in relation to the Standard & Poor’s 500, which by definition has a beta of 1.0. A beta higher than this implies greater volatility than the overall market. Thus, a stock with a beta of 1.5 will move up 15 percent when the market rises 10 percent. In good times, high betas imply high returns, since a beta above 1.0 amplifies the market’s movements. In bad times, of course, a beta below 1.0 is desirable, since you wouldn’t want your portfolio to magnify downward movements. Ideally, you want a low beta and high returns, which is hard to get. You can lower the overall beta of your portfolio by adding lower beta stocks to the mix, in effect diversifying away some of the volatility.”

Investment managment education with AIMS London Hertfordshire Bedfordshire

Flash Traffic Stocks news

Canon: Expcet Digital Camera Sales to Grow 6% in 2010 to 25.7m Units.

How to value stocks: Earnings based valuations

Its very normal to value a company via its earnings, often referred to as net income or net profit. Essentially earnings are the money left after all the bills are paid.  To compare companies like-for-like investors measure earnings with an earnings per share (EPS) formula.

EPS

To find the EPS of a company you divide the amount of earnings of a company (in currency) by the number of shares the company has outstanding. We will use good old XZY PLC for our examples:

XYZ PLC produced $1 million earnings in the last 12 months and has 1 million shares outstanding; our EPS formula would produce an EPS of $1.

$1mil earnings /1mil shares = $1 EPS

P/E

Unfortunately the EPS tells us nothing about the companies shares fair value, we need something to compare relative to its share price. Many investors use another formula, the price/earnings ration. P/E looks at the share price and divides it by the last four quarters worth of earnings. XYZ PLC volunteers yet again; the current share price of XYZ PLC is at $10 a share:

$10 share price / $1 in EPS = 10 P/E

Sometimes called a multiple the P/E is often compared to the current rate of growth in the EPS, if both are approximately equal then fair value could be argued, this assumes that the P/E ratio at 10 is roughly inline with the companies current growth rate of lets say 11% for XYZ PLC, this would make P/E relative to current earnings growth a more sensible measurement, if on the other hand a companies growth decreases then P/E would not make sense as a measurement tool.

Both of these methods produce a “trailing” ratio, in other words the methods are based on historical data and benchmark what has happened. Quite a few investors I have meet stop here and use this data for their “informed” decision on a stock, frankly I feel this is a leap of faith and alike driving car while firmly fixed on the rear view mirror.

Since XYZ PLC has a current growth rate of 11% we can extend the use of P/E, I don’t want to look at the past for a decision, I want to forecast into the future. For this we can use two simple methods, these are the “P/E & Growth” (PEG) and the “year ahead P/E & Growth” (YPEG).

PEG

To use PEG we expand the growth rate out into the future and then compare it to its trailing P/E.

10 Trailing P/E / 11% projected EPS growth rate = 0.90 PEG

The lower PEG ratio the more of a bargain the companies’ price is. As you can see the 1% increase in current growth compared to its trailing valuation of 10% growth shows up in our analysis using PEG.

YPEG

YPEG uses the same assumption but uses different data. Instead of using trailing earnings data YPEG looks at the price to earning estimates for the coming year, then we apply 5 year growth rates estimates found at many quote sources.

So, if the forward P/E is 10 and we expect the company growth at 20% over 5 years, the YPEG is equal to 0.5.

We should not use PEG or YPEG in isolation, they make excellent measures if viewed with other methods, they do not provide one-stop-shop magic numbers.

FTSE visual update

A quick update for those of you following our FTSE analysis. As your remember we forecast a fall in the FTSE from the 5494.84 area on the 14th Jan 2010 >>>

Intrim report from here >>>

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.

Stock focus – Tesco PLC (TSCO.L)

Christmas period: Terry Leahy, Chief Executive, commented: “We’ve delivered a very strong performance over the Christmas period and New Year period. It was a great Christmas for Tesco customers with an excellent seasonal range in store and online.”

Group sales increased by 7.5% at constant exchange rates (6.9% at actual rates) in the six weeks to the 9^th January 2010. Overseas business grew over the same period (excluding petrol) by 4.1% constant exchange rate or 2.4% actual exchange rates.

In Europe sales grew 0.8% at constant (excluding petrol), sales incurred a 2.2% decrease in sales when actual exchange rates are applied.

Asia sales (Homever stores) gained 7.8% constant or 8.0% actual whilst United States (Fresh & Easy) concerns had a strong Christmas campaign then last year posting constant sales of 35% (24% actual).

Pre-Christmas

Group sales for the Q3 period tell us a more challenging Christmas tale, the 13 weeks ending 28^th November increased by 8.8% excluding petrol and Group results ending August 2009 posted an 8.3% increase.

Technical Analysis

Technically price is at the conclusion of a weekly Elliot wave closing in on its C-objective classically in-line with point 2. For those not familiar with the Elliot wave concept Elliot wave theory is a principle of crowd psychology (in our case the crowd are investors) and gauges the collectives’ moves from optimism to pessimism, repeat and rinse. The swings create patterns and provide evidence of prices movements and trends.

Within the dominant trend, waves 1, 3, and 5 are “motive” waves, and each motive wave itself subdivides in five waves. Waves 2 and 4 are “corrective” waves, and subdivide in three waves. Technical analysts use symbols for each wave to indicate function and degree, numbers for motive waves, letters for corrective waves.

Investor’s vehicles – Hedge or Mutual fund

A student recently asked me “what is a hedge fund?”,  A rather expansive question given we where discussing intra-day tactics I thought. My answer was as short as possible, given my real aim was to implant Fibonacci techniques during the training session, but I felt the question needed further analysis, as any misconception of a hedge fund or “hedging” could be detrimental to the students trading campaign, so I asked the student the question, “what do you think it is?”.

Their answer was, as I expected, the mean average, “it’s a fund where you put money in and a manager looks for long (bull/up/ascending) position to increase your money”, oh dear my semi-conscious response and prompted this post.

A hedge fund is not a mutual fund

A hedge fund can use any means necessary to make money long or short, unlike a mutual fund that  (under SEC) is not allowed to use derivatives or employ shorting strategies to make money. A mutual fund manager is limited to taking long positions in stocks or bonds; therefore there is a greater risk in investing in a mutual fund then a hedge fund.

A mutual fund manager is paid on the amount of assets under management winning or losing, a hedge fund manager is paid for results and very normally he/she also deploys their own capital into their own fund.

Alfred Winslow Jones coined the term “hedge fund”, hedge funds are private pools of money for investment. Initially hedge funds invested in equities on leverage and actually had to “hedge” for protection against market swings with long and short positions, only a hedging fund was actually called a “hedged fund”.

A genuine hedge fund manager employs in arbitrage, buy on one market and sell on the other to exploit discrepancies, and hedging strategies, securities transactions that reduce risk on an exiting investment position.

The long-only equity strategy is not a hedged fund; in fact it’s a type of mutual fund, a very expensive fund at that.

So, to Hedging: To minimize or protect against the loss of by counterbalancing one transaction, against another, necessary? Certainly worth deploying, we will discuss hedging tactics and strategies in a later educational post from AiM School.

FTSE100 – Hovers on 61.8%

The analysis of the FTSE100 re-finds the 61.8% Fibonacci retracement on the “great fall” today. The 2007 to 2009 fall which saw the FTSE tumble from 6751.70 down to 3460.71 has now attached itself firmly onto its 61.8% level retracement after only spending 1 trading day below. Price today has poked its head over and the close will give valued insight to the markets commitment to risk appetite.

A fall from this area should be on the cards if resistance holds.

JAL shares dumped

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