Max Isaacman is a nationally-known columnist and financial journalist. He writes for the award-winning newspaper San Francisco Examiner, and has also written for Delta Airlines Sky Magazine, Financial Technology News and Personal Investing News. He is also featured on the Multex, the largest on-line research source. Over a career that has spanned 30 years, Isaacman was a representative of Montgomery Securities, a partner of Cowen and Company, a Vice President of Lehman Brothers, and a member of the President’s Club at MERRILL Lynch. He is currently President of MDI Research, his investor relations and research firm, located in San Francisco.

INVESTING WITH Intelligent ETFs

Strategies for Profiting from the New Breed of SecuritiesBy MAX ISAACMAN

The McGraw-Hill Companies, Inc.

Copyright © 2008 Max Isaacman
All right reserved.
ISBN: 978-0-07-154389-7

Contents

Chapter One

EXPLAINING EXCHANGETRADED FUNDS

Exchange-traded funds (ETFs) are securities classes that track an index, an industry, a style group, geographic region, or other market segment, all of which is spelled out in an ETF’s offering prospectus. For most ETFs that deal in stocks or bonds, this entails buying the stocks or bonds that exactly or approximately replicate its index. ETFs, especially ones of the new generation, offer exposure to stocks picked according to indexing methodologies and disciplines based on exhaustive and original research.

ETFs are constructed somewhat similar to mutual funds, but there are important differences. ETFs trade on stock exchanges like individual securities. With ETFs, investors trade a security that has even more flexibility than a stock and can gain the diversification that indexing offers.

The new generation of ETFs gives enhanced quantitative methodology that seeks to accomplish certain goals such as gaining alpha and reducing risk by diversifying. The indexes that the ETFs attempt to replicate have been back-tested and many use new weighting techniques.

For traders, during the day as the markets move up and down, you can trade ETFs as you would individual stocks, taking advantage of rallies and dips. Because you are trading a market segment, you are not subject to the high risk of trading a single issue.

For investors, you can buy a market segment or indexing methodology or any of a host of ETF offerings, hold that exposure as long as you want, for years even, and probably have a taxable event only when you sell the security. Unlike a mutual fund, there will be little or no taxable events during the time you hold it.

ADVANTAGES OF TRADING AND INVESTING IN ETFS

Investors and traders can buy and sell shares anytime the markets are open. ETFs can be bought and traded on margin; they can be sold short, and unlike stocks, which have to be shorted on an uptick, ETFs can be shorted on a downtick. Often ETFs have lower management fees than funds or active money managers. Because of the creation and redemption process, ETFs offer tax efficiencies. With ETFs you know what stocks you are getting, because you can go to the Web site of the ETF creator or other sources and see what stocks are held in the ETF.

There are also differences between buying and selling ETFs versus mutual funds. Consider Table 1.1 which shows some of the differences between the two structures.

You can see from Table 1.1 that there are advantages to trading ETFs versus mutual funds. And there are also advantages to trading ETFs versus stocks. You can buy and sell in size with ETFs and not affect the market price too much since ETFs are sold mainly on the basis of their net asset value.

As mentioned, you can short an ETF on a downtick or a zero downtick, whereas a stock needs an uptick to be shorted. If a stock traded at 30 and then trades at 30.02, that price is an uptick. A stock can be shorted there. If a stock trades at 30.02 again, that second 30.02 trade would be a zero-plus tick, meaning it is continuing to trade higher. If a stock trades at 30, then at 29.95, that trade is a downtick and stock cannot be shorted there. If the next trade is again at 29.95 that is a zero downtick, and stock can still not be shorted.

This SEC rule of not shorting on a downtick or a zero downtick does not apply to ETFs. If the market is tumbling and you want to short the market to take advantage, you don’t have to wait for an uptick with an ETF. This securities class is exempt from the downtick rule, and you can short in a falling market.

Say the market is looking weak and you have good gains in your portfolio and don’t want to sell just now. You don’t want to take the gains, which are short term and taxed at a high rate, and you think the market will still go up after a correction of 10 percent or so. You are not a trader but you do time the market on occasion. Besides, you will only short about 10 percent of your portfolio, and if you are wrong, you will be right on the 90 percent of your portfolio that you are holding.

Shorting an individual stock is generally riskier than shorting an ETF, just as buying a single stock is generally riskier than buying an ETF. ETFs are baskets of stocks, in most cases replicating stock indexes, so there is a built-in diversification component. Just like buying a stock, shorting a stock exposes you to the vicissitudes of the fortune of a single company, and the myriad unforeseen events that can affect a company at any given time. Maybe you have researched a company and know everything about it. You have great confidence in the company, most analysts praise it, and you don’t see a downside, given its low P/E and low Price to Book ratio. But things happen, and you don’t have to live through many Enrons and WorldComs to realize that there are limits to investment research. WorldCom looked good on paper, but in reality there were accounting problems that only surfaced after the stock had declined quite a bit.

If you want to short the market but don’t know what to short, just that you want a market proxy to follow the market direction that you think is downward, you could short SPY. SPY is the symbol of one of the S&P 500 Index ETFs. Say that SPY is selling at 145.20 a share and starting to drop. As stated, with a stock you have to wait for an uptick or zero uptick, but with ETFs you can short anytime. You could call your broker and get stock protection for when you want to cover the short. You tell your broker to short 500 shares of SPY. Something as liquid as SPY can be easily short at the market. Now you have a slightly hedged position, in that just 10 percent of your portfolio is short. When shorting an ETF, you are not subject to single stock shocks. SPY will probably go in the direction of the other market indexes. You can cover the position anytime you want.

You also don’t have to worry about trading size since ETFs, with the creation and redemption process, are very efficient. If there is large demand, orders for hundreds of thousands of shares, the authorized participants can create more shares. If there is too much supply, participants can redeem shares and shrink the supply. ETFs trade based on their underlying value and, to a much lesser extent, the buying and selling pressure from traders and investors throughout the day. Prices are usually kept pretty tight, but you can always put in a limit order to be sure you get the price you want.

Some ETFs have proved to be not very liquid, especially the newer and lesser known ones. But because ETFs trade on a net asset value basis, they usually do not stray far from their asset value. You do have to be careful when trading and investing in the less liquid issues. It is a good idea to watch the trading in the ETFs you are interested in and make sure they trade near their asset values.

Before I buy an ETF, especially a lesser known one, I watch the trading for a while to make sure that the trades are near the bid and asked prices. Sometimes I put in market orders to make sure that orders are executed near the bid and asked prices. When trading in a less active ETF, you could use limits on buys and sells, at least until you get comfortable enough to trust the trading in that ETF to enter market orders.

Recently I had to invest some money for a client, so I did my research and bought several ETFs. It took some time to get the trades done, but nothing like the work it would have taken to trade stocks. I bought some of the lesser known ETFs, and didn’t see where I moved the market at all; in most cases I bought easily on the offered side. I could have tried to split the bid and asked, but I wanted to get the money working quickly.

Trading stocks is different, especially in the lesser known, less liquid stocks. In those cases you almost have to use limits, because without that safeguard you could make an unfortunate execution. In a fast-moving market it is often hard to get a feeling of where you can get trades done.

THE CREATION AND REDEMPTION PROCESS

ETFs are created and redeemed in creation units, which are blocks of ETFs, usually created in 50,000 share units. Many factors are taken into consideration in deciding to create more shares, including the need to fill orders and the desire to create more inventory. Shares are redeemed when it is decided that too many shares are outstanding and that a market can be easily made with fewer shares.

Creation and redemptions are done by authorized participants, which are usually large financial institutions such as banks or trust companies that have been authorized to participate in this process. Creations and redemptions are performed on a continuous basis on an ETF’s net asset value (NAV). The NAV represents the total value of all the investments an ETF owns. This figure includes the value of the securities the ETF is holding, any cash components in the ETF, and any other assets, such as derivatives. When the participant delivers the basket of shares to be converted into ETF shares, it also brings cash to cover items such as accrued dividends, creation fees, and interest on dividends. The NAV reflects the value of the ETF shares, and ETF market prices fluctuate during the day due to supply and demand. Factors that change the NAV during the trading day include currency exchange rate fluctuations and changes in the value of the securities in the index.

Investors and traders can see the approximate value of an ETF by checking its intra-day portfolio value (IPV). Although an ETF NAV is set once a day, the IPV constantly changes throughout the trading day. The IPV does not reflect at what price an ETF can be created or redeemed, but it is an indication of the value of the stocks comprising the index. When buying or trading ETFs, the ETF market price is a moving target, similar to stock prices. However, ETFs are usually less volatile because they are baskets of stocks. When you buy a fast-moving tech stock, you know that in falling markets you may buy it cheaper and in rising markets you may have to pay up from its last price. This is true of ETFs also. When oil stocks are running, you usually have to pay up for an energy ETF.

There are instances where the IPV is not tied to the value of the underlying stocks but is more an indication of prices. One example is trading and investing in the ETFs of foreign countries and regions. Some of these ETFs are trading on the U.S. markets and are Asian, European, or other foreign ETFs. Asia and Europe are sleeping during our trading days, and those markets are closed. The IPV in this circumstance is an indication only; an indication of where traders and investors in the United States think those ETFs will trade. Even so, foreign ETFs have a good record of keeping fairly close approximate prices to the actual prices of stocks in the foreign regions. Traders and investors can usually get the IPV symbol for an ETF from the ETF prospectus or the ETF creator’s Web site.

For most ETFs the creation process includes buying all the stocks that comprise the index the ETF is attempting to emulate. There are also ETFs that optimize an index, meaning that the shares are not held in the exact proportion in which the replicated index holds the shares. The ETF maker describes in the prospectus whether the ETF optimizes or uses other methods for construction. Also the prospectus will reveal if and to what extent derivatives and other instruments are used.

Authorized participants calculate the number of shares of each stock needed to replicate an index. The participants tell the specialist the number of shares needed to buy to create a basket of stocks to comprise the index. As an example, consider two of the ETFs that replicate the S&P 500 Index, which are SPY and IVV. The specialist will be told what shares to buy to replicate 50,000 shares of this index: perhaps 345 shares of IBM, 180 shares of Wal-Mart, and so on. This basket of shares will be presented to authorized participants, accompanied by a cash component to cover items such as creation fees, accrued dividends, interest on dividends, any capital gains less losses that have not been reinvested since the last distribution, and usually a small amount to cover differences resulting from the rounding of the number of shares that need to be delivered.

In the ETF creation and redemption structure the money flows from the buyer to the broker, through the ETF market maker, to the ETF creator. The ETF creator creates the ETF shares, flows them through the ETF market maker, and back to the buyer. Most ETFs are created this way and most ETFs are backed by shares of stock. In the mutual fund structure the cash flows from the buyer to the fund, the fund buys shares in the capital markets, and flows fund shares back to the buyer.

So when you buy a fund, you buy from the fund itself, and the fund goes into the capital markets to buy shares. When you buy an ETF, you buy from the ETF market maker. When ETF shares are redeemed they are redeemed in kind, which benefits you and is not a tax event.

For ETF creation, when the authorized participant requests the basket of stocks, the specialist on the floor of the exchange will deliver the shares, which were bought on the open market. The participating firm can deliver the new ETFs to the specialist. As the value of the replicated index fluctuates that day, the new ETFs will trade in the open market. The key to this process is that the transaction between the specialist and the participating member happens in kind. The specialist on the floor does not deliver cash; the basket of stocks is delivered to the participant. The participant delivers new ETF shares. This creates no or very little tax consequence for you, the ETF buyer.

TAX CONSIDERATIONS

You do not know your potential tax liability when you buy a mutual fund. Mutual fund shares are purchased and redeemed from the fund itself, and when the fund needs cash to pay its shareholders who are redeeming shares, it may incur a capital gain that will be paid by those who have held or still hold the fund. A phantom capital gain is not a welcome surprise, especially if you sold the stock at a loss and get taxed for a gain. With ETFs this threat is minimized.

Suppose a fund has grown over many years, and the stock the fund holds has increased in price, and the cost basis of the shares in the fund is well below the NAV of the fund. For example, suppose the market price of the fund is $10 a share and its NAV is also $10 a share. The cost basis of the stock in this case averages about $5. There would be a built- in short- and/or long-term gain in the fund’s market price.

If owners of the fund sell their shares, for example, when tech holders started selling shares in the tech implosion starting in 2002, the fund would have to sell stock to redeem its fund holders. The fund could decide to sell off their lowest-cost stock, not an unusual decision since this would be stock held the longest, and probably would qualify for capital- gains tax status. These capital gains would be passed on to fund holders when a capital- gains distribution is made at year end. So even if a fund holder bought and held the fund and did no other trading, she could find herself facing a taxable event because she received a capital-gains distribution.

Because of the ETF creation and redemption process, an investor or trader buys shares on an exchange. This is unlike buying a fund, because a fund buyer buys directly from the fund. Of course, there will be tax consequences when taking a profit or loss from the purchase and sale of ETFs, but only when the shares are sold or, in the case of shorting, when the positions are covered.

Another example may clarify what could happen and the differences between funds and ETFs. Let’s say that a new fund is created and the price is $100 a share. Your friend buys it and the fund goes up. He tells you about it and you buy, paying $200 a share. After that the market goes down and holders start selling the fund. The fund would have to sell shares to pay redeeming fund holders. When the fund sells its low-cost shares, it has to take a capital gain, in this case $25 a share. You hold your shares and the stock goes down to $100 a share.

What about the capital gains the fund had to take? It will be distributed, and the distribution goes out to all the fund holders, including you. You would receive a capital- gains distribution of $25 a share, on which you must pay taxes, even though your shares have declined by half. The net result is that you have a $100 loss in the market value of your fund.

The above example does happen. Market cycles come and go, and funds go up in value, and when the sector or market segment the fund specializes in falls out of favor, and the fund declines, fund holders will redeem their shares, and whatever capital gains there are will be passed on to the fund holders. The conventional fund structure is part of the problem of phantom gains appearing for an investor holding a losing fund. Another possibility that could cause a mutual fund to incur large capital gains that it would have to pass on to investors has to do with the merger and corporate finance activities that have increased with the global economy. A fund could have low-cost shares of a major industrial company, which the fund does not plan to sell in the foreseeable future. Another company could come along, a company headquartered anywhere in the world, and take over the company in which the fund has low-priced shares. With the takeover the fund will incur a capital gain and, of course, pass the gain on to the fund holders.

(Continues…)

Excerpted from INVESTING WITH Intelligent ETFsby MAX ISAACMAN Copyright © 2008 by Max Isaacman. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.