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Today's Commentary: 01.11.05
When the Index goes Active
At the end of last year, the investment world lost a visionary. Nate Most, the inventor of the Exchange Traded Fund or ETF passed away at age 90 leaving a fundamental change in how investors use the American Stock Exchange, the red-headed step child of Wall Street. Back in 1993, he introduced the Spider, a fund that traded like a stock but mimicked the Standard & Poors 500 Index of large cap stocks.
This type of tradable index fund shed new light and increased revenues on the beleaguered Amex and as of his passing, accounted for half of the shares changing hands. These funds have now become a force to be considered among the investment community although the $7.2 trillion mutual fund industry still makes light of the threat. Quickly advancing in terms of tax efficiency, lowered fees, and convenience, the ETF has come into its own as a place of indexed protection.
Vanguard has launched its own imitations of ETFs called VIPERs with many other funds creating similar offerings. While this is a typical form of Wall Street flattery, many fund managers have found the ETF an excellent place to equitize their cash reserves. Another benefit of these offerings allows fund managers to actively play industries or sectors that they perceive to be attractive. The risk is not eliminated however and may even be heightened. Many ETFs give the appearance of balance but may in fact be heavily weighted with large holdings creating a disproportionate amount of the index's investment.
Moving away from a strictly equity based fund, a gold index fund from streetTRACKs was based on the commodity with each shore offering a portion of an actual ingot. Initially Wall Street believed such an offering would entice foreign investors away from dollar based investments such as Treasuries to an offering with an actual metal attached.
The Net Asset Value of ETF is calculated in much the same manner as a mutual fund would. The NAV calculated by the mutual fund does not reflect supply and demand. Supply and demand are primary forces in the open market and because of that, the share price of an ETF may be trading higher or lower than the underlying worth.
ETFs outperform mutual funds in terms of flexibility though. The ability to trade throughout the day is one of the primary attractions for investors interested in ETFs. Frequent traders however may fell the sting of commissions more than those who chose another longer term strategy.
Two things make these shares worth avoiding. The first is that pesky problem of discount. In a market correction, ETFs may be on the surface, worth more than the NAV of the securities they represent. The second deals with expenses and the possible illusion that you are saving money. I have always encouraged dollar cost averaging, low expenses, and low entry fees for the mutual funds here at the BlueCollarDollar. ETFs would not fit that criteria. Dollar Cost Averaging, the act of making regular and steady contributions to a fund to offset high and low markets would rack up an enormous amount of commission costs. One lump sum purchase, perhaps with a windfall or a tax return check would be the best wait to fully realize the value of such a trade. This is the very reason Dollar Cost Averaging works so well. Buying the NASDAQ 100 or ticker symbol QQQ, a tech laden grouping of the top stocks on the NASDAQ at the high dollar mark of $110 would find you with a share worth two thirds less today. Using dollar cost averaging, the hypothetical investor would be purchasing shares at this greatly discounted price and with any luck, it will offset the share they bought back in '00. The current closing price at this writing (08.27.03) is down only 10% from the inception price of $50.
Expenses are considerably less than many index funds but this is also a smoke and mirrors effect. Unless you hold onto the ETF for a sufficient amount of time to offset the cost of the purchased ETF and the expenses, you are probably better suited for a mutual fund.
One of the most under considered expense is taxes. In a mutual fund, an investor sells shares and the whole fund feels the ripple effect. In order for that investor to receive the value of their investment, the fund must sell something to pay off the departing shareholder. This can negatively impact the remaining long term investors. If the stocks that are sold have experienced gains, taxes must be paid.
In the world of ETFs, this exchange is done between other shareholders and doesn't impact anyone other than those involved. Be aware though of two things that can be considered taxable and unavoidable. The securities in an ETF may still pay capital gains distributions. The second one is an indexing problem. When the fund needs to rebalance because of a change in the benchmark, stocks sold may have capital gains as well.
The choice of ETFs over mutual funds should be considered very carefully. In a long term investment strategy that employs dollar cost averaging, the benefits of ETFs fade very quickly.
The introduction of actively traded ETFs, however will present new opportunities for small fund companies but at the same time, effect the transparency currently being touted by brokerages will come under fire. Too much transparency will allow for front running and free riding, problems that do not effect actively traded mutual funds whose portfolios are closed during the trading session and are rebalanced at the end of each day.
Below you will find a list of these funds along with some pertinent information.
Qubes The NASDAQ 100 Index Tracking Stock, commonly referred to as Qubes from its ticker symbol QQQ, is an exchange-traded fund that tracks the NASDAQ 100 Index by investing in the constituent index stocks. This index, which is reviewed quarterly and rebalanced annually, is a modified market-capitalization weighted composite of 100 of the largest and most actively traded non-financial companies listed on the NASDAQ stock market.
The NASDAQ 100 Index reflects NASDAQ's largest companies across several major industry groups, including computer and office equipment, computer software and services, telecommunications, retail/wholesale trade, and biotechnology.
SPDRS Standard & Poor's Depository Receipts, commonly referred to as SPDRs, are a group of exchange-traded funds that track various Standard & Poor's indexes.
iShares are a family of open-ended exchange-traded funds that seek to track the performance of any of an array of market indexes, such as the Russell 2000 Value Index or the Dow Jones US Consumer Cyclical Sector Index.
DIAMONDS is the common name for a specific index ETF that seeks to track the Dow Jones Industrial Average (DJIA) index by investing in the constituent stocks of this index.
streetTRACKS is a family of exchange-traded funds that are marketed by State Street Capital Markets and represent ownership in the streetTRACKS Series Trust, an index fund that consists of separate portfolios of common stocks. Each fund is designed to track a specific index, such as the Dow Jones Total Market Index Series (US Large-Cap Value, US Large-Cap Growth, US Small-Cap Value, US Small-Cap Growth), Morgan Stanley Internet Index, Fortune 500 or the Fortune e50 Index.
One final note. Investors, especially those who look at sentiment before investing, these funds can be a quick look at what is happening.
Today's Commentary: 01.10.05
Who Owns What? - Ownership, Mergers, Acquisitions and the Failure of the Dream
As we began the new year, we settled into a fund raising frenzy for those less fortunate than us in the Tsunami's path of destruction. Our prayers go to the survivors and to the departed. But here at home, the financial world continued to buzz right along, anxious to begin trading in 2005 and most importantly, lobbying to end the world as we know it.
We should begin at the White House and move laterally to the gutters of Wall Street. The term Ownership Society has resurfaced with vigor with the President's talk of Social Security reform. This saw an increase in dissenting editorials as the financial implications of the re-election of Mr. Bush for four more years began to settle in among voters. This President was going to redefine lameduckiness by changing the future of millions of Americans, many of whom can little afford the shift in the status quo.
The future owners that Mr. Bush speaks about live in a fantasy world where society has control of its own destiny. But what is needed to be part of this new class of citizens? The answer is not much except ignorance, insouciance, and lack of involvement.
Your participation is by default but there are certain things you will be asked to do. In an ownership society, the choices have been limited so as to make your choice easier. In the case of Social Security, the warm blanket by the fire at the end of a long career will not be yours until much further down the road if the program changes. Pushing those retirement years further into the future will not shore up the supposedly rickety structure of Social Security as much as a change in how it is calculated would, but you will be asked to wait for that first benefit check a little longer nonetheless. This is not being asked of you based on your physical ability to work beyond the current retirement age but upon estimates that even actuaries discount as unrealistic.
And that check, when you eventually become eligible will be less as well. Cutting those benefits for the sake of those who don't believe in the ability of the program to provide for them, namely the younger worker, and those who are mutually excluded by wealth, will not be an easier pill to swallow because you have, through sacrifice "saved" the program. While Mr. Bush's plan goes much further, many retirees have become focused on those two issues as they coax those work weary muscles into motion each morning.
At the heart of the administration's proposed change in Social Security is their own belief that good faith and credit of the federal government is no longer any good for the Social Security program. For years, they have been placing IOUs in the program's coffers as they lifted the surpluses out. These IOUs are Treasury notes, the same type of bond we sell those Chinese and Asian bankers by the boatload. The message this sends to our benevolent foreign investors has not gone unnoticed. Along with increasing interest rates, our slowly falling dollar, and deficits of worrisome size, the foreign investor is not likely to shine on this internal shift in thinking.
Which brings me to my second point. What does Wall Street think of this shift in policy? A reformed and privatized program would be manna from heaven to a land already spending last year's substantial bonuses. The Street did hedge their bets with generous campaign contributions made to this administration. The result has the Street silently salivating in wings and rightly so. The denizens of finance understand the high cost of caring for other people's money and as a result, are not idle by any means. They are making sure that the market that greets this new group of investors is attractive and welcoming. By the time the new program is inked into law, the equities and bond markets will be wholly different places rife with success stories and track records of dubious performance.
What you will own will be a piece of Wall Street. And for that, we are to give thanks according to the rules of ownership. In such a society, the benefit, even if it is less, will be for the greater good.
The net effect on the equities markets, off to an agonizingly slow start this year, will be dramatic. If the administration fails to get the proposed changes to the program through - and one can only hope Congress will stand-up to the far-fetched estimations and unrealistic predictions of doom - then the markets will be exposed for what they are: high priced and bloated. Far too many companies are flush with cash, and that can only mean one thing for Wall Street, who has expressed the continued desire for lean and slightly underemployed industries.
Mergers & Acquisitions are the real bread and butter for Wall Street and if December was any indication, activity will be increasing in 2005. Not since 1999, when the inflated prices of equities created currency better than cash, has so much M&A activity taken place.
While industry consolidation seems like a good thing for shareholders, in an ownership society, two things happen. The first and of least importance is the inflated cost of the company merger. Creating a larger entity does not always increase the underlying value as it reshapes the share price. And secondly, the reason for the share price change - usually an increase - is not the sudden realization that the new company will somehow be better able to price their products, operate more efficiently, or be more nimble in a changing world but instead to be able to jettison their pension plans obligations.
The new game played by these companies involves the legal dissolution of subsidiaries within the larger corporation effectively removing any pension liability. Miscalculations of duration, an insurance term that helps make estimations on how the plan is able to distribute benefits and for how long, as well as poorly diversified portfolios have turned many pensions from bankable and reportable profits to drags on the financial statement. This makes for a very enticing incentive for continued M&A activity in an uncertain world full of unpredictable pension liabilities.
Pension woes will eventually become the taxpayers problem and that has caught the ire of the White House. If these plans are not dissolved through M&A activity, they are bailed out by the Pension Benefit Guaranty Corporation, an insurance policy for pension plans.
Now the PBGC, which is best compared to the Federal Deposit Insurance Corporation or FDIC, a program that protects the nation's savers, is facing financial difficulty of its own. This spells further disaster for those currently retired, about to or worse, those who have believed that this leg of their retirement stool was almost as safe as Social Security. The current premiums collected by the agency are predicted to fall short of future obligations especially if other airlines besides United and US Airways simply jettison their obligations. If other struggling industries see this as the cure for their own hemorrhaging plans, PBGC would be in serious trouble.
This would create a taxpayer burden of astronomical proportions Any changes in the plan however would need to come from Congress.
Some of the suggestions to change how PBGC operates would not benefit the employee or future retiree. Raising the premiums of member companies would help in the short term. Charging higher premiums for riskier plans would, on the surface seem like a good idea as well. Although that may have the negative effect of encouraging pension restructuring from defined benefit to defined contribution plans - which would change the retirement outlook for older workers - to selling unwieldy subsidiaries whose plans have become cumbersome.
Increased transparency would not give workers a feeling of well-being as suggested by the administration. Two additional proposed rule changes would have companies issuing health reports on their plans containing both short term outlooks - if the pension were to fail today - and long term views - how the pension is expected to fair with its current investment style, costs of administration and management objectives.
Which makes the hidden cloak of M&A even more enticing. The current belief among CEOs is not growing a company for the long term but rather creating an entity that can morph, even dissolve into something wholly different, shedding past liabilities like a snake does its skin.
The detritus however will be the employee as the real reasons for ownership become apparent. Wall Street will benefit from increased banking activity. The administration will be able to shift even more business to the financial district in the shape of 401(k) plans, further inflating the equities market as new money buys into already expensive stocks. And Social Security, the golden ring on this investment merry-go-round would be the final blow to what seemed like a relatively secure, safe, and comfortable future only five years ago.
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