By Paul Petillo
When is an investment more than the sum of its parts? When are the parts for sale to other investors who, once they own them sell them short, take their profit, returns the rest to the investment firm who then splits the remainder with you? If you answered "when you own an exchange traded fund, specifically one managed by Barclays, Goldman Sachs or JP Morgan" feel free to move on. You are probably fully on board with the practice, one that generates additional fees for the investment firm with only a small trinket for the shareholder.
But if you own these relatively new additions to the world of mutual funds and are unaware of the practice, it might come as quite the surprise.
If, one the other hand, you were on the fence about ETFs, attracted by the ability to trade them as frequently as stock and wondering how some of these index funds did better from their staid counterparts, you would do well to take a peek at an investment divided.
Back in 1993, the late Nate Most introduced the Spider, a fund that traded like a stock but mimicked the Standard & Poor's 500 Index of large cap stocks.
This type of tradable index fund shed new light and increased revenues on the beleaguered Amex (American Stock Exchange). They currently account 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. In other words, using an ETF allows the fund to remain invested in a liquid asset.
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 total investment.
Moving away from a strictly equity based fund, a gold index fund from streetTRACKs was based on the commodity with each share 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 of the total index.
ETFs do outperform mutual funds in terms of flexibility. The ability to trade throughout the day is one of the primary attractions for investors interested in ETFs. Frequent traders however may feel the sting of commissions more than those who chose another longer-term strategy.
Several things make these shares worth serious consideration. 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.
Another deals with expenses and the possible illusion that you are saving money. 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 (add in broker's fees on both ends of the trade) along with 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 that has 100% of its shareholder money at work 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, capital gains taxes must also be paid.
In the world of ETFs, this exchange of shares for dollars 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 real trouble with ETFs comes largely with lagging returns. This is why Barclays is taking advantage of an S.E.C. approved technique to improve those returns often without the knowledge of the investors involved.
The concept behind borrowing and lending securities is not new. Hedge funds who specialize in such strategies as short selling have often bought share held by firms for just that purpose. Doing it with exchange-traded funds however is a relatively new development and one the industry is not all that willing to discuss openly.
Short selling involves borrowing a security and selling it, with the hope those prices will fall. The borrower can then purchase the same shares at a less expensive price replacing the borrowed shares and pocketing the difference.
Here's where the problem comes in and why the individual investor should worry. When profits such as these are available, the shareholder of an ETF becomes secondary to the investment company's objective of increased revenues. This kind of conflict, as yet fully addressed by the S.E.C. shortchanges the shareholder of often-sizable returns.
While Barclays, the company that manages iShares ETFs does return some of this income to the shareholders, it can amount to less than 0.2%. This additional income, perceived by the company (and the S.E.C. to be fair and reasonable) should leave shareholders with a bad taste in their mouth. This 50-50 arrangement as the company portrays largely deceives the shareholder even if they know about the arrangement.
Firms lending shares generally hire outside agents to sell those shares. In-house agents, while bringing increased scrutiny allow companies such as Barclays to keep the fees adding them to the already disclosed advisory fees. Those fees can run from 10-50% of the transaction cost and are, if the transaction is done at the selling firm, fully absorbed.
Volatile portfolio composition such as the kind available in small-cap and international ETFs is particularly attractive to both the seller and the hedge fund looking to short. As investors trade in these types securities, they often overlook these subtle nuances taking the funds return at face value.
One might suggest that the profitability of the managing company is as important as the shareholder returns and they would be right. But profitability should be transparent and the shareholder should be at the heart and soul of a fund company's focus. Where mutual funds succeed in putting the shareholder first, ETFs fail.
