Archives: August , 2012
ETF News

Assessing the Merits of an ETF: Debunking Common Myths

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Extract of white paper published by Chris Hempstead, Head of ETF Trade Execution for WallachBeth Capital LLC

With respect to analyzing and selecting ETFs, one of the most common and frustrating mistakes that I overhear is “..unless the fund has at least some minimum AUM ($50mm in many cases), or has average daily trading volume less than [some other arbitrary number] (say 250k shares) it should be avoided…”

Some other arguments against ETFs go so far as to suggest that “..ETFs need to have a certain history or track record before they should be considered…” Adding insult to injury is the claim that “investors are at risk of losing all their money if an ETF shuts down.”

In light of recent articles being picked up by media from New York to Seattle, I would like to dismiss a few of these common, yet unwarranted reasons to avoid an ETF based solely on AUM, ADV or track record.

 First, let’s address AUM:

“ETFs with less than $50mm should be avoided”

In order for an ETF to come to market (list on an exchange) the fund needs to have shares created. This process is often referred to as “seeding”. The ‘seeder’ is the initial investor who delivers into the custodial bank the assets required to back the initial tradable shares of the ETF in the secondary market. ETFs issue shares in what are known as creation units. The vast majority of ETFs have creation unit sizes of 25k, 50k or 100k shares.

When a ‘new’ fund comes to market, they are usually seeded with at least 2 units of the fund. There are very few examples of ETFs that come to market with more than $5mm in AUM or an excess of 200k shares outstanding. One recent exception comes to mind: Pimco’s BOND launched with ~$100mm AUM and 1mm shares outstanding.

Understanding that ETFs have to start somewhere, it would be difficult to explain how more than 55% of ETFs (excluding ETNs, Leveraged ETFs and Inverse ETFs) have garnered AUM in excess of $50mm.

In other words, someone had to take a close look and invest into the funds. The ‘I will if you will’ mentality is probably not how the most successful fund managers find ways to outperform.

Ten of the top thirty performing ETFs year to date have AUM below $50mm.

(EGPT, TAO, HGEM, IFAS, SOYB, PKB, RTL, QQQV, ROOF and RWW)

Congratulations to the pioneers who ‘went it alone’, as they say. Continue reading →

ETF News

ETFs move into long-term investing mainstream

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By Murray Coleman

–Evidence mounts that ETFs aren’t just trading tools

–More retirement funds, endowments adopting ETFs

–ETF advisers remain largely long term in focus

Since turning to exchange-traded funds to build investment portfolios for high-net-worth and institutional clients more than a decade ago, adviser Rob DeHollander says he has seen a stigma form around the industry.

Contrary to popular views that ETFs contributed to the “flash crash” in May 2010 and other high-frequency trading mishaps, a growing number of conservative investors managing endowments and large pension funds are turning to ETFs, notes the co-founder of DeHollander & Janse. The firm in Greenville, S.C., manages about $100 million in assets.

“There’s no doubt ETFs are popular with hedge funds and day traders,” Mr. DeHollander says. “But they’re also finding broader acceptance among institutional investors and wealth managers with longer-term investment strategies.”

How much is a source of rising industry debate. A recent Deutsche Bank study found that advisers with discretionary control over client portfolios and more than $100 million in assets in 2011 overwhelmingly accounted for the biggest chuck of ETF assets held by big, institutional-level investors. Continue reading →

ETF News

Industry Sounds Off On Paying ETF Market Makers

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Courtesy of James Armstrong

If issuers of exchange-traded funds could pay to attract market makers to their products, would there be more liquidity in ETFs? Or would paying market-makers create a dangerous precedent and harm long-term investors? Or, is Tim Quast, MD of trading analytics firm “Modern Networks IR” correct when suggesting to the SEC in his comment letter “..paying market makers could constitute a racketeering felony and would increase speculative, short-term trading rather than focusing the markets on capital formation..”?

Both Nasdaq and NYSE Arca have proposed programs allowing ETF issuers to pay fees to the exchanges for market-maker support. The proposals are similar to a program already implemented on the BATS exchange, which has a handful of ETF listings. These proposals, according to comment letters to the Securities and Exchange Commission, are drawing strong reactions from key industry figures.

The Investment Company Institute has come out in favor of the measures, arguing they could result in narrower spreads and more liquid markets. In a letter to the SEC, ICI’s general counsel, Ari Burstein, said the organization has long advocated changes to increase the efficiency of markets. “As ETF sponsors, ICI members have a strong interest in ensuring that the securities markets are highly competitive, transparent and efficient,” Burstein said. “Liquid markets are critical for ETFs, particularly smaller and less frequently traded ETFs.”

Vanguard, the mutual fund giant which also offers a number of ETFs, said it neither supports nor opposes the Nasdaq proposal and certainly does not support the NYSE Arca proposal, at least as it is currently structured.

In a letter concerning Nasdaq’s ETF initiative, Vanguard’s chief investment officer, Gus Sauter, said payments to market makers have the potential to distort the markets and create conflicts of interest. Though Nasdaq proposed several safeguards to prevent that from happening, Sauter suggested a longer review and comment period would be a good idea.

BlackRock, the nation’s largest ETF issuer is opposed to the idea of paying market-makers.

Continue reading →

ETF News, Strike Price

Collaring Multiple-Asset ETFs to Manage Tail Risk

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Courtesy of Phil Gocke, Options Industry Council

Since the 2008-09 financial crisis and the central bank’s response of near zero interest rates, financial markets have been vacillating violently between risk-on and risk-off periods. This bipolar attitude toward risk has increased asset class correlations, negating the effective benefit of many traditional equity diversifiers. In this unpredictable climate, investors are focused on seeking strategies that offer downside protection but also upside participation.

One solution to achieving both of these often mutually exclusive desires is an option-based equity collar. A long collar strategy involves owning the underlying, while being long a put option with a strike price below the market and short a call option with a strike price above the market. This orientation of the strike prices makes each put and call option out-of-the-money (OTM). An option collar can provide portfolios with greater downside risk protection than standard multi-asset diversification programs, but they also allow for profits during risk-on rallies.

Recent research has examined the performance of the collar strategy against a range of exchange-traded funds (ETFs) across multiple asset classes, including equity, currency, commodity, fixed income and real estate. The resulting book, “Option-Based Risk Management in a Multi-Asset World,” was authored by Research Analyst Edward Szado and University of Massachusetts Isenberg School of Management Professor of Finance Thomas Schneeweis. Their analysis shows that for most of the asset classes considered, an option-based collar strategy, using six-month put purchases and consecutive one-month call writes, provides a holy grail of investing of improved risk-adjusted performance and significant risk reduction.

“Collar growth” (below) illustrates the benefit of an equity collar strategy on the popular SPDR S&P 500 (SPY) ETF. Over the 55-month study period ending Dec. 30, 2011, the 2% OTM passive SPY collar returned more than 22% (4.5% annually), while the long SPY experienced a loss of more than 9% (–2.1% annually). The collar earns its superior returns with less than half the risk as measured by the standard deviation (8.4% for the collar vs. 19.5% for SPY).

One of the most telling statistics supporting the potential benefit of equity collar protection is the maximum drawdown. During the study period, SPY experienced a maximum loss of 50.8% while the 2% OTM collar reduced this negative performance by four-fifths to a maximum loss of 11.1%. Continue reading →

ETF News

Light On Knight: Editorial Opinion

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Editorial Opinion

In an era in which “CYA” is perhaps the most-used acronym by institutional fund managers focused on fiduciary responsibilities, its almost surprising to notice the many anecdotal remarks that point to a single-point-of reliance on Knight Capital’s role within the ETF marketplace.  Some would think it “shocking” that so many institutions were caught without having a chair when Knight stopped the music and instructed their customers to trade elsewhere.

Yes, based on volume/market share, Knight had become the single-largest “market-maker” for ETFs, as well as a broad universe of exchange-listed equities. Arguably, their pole position is courtesy of pay-to-play pacts with large equity stake holders and ‘strategic partners’ who control significant retail and institutional order flow; including household names such as TD Ameritrade, E-Trade and Blackrock.

This is not to suggest that Knight Capital has not earned its designation for being a formidable market-maker within the securities industry. Their most senior executives are deservedly well-regarded by peers, competitors and clients alike, and their trading capabilities are revered by many.

And yes, Knight’s most recent travails are, to a great extent the result of a  “bizarre software glitch” that corrupted the integrity of their order execution platform. There’s a reason why software is called soft-ware.

That said, this latest Wall Street fiasco–which resulted in a temporary disruption of NYSE trading and the permanent re-structuring of one of the biggest players on Wall Street who was rescued from the brink of total failure– is less about that firm being “too big to fail”,  or the many spirited debates regarding “algorithms that have run amok”, or even the loudly-voiced and often under-informed shouts coming from politicians in Washington regarding the ‘pock-marked’ regulatory framework by which US securities markets operate.

This story is about something much more basic: dependence by seemingly savvy fiduciaries  on a single, market-making firm that figuratively and literally trade against customers in order to administer the daily execution of literally hundreds of millions of dollars worth of retail and institutional customer orders. This happens, all despite the same fiduciaries  commonly inserting the phrase “best execution” within their very own mandates, internal policy documents and regulatory filings.

Many of these fiduciaries may not truly appreciate where Knight resides in the trading market ecosystem, the actual meaning of  “best execution”, or how they can achieve true best execution without being reliant on a single firm whose first priority is not to the client, but to themselves and their shareholders, who depend on the firm’s  ability to extract trading profits when ‘facilitating’ customer orders as being the ultimate metric for the value of their employee bonus and/or their ownership of shares in that enterprise.

CNBC, Barrons, and IndexUniverse (among others) have been following this story closely, and we point to excerpts from a reader comment posted in response to IU’s Aug 6 column  “4 ETF Lessons From Knight”  by Dave Nadig: Continue reading →

ETF News, Strike Price

Options Trading is Not Dead, Institutions Ramping Up

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Courtesy of TABB Forum

Options trading volumes may be down across the industry but the buy side continues to remain captivated by the potential of using options. TABB Group expects options volume to decline by as much as 10 percent in 2012, yet a combination of greater buy-side adoption and increased focus on managing risk will set the foundation for future growth, especially when investors refocus their attention on equity markets.

Global equity markets are under stress and for good reason. Many observers consider the markets to be broken, with structural inequities that favor professional investors over the uniformed.

Add to that slowing global growth, continued political uncertainty and new regulations that threaten to indelibly shift market structure and you have most of the reasons that can explain today’s depressed U.S. equity trading volumes, which, this year through July, are off more than 14 percent compared with the same period in 2011.

The impact can also be seen in U.S. options markets. However, the drop has been less severe, with trading off just 7 percent this year, through July. A number of factors are contributing to this phenomenon, including greater adoption of options strategies by the buy side as well as replication strategies that use short-term options as a proxy for the underlying security. But perhaps the biggest factor contributing to the disparity can be observed in the new ways that buy-side firms are using options in their strategies.

Growing Sophistication and the Rising Complexity of Strategies
The buy side is becoming more sophisticated in its options trading strategies with traders at both asset managers and hedge funds using more-complex strategies in their trading activities. Multi-legged options trades make up a growing proportion of trading volume, as the buy side looks for cheaper and more efficient ways to manage exposure. And as buy-side trading activities become more complex, investment managers are investing in more powerful technology systems to support the growing complexity of both their front- and back-office derivative activities.

Buy-side firms are upgrading to newer versions of order management systems that can support options and provide real-time pricing, analytics and FIX connectivity to broker trading desks. Traders requiring more sophisticated functionality are deploying best of breed execution management systems alongside existing trading platforms in order to support complex orders and algorithmic trading capabilities. Continue reading →

ETF News, Tech Talk

Knight Seeks Lifeline After $440 Mil Loss : What’s Next?

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Courtesy of Olly Ludwig/IndexUniverse

Knight Capital (NYSE: KCG), the biggest ETF market maker in the U.S., is seeking financing after saying that a trading glitch involving its systems on Wednesday that affected 148 stocks will result in a $440 million pre-tax loss. The company’s stock was down 45 percent in early morning trade.

“The company is actively pursuing its strategic and financing alternatives to strengthen its capital base,” Knight said on Thursday in a press release, stressing that it will be business as usual for the company in the wake of the wayward trading episode.

The swiftly moving story is one of the more astonishing developments in the world of electronic securities trading, where Knight plays a dominant role. Industry sources say that whatever reputational challenges Knight faces at this very moment pale in comparison to the attractiveness of its business, or at least particular pieces of it.

The Jersey City, N.J.-based firm, the biggest ETF U.S. market maker, said in the press release that while the whole episode “severely impacted” its capital base, its broker-dealer units remain in compliance with net capital requirements.

*Editor insert: MarketsMuse spoke with one industry expert, who requests no mention of his name, but framed the Knight story as follows: “This is exactly the type of episode that should cause institutional fund managers to re-think how/where their orders are executed. Relying on a single market-making firm–which by definition, is counter-intuitive to the notion of best execution–is a recipe for disaster. The right approach is to use a qualified, agency-only liquidity aggregators– firms that focus on capturing best prices by canvassing a broad list of market-makers. The latter approach addresses the PM’s fiduciary obligation, and significantly mitigates dependence on one market-maker, particularly one that may have been perceived for being “too big to fail.”

The Accident That Happened

On Wednesday, Knight saw its stock drop by a third due to the wayward program trading involving its system. The episode was reportedly triggered by a human error that caused hundreds of trades to be executed in minutes instead of over a longer period.

“An initial review by Knight indicates that a technology issue occurred in the company’s market-making unit related to the routing of shares of approximately 150 stocks to the NYSE,” the company said in a prepared statement on Wednesday.

For the full IndexUniverse coverage, click here