Saturday, September 20, 2008

Exchange Traded Funds: The Ideal Investment Vehicle?

Ever since it’s ad hoc genesis in 1989, exchange-traded funds or ETF s has been seen by many as the most innovative investment vehicle of the last two decades. But are ETF s too good to be true in the face of our current global economic slowdown?

By: Ringo Bones

Recently hailed by a number of investment savvy as one of the methods that made them profit from the sky-is-the-limit crude oil prices of July 2008, crude oil ETF s really paid their investors rich dividends. But is this just a case of Emperor Nero fiddling away while Rome burned to the ground thus forever reinforcing the notion that our current global financial system can only thrive in an environment of extreme financial disparity? To find out if ETF s truly deserving of this reputation, let us first examine what makes them tick.

An exchange-traded fund or ETF is an investment vehicle traded on the world’s stock exchanges, much like stocks or bonds. A typical ETF holds assets such as stocks or bonds by trading them at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Majority of ETF s are valued by pegging or tracking at an index, such as the DOW Jones Industrial Average or the S&P 500. An ETF is seen by many as attractive investments because of its low costs, tax efficiency, and stock-like features.

An ETF combines the valuation feature of existing mutual funds or unit investment trusts, which can be purchased or redeemed at the end of each trading day for its net asset value. Close-end funds are not considered to be exchange-traded funds, even though they are funds and are traded on an exchange. In general, ETF s will not require a lot of micro-management. You can simply set them up and forget them and then rake in the dividends. In fact, some investors take this to the extreme by building so-called “lazy portfolios”.

A poll was conducted on a group of investment professionals in March 2008. 67% of those polled say that ETF s are the most innovative investment vehicle developed during the last two decades, while 60% reported that ETF s have fundamentally changed the way investment professionals constructed investment portfolios.

ETF s had their ad hoc origins in 1989 with Index Participation Shares, which - for all intents and purposes - was an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. This product, however, was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in halting the sales of ETF s in the United States. A similar product, Toronto Index Participation Shares started trading on the Toronto Stock Exchange in 1990. The shares, which pegged the TSE 35 and later the TSE 100 stocks, proved to be so popular. The popularity of these products led the American Stock Exchange to try to develop something that would comply with Securities and Exchange Commission or SEC regulation to be sold on US soil.

ETF s had been available in the US since 1993 and in Europe in 1999. Exchange traded funds have traditionally been classified as index funds. But in 2008, the US Securities and Exchange Commission started to authorize the creation of actively-managed ETF s. Usually investors only buy and sell ETF s in market transactions. But institutional investors can redeem large blocks of shares of the ETF – known as creation units – for a “basket” of the underlying assets or alternatively, exchange the underlying assets for creation units. This creation and redemption of shares enables institutions to engage in arbitrage that causes the value of the ETF to approximate the net asset value of the underlying assets.

Exchange-traded funds offer public investors’ undivided interests in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds. Except shares in an ETF can be bought and sold throughout the trading day like stocks on a securities exchange through a broker-dealer. Unlike traditional mutual funds, ETF s does not sell or redeem their individual shares at net asset value (NAV). Instead, financial institutions purchase and redeem ETF shares directly from the ETF. But only in large blocks that vary in size from 25,000 to 200,000 shares called “creation units”. Purchase and redemption of creation units are generally in kind. With the institutional investor contributing or receiving a basket of securities of the same type and proportion held by the ETF. Although some ETF s may require or allow purchasing or redeeming shareholders to substitute cash for some - or all - of the securities in the basket of assets.

The ability to purchase and redeem creation units gave ETF s an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETF s have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit. And the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals.

In practice, many experts have viewed exchange-traded funds with mixed feelings. John C. Bogle, founder of The Vanguard Group, which is a leading issuer of index funds and – since Bogle’s retirement – of ETF s. Bogle has argued that ETF s are nothing more than a representation of short-term speculation because their trading expenses decrease returns to investors. And also, ETF s provides insufficient diversification. But Bogle later concedes that a broadly diversified ETF that is held over time can be a good investment.

But major investing institutions, like The Vanguard Group or Fidelity Investments for example, already control billions of shares. It is easy for them to create an ETF by simply peeling a few million shares off the top of the pile. Then putting together a basket of stocks to represent the appropriate index, say the NASDAQ composite or the TBOPP index made up for the start-up article. Does this serve as proof that patience and prudence together with a good perspective on the marketplace is still the cornerstone of a good and profitable business model then?