The ETF Book is an introduction to exchange-traded funds (ETFs). It explains what ETFs are, describes the different ETF types, and shows ideas for managing a portfolio with ETFs.
I found The ETF Book an interesting and instructive read. The author explains things in a way that's easy to understand, even for someone like me who didn't know anything about ETFs at the beginning. Less useful were the tax-related information as I don't live in the USA and hence don't pay taxes there. One thing I disliked is that there is a lot of repetition.
At their core, ETFs are a simple idea. They represent a basket of securities that you can buy or sell over a stock exchange.
One difference between ETFs and traditional open-end mutual funds is that ETFs do not necessarily trade at their net asset value (NAV). That is the combined market value of the underlying security and cash holdings. Although the supply and demand for ETF shares is driven by the values of the underlying securities in the index they track, other factors can and do affect ETF market prices. As such, the market price for ETF shares is determined by forces of supply and demand for those ETF shares, and the price occasionally gets off track from the underlying values in the fund. But not by much. ETFs have a mechanism that controls price discrepancy and stops discounts or premiums from becoming large or persistent.
The market price of an ETF is kept close to its NAV by allowing a few large institutional investors called authorized participants (AP) to buy or redeem ETF shares in-kind (using the underlying securities rather than cash). When a small price discrepancy occurs between an ETF and its underlying securities, APs conduct a risk-free arbitrage trade. The arbitrage trade allows APs to exchange individual securities for large blocks of ETF shares and vice versa. The arbitrage mechanism brings the market price of ETF shares in line with the fund's true value [...].
ETFs from Evolution to Revolution
Closed-end mutual funds raise cash for investment by selling a fixed number of fund shares. Then a fund manager invests the cash from the sale of shares in accordance with the fund's investment objective and policies. The shares are then listed on a physical stock exchange or trade in the over-the-counter market. A closed-end fund does not need to liquidate securities to meet investor demand for cash or to purchase securities to invest the proceeds of investor purchases. Because the fund is not subject to the demands of investors for cash, the fund may invest in less liquid portfolio securities.
Like other publicly traded securities, the market price of closed-end fund shares fluctuates on the basis of supply and demand for the fund shares. The market price of a closed-end fund may not be the same as its underlying net asset value because demand for the fund may be different from the demand for the underlying securities in the fund.
The open-end method allows each fund company to create or redeem shares as needed to satisfy investor demand.
An index fund achieves the return of the stock market, minus a small amount for administrative costs.
The only four factors needed for ETF creation are: a market index to use as a benchmark, liquid and marketable underlying securities that make up the ETF, successful passage of the idea through SEC registration, and market participants.
Actively managed ETFs do not follow an index. Instead, funds are invested in an actively managed portfolio of securities that is subjectively chosen by a fund manager.
Like stocks, ETFs offer investors the flexibility to buy and sell shares during the day anytime the exchanges are open. Like open-end mutual funds, ETFs offer broad security diversification in a professionally managed account.
The Nuts and Bolts of ETFs
APs can trade directly with the fund company, and that means ultimately ETF shareholders acquire their shares from a larger block called a creation unit, which is owned by an AP. In essence, individual ETF investors own their shares indirectly as part of a larger block that is owned by a third party.
Open-end mutual funds are priced once per day at their closing net asset value for the day. To the contrary, ETF shares are priced continuously during the day whenever the stock market is open.
The price paid for ETF shares is the market price of those shares at the time of sale. The NAV of all ETFs is still calculated only once per day, but an estimate of intraday value is calculated for all ETFs every 15 seconds. The exchange that trades an ETF is responsible for providing the estimate of an intraday value and making those amounts available to the public.
The intraday value is not an absolute number. There could be discrepancies from delayed pricing of securities trades or the ETF may hold securities that have not traded that day. ETFs that invest in foreign securities will often have intraday value estimates that are not a true reflection of NAV because during most trading hours in the United States, the overseas markets are closed.
Like stocks, ETFs always have two prices: a bid and an ask price. The price you will receive depends on whether you are buying (ask) or selling (bid). The trading spread is the difference between the bid and the ask.
The spread in some ETFs can be persistently larger than the spread in others. That is due to the securities that make up the underlying ETF. Trading spreads of ETFs reflect a compilation of the trading spreads in the underlying securities of that fund.
Accumulated Dividends are per ETF share, net of expenses, through and including the previous day's close. Stocks pay dividends throughout the quarter while ETFs pay dividends only once per quarter. The accumulated dividend is the amount embedded in the share price and the Intraday Indicative Value [intraday value] waiting to be paid out.
Types of Exchange-Traded Portfolios
The caption Exchange-Traded Portfolios makes a lot of sense because there are different types of exchange traded securities that have the look and feel of an ETF, and are referred to by most people as an ETF, but they are not exchange-traded funds. They are alternatives to ETFs, such as special trusts and notes.
Each exchange-traded portfolio type has similarities and differences with the others. All types trade on a stock exchange. They all attempt to track the performance of an index, a currency, a commodity, or other benchmark. Each one has an arbitrage mechanism of sorts that keeps the market price of the exchange traded share or units in line with its Intraday Indicative Value. The difference in each type of exchange-traded portfolio is in how they operate and how they are governed.
It is the mandate of most exchange-traded portfolios to closely track the performance of an index. There are many ways to accomplish that objective. One method is to fully replicate the holdings of an index by matching security for security. A second method is for fund managers to use sophisticated sampling strategies designed to mirror the fundamental characteristics of an index and thus closely track index performance. A third method is to hold derivatives such as futures that closely follow index values in lieu of holding individual securities that make up the index.
ETFs organized as Unit Investment Trusts (UITs) have several telltale characteristics. First, UITs are nonmanaged entities. Nonmanaged means the manager of the fund can have no discretion as to which securities go into a UIT and which do not. The manager must follow the index exactly.
Another restriction in the UIT structure is on the accumulation of dividends paid by stocks in the fund. The UIT manager cannot reinvest cash from dividends paid by the underlying companies in more shares of stock within the security. That cash must go in a non-interest-bearing escrow account where it will sit until paid out to shareholders on a quarterly basis.
Noninvested cash from dividends hurts the total return of a UIT during a bull market in stocks. This phenomenon is known as cash drag. The index is assumed to automatically reinvest dividends. Since the UIT does not reinvest, cash becomes a drag on performance during rising prices. Of course, when dividends sit in cash during a bear market it helps the total return. Cash drag is one reason a UIT can never precisely track its index.
A majority of exchange-traded portfolios are organized as regulated investment companies (RIC). [...] The most important characteristic of RICs is that the fund manager can modify the holdings of a fund as needed to adhere to the investment objectives. Instead of buying all the stocks in an index, a fund manager can sample an index that is difficult to replicate, and then optimize the portfolio holding so the portfolio tracks close to its index. In addition, the fund manager may use securities in an ETF portfolio that are not included in the corresponding index. Those securities may include other stocks and bonds as well as futures, options, and other derivatives.
The RIC structure also allows the reinvestment of dividends within a fund.
There are disadvantages to allowing a RIC manager flexibility and discretion in security selection. It may be the manager's intent to select stocks that track an index, but there is no guarantee that the manager's methods will be successful. You may think you are buying an index tracking fund, but small management decisions in a fund can lead to large tracking errors with the index.
Unlike ETFs, grantor trust investors have voting rights in the companies composing the trust. [...] The cash from corporate dividends paid in to a grantor trust are immediately paid out to unit investors.
One disadvantage of the grantor trust structure is that the trusts cannot change securities. New securities cannot be added or old ones deleted. That leads to less diversification over time, as some of the companies grow large and others are bought or head into bankruptcy.
Unlike other exchange-traded portfolios, Exchange-Traded Notes (ETNs) do not represent interest in a pool of securities that is divided among all investors. ETNs are simply direct debt obligations issued by a bank. ETNs pay no interest and offer no principal protection. The bank simply promises to pay holders a certain return based on the return of a securities index or other benchmark, minus annual fees.
ETF Benefits and Drawbacks
Traditional open-end mutual fund shares are traded only once per day after the markets close. All trading is done with the mutual fund company that issues the shares. Investors must wait until the end of the day when the fund NAV is announced before knowing what price they paid for new shares when buying that day and the price they will receive for existing shares they sold that day. [...] ETFs are bought and sold during the day when the markets are open. The pricing of ETF shares is continuous during normal exchange hours. Share prices vary throughout the day, based mainly on the changing intraday value of the underlying assets in the fund. ETF investors know within moments how much they paid to buy shares and how much they received after selling.
Trading flexibility is a double-edged sword. The ability to trade anytime and as much as you want are a benefit to busy investors and active traders, but that flexibility can entice some people to trade too much. High turnover of a portfolio increases its cost and reduces returns.
The cost of dollar-cost averaging into ETFs may prove to be more expensive than investors hoped for. ETF investors pay a brokerage commission every time they buy or sell ETF shares. Consequently, ETFs tend not to be a good vehicle for investors making frequent, small investments.
Not all ETFs are low cost. Prospective buyers should look carefully at the expense ratio of the specific ETF they are interested in.
Indexes do not hold cash but ETFs do, so a certain amount of tracking error in an ETF is expected. Fund managers generally hold some cash in a fund to pay administrative expenses and management fees.
ETFs must publish their holdings every day, which makes them more transparent than traditional funds that must disclose only twice a year.
Actively Managed ETFs
Actively managed ETFs will invest in a portfolio of securities that is subjectively chosen by a fund manager rather than follow a rules-based index. The idea is to perform better than an index through active management. And, for their supposed investment skill, actively managed ETFs will likely charge a higher fee than ETFs that follow indexes.
The biggest benefit in actively managed ETFs will go to investors who would otherwise invest in a comparable actively managed open-end fund. An actively managed ETF would likely charge less than its open-end counterpart because the structure allows ETF companies to eliminate many client services and to reduce the cost of some administrative services.
It is difficult at best for active managers to beat a market index, let alone when that manager must operate under an ETF system that requires the disclosure of fund holdings.
The Indexes ETFs Follow
Market Indexes and Custom Indexes
There are two types of indexes: market indexes and custom indexes. A market index is a measurement tool. The intent is to measure the general price level and value of a financial market. A custom index is an investment strategy. The intent is to develop a portfolio management technique that is used as the basis for investment products, including ETFs.
Market index-based ETFs and custom index-based ETFs are two different types of investment products. The first earns the return of the markets less fees and the second earns the return of the portfolio strategy less fees.
Market indexes track the performance of financial markets. Their purpose is to reflect the value and price changes of a broad sampling of securities that are targeted for measurement. Market indexes tend to be passive in nature, meaning that security selection and security weighting is based on the natural state of a market. An unbiased sampling of securities that regularly trade on a market is used, and their weight in the index is based on the market value of each security relative to the value of all other securities in the index.
Custom indexes are not market indexes. They are not intended to measure the value or performance of financial markets, sectors, or styles. Customized indexes are investment strategies. They are designed for whatever specific purpose their creators intend. That goal is accomplished through engineered security selection methodologies or modified security weighting methods, or both.
Market indexes are capitalization (cap) weighted. In an equity index, each company is weighted in proportion to its market value relative to all other companies in the index. As such, a large company will have more influence on index performance than a small company.
There are four types of capitalization weighted indexes: full cap, free-float, capped, and liquidity. The difference between full cap and free-float is that the former includes the value of all securities outstanding while the latter only includes that portion of securities that are available to individual investors. [...] Liquidity indexes are a relatively new idea. Stocks are weighted on the basis of the amount of shares that trade regularly rather than free float. [...] A capped or restrained index may be used when one or more of the securities in a free-float index dominate the index. In those cases, the dominant securities may be capped at 5 or 10 percent, and the remaining allocation spread across all other securities. Capped indexes ensure that an index is not overly influenced by a single security.
Index Strategy Boxes
The rules for index construction generally fall into two broad categories: security selection and security weighting. How securities are selected is the first step in index construction. How those selected securities are weighted in the index is the second step.
Index Strategy Boxes will help you understand how an index is constructed and managed on the basis of its published rules. Which box an index sits in provides clues as to how an ETF that follows the index is expected to perform over various phases of a market cycle.
On the vertical axis of Index Strategy Boxes is Security Selection. The category represents the methodology used to select securities from the broad financial markets. The three selection methods are passive, screened, and quantitative.
The first category is passive security selection. Passive selection replicates the broad market or a sector of the market. Most passive indexes do not hold all the securities that trade on a market, although it is the intent of the index provider to represent the broad market. Passive indexes typically hold enough securities so that the basket has similar risk and return characteristics in relation to the market as a whole.
There are typically few requirements for a security to be a member of a passive index. Those requirements typically include a minimum number of shares outstanding, a certain minimum daily trading volume, and a minimum market capitalization.
The second type of security selection is screening. Screening securities eliminates unwanted issues from an index. It starts with a broad market universe of securities and then filters out those that do not meet certain criteria.
The third type of security selection is quantitative. Securities in a quantitative (or quant) index are selected on the basis of advanced computer models that follow complex mathematical formulas. These models are often referred to as black boxes because those on the outside are not supposed to know how the models work.
The horizontal axis of Index Strategy Boxes classify weighting methodologies using three basic methods, which are capitalization weight, fundamental weight, and fixed weight.
Capitalization weighting is the traditional method for constructing market indexes. Securities in a market index are allocated on the basis of the market value of each security in relation to all of the other securities in the index.
The second type of weighting methodology uses fundamental factors. A fundamental weighted index relies on a factor or set of factors other than market capitalization to weight stocks in an index. Information that may be used includes financial factors such as dividend yield or earnings yield, earnings predictions, or other factors such as security price, price momentum, and rankings of social responsibility.
The third weighting category represents fixed weight strategies. There are five basic types: equal, modified equal, leveraged, inverse, and long-short. An equal weight allocation assigns the same percentage to every security. [...] Modified equal weights are used to allocate securities among two or more fixed percentages based on some method of priority. [...] Leveraged indexes double or triple the daily gains and losses of a broad market index, while inverse indexes go the opposite direction of the broad market. A long-short weighting methodology overweights securities that are believed to provide market-beating returns and shorts securities thought to be underperformers.
Index Security Selection
Securities are selected for indexes based on rules that are specified in advance and rigorously applied. Index rules state that the securities selected for that index must have certain characteristics. Those characteristics must be maintained for continued inclusion in the index.
The rules for index security selection can be categorized into three broad classifications: passive, screened, and quantitative. Passive rules are very basic and they tend to eliminate illiquid securities and only a few other types that would have only a minor effect on the performance if included. Screened indexes eliminate broad swaths of the market that the index provider does not want in his custom index. Quantitative analysis is used at the highest level of security selection in that the provider applies deep mathematical analysis to isolate securities he believes will outperform the broad market average.
The strategy [of passive selection] focuses on representing a market. As such, a passive index holds as many positions as necessary to reflect the general price movement of all stocks that trade on a market or a segment of a market. There are no biases in a passive selection process that screens out large segments of the market, and there is no forecasting of security performance in an attempt to create a basket that outperforms the market.
Security screening is a second type of index security selection methodology. Index providers filter passive baskets of securities to eliminate those that have undesirable characteristics. Screening methodology is only limited by the imagination of the index provider and the information they can gather about the factor they wish to screen for.
Custom indexes based on screens are not market indexes and products that follow them should not be bought under the assumption that they will outperform a market index.
Quantitative security selection strategies are designed to find securities that are believed to have superior performance potential. The strategies use sophisticated black box methods to analyze and rank securities. Those methods model the markets and predict which securities have the highest probability of beating the market.
A quantitative index holds a relatively small number of stocks, typically between 40 and 100 securities. That is in contrast to hundreds of securities in filtered indexes and sometimes thousands of securities in passively selected indexes.
Higher turnover is a second characteristic of quantitative selection. The amount of buying and selling in an ETF depends highly on the frequency at which the index provider recreates the index.
The third characteristic of quantitative security selection is that the selection rules provided to the public are vague, at best.
ETFs that employ quantitative methods charge the highest fees of any type.
When you are investing in quantitative ETFs, you are investing mainly on faith. You hope the strategy works well enough to make up the higher fees and then some.
Index Security Weighting
The weight allocated to each security in an index is an important characteristic because different weighting schemes applied to the same basket of securities can make a profound impact on performance characteristics of the index.
Index providers allocate securities in their indexes using three basic methods: capitalization weight, fundamental weight, and fixed weight. A capitalization weighted index bases the allocation on the relative market value of each security in that index. Fundamental weighted indexes use financial ratios or qualitative factors to allocate among index constituencies. Fixed weighting assigns a set weight to each security in an index. Leverage, short (inverse), and long-short ETFs are also considered fixed weighted indexes because the weighting of the entire index is changed by a fixed amount.
Capitalization weighting is a natural method for security allocation in an index because it reflects the total dollar value of the securities in an index. The basic premise of a capitalization weighting is to let the markets decide what importance each security should have based on how much investors value each company.
There are four basic types of capitalization weighted indexes: full cap, free float, constrained (capped), and liquidity. The difference between full cap and free float is that the former includes the total value of all securities outstanding while the latter includes only the value of shares that are available in the public markets. Capped indexes preclude a few securities from dominating a narrowly defined index. Liquidity indexes are useful in thinly traded markets to ensure there is enough trading volume of securities to physically create investment products such as ETFs.
A fundamental weighted index uses a factor other than market cap to determine the weight of securities in an index. Most fundamental weighted index derived factors are from the corporate financial statements. [...] Most fundamentally weighted indexes must be rebalanced periodically to realign the index with changing fundamental conditions.
There is an inherent flaw in calculating fundamental weighted indexes that capitalization weighted indexes do not have to deal with. Different companies report fundamental data at different times throughout the quarter. Therefore, the weighting of each stock in a fundamental index should change almost daily as new information flows in. But that is not feasible from an investment point of view. ETFs would generate too much trading activity from daily rebalancing [...].
The third category of security weighting is fixed weight. The category covers a broad spectrum of weighting schemes, including equal, modified equal, leveraged, inverse, and long and short methods.
Equal weighting is the simplest form of weighting. All securities in an index are allocated the same percentage.
Modified equal weight is another method in the fixed weight category. [...] Instead of using one equal weight, there are two or three levels of equal weights. Stocks are assigned to one of the levels based on a rank or size or some other factor.
Like fundamentally weighted indexes, there is an inherent problem with several fixed weight schemes. Since the value of each stock changes every day, the allocation of an equal weighted portfolio (and other methods) is not equal after the first day of trading. Hence, index providers and portfolio managers should rebalance securities weights daily to regularly realign the portfolio with the index. But that is not feasible. [...] Instead of using daily reweighting methods, the providers reallocate most fixed weighted indexes once per quarter, or less. Consequently, most fixed weight indexes do not represent a true fixed weight strategy.
ETF Styles and Choices
Broad U.S. Equity and Style ETFs
Broad market indexes measure the pulse of the securities market they follow. They are also referred to as all cap or total market indexes. Broad markets are a compilation of passively selected securities that are weighted on the basis of capitalization.
Broad market indexes are divided into size components based on the average size of the companies they hold. [...] Indexes that represent predominantly large company stocks are classified as large cap, those that represent smaller companies are labeled mid cap and small cap, and those that invest in the smallest companies are micro cap indexes.
Style indexes divide broad indexes and size sectors into growth and value components. [...] Some index providers have only growth and value sectors, while others have a third, middle style called blended, neutral, or core. The middle style is for stocks that have characteristics of both growth and value or neither growth nor value.
Although the S&P 500 is considered the most important benchmark for large companies, it is not the most complete. A popular misconception about the S&P 500 is that it contains only large companies. First, not all large cap stocks are in the S&P 500, and second, not all stocks in the index are large cap. About 10 percent are in mid cap companies. Actually, there is not a market capitalization limit for inclusion in the index. The guiding principle is that the company must be a leader in an important industry, regardless of its size.
Investors who want the broadest possible breadth of stocks in the U.S. market will find that an ETF benchmarked to the DJ Wilshire 5000 provides it.
The lowest-cost funds tend to follow market indexes where securities are passively selected and capitalization weighted. As the complexity of security selection and weighting increases, so do the expenses of the ETFs that follow those indexes.
Global Equity ETFs
Markets and currencies around the globe often move in different directions at different times. When that occurs, a globally diversified portfolio naturally hedges one market against another.
One disadvantage of investing in overseas stocks is the tax treatment of dividends. When a foreign company pays a cash dividend, the company's home country often taxes that dividend before the cash is sent overseas. You never get that tax withholding back directly.
Several international companies trade on U.S. exchanges in the form of an American Depositary Receipt (ADR). Each ADR is issued by a U.S. depositary bank and represents one or more shares of foreign company stock that are held in trust at the bank. The shares are traded in U.S. dollars. A global form of the ADRs is called a global depositary receipt (GDR).
Industry Sector ETFs
Classifying companies by what business they are in is a logical method. That allows investors to study the market economy and make industry bets as they anticipate the movement of capital from one industry sector to another.
The listing of new businesses on stock exchanges leads to new industry sectors and subsectors. At the same time, established industries fade away. Thus, the industry classification system is constantly evolving.
Real estate investment trusts (REITs) represent indirect ownership in a group of real properties. You actually own a small part of a publicly traded management company whose purpose is to acquire and manage commercial real estate. That company selects or builds properties, finds tenants, collects rents, and distributes profits to shareholders.
REITs provide diversification benefits in a portfolio. Adding a REIT's ETF tends to reduce portfolio risk and increase portfolio returns over the long term. That is because of the low correlation of returns between REITs, stocks, and bonds.
Special Equity ETFs
Special equity is an interesting category of ETFs. They represent unique, a little quirky, and sometimes expressive investment strategies. These funds make a statement. Some say, "We are environmentally friendly"; others say, "We can cure the world's diseases"; and still others say, "We know a new way to beat the market." Whatever the message of the ETF, it is sure to be different from broad-based market index ETFs. Every special equity ETF is based on a customized index, and that alone makes a statement – higher fees.
Theme funds follow indexes that focus on a particular idea, such as the environment or corporate governance. Sector rotation funds attempt to move ahead of the masses by rotating stocks around various industry sectors. Stock picker indexes are derived from the Wall Street analyst buy rating lists. Leveraged ETFs put a market index on steroids by providing two times the price movement, while short ETFs move in the opposite direction.
Some investors have a moral dilemma with the products some companies make or the businesses they are in. Rather than selecting companies to invest in, socially responsible indexes attempt to gain broadbased equity exposure while excluding companies that do not pass certain social criteria tests. Examples of screens include eliminating companies in the tobacco, alcoholic beverages, and pornography industries.
Investors in socially screened ETFs should be aware of what industries are being screened out of an index. You may not agree with what is being called socially irresponsible.
Sector rotation strategies are in many ways the opposite of thematic investing. In contrast to thematic investing, where investors hold narrow slices of the market and wait for long-term gains, sector rotation ETFs frequently shift money from one industry sector to another.
Fixed Income ETFs
The U.S. fixed income market is composed of many types of securities. They include, but are not limited to, Treasury issues, government agency issues, mortgages, corporate bonds, municipal bonds, asset-backed securities, and inflation protected securities.
Bonds are generally categorized by type, maturity, and credit rating.
Bond indexes divide maturities into three ranges. Short-term indexes hold bonds that have an average maturity of three years or less, intermediate-term indexes hold bonds with an average maturity of four to nine years, and long-term indexes hold bonds that have an average maturity of 10 years or longer.
Bond index average duration is an important characteristic. Duration is a measure of interest rate risk. If interest rates move higher, ETFs benchmarked to indexes with longer durations will go down more in value than ETFs benchmarked to indexes that have shorter durations. In the long term, since there is more risk in long-duration bonds, you should expect indexes with long durations to generate a higher total return than indexes with a short duration.
The credit risk of a bond index is more complex than its interest rate risk. Credit risk is a reflection of the financial strength of the issuer. The higher the credit risk, the greater the chance of a default, and the higher the interest rate needs to be to compensate for that risk.
Asset-backed securities are a type of bond that is issued on the basis of pools of assets or is collateralized by the cash flows from a broad pool of underlying assets. Assets are pooled to make otherwise minor and uneconomical investments worthwhile and reduces the risk by diversifying among several issuers.
Less than investment grade corporate bonds are known as high yield or junk bonds. They are the speculative part of the fixed income universe. Most companies that issue junk bonds are not in the best financial condition. Nor are those companies whose rating has been cut to a junk status by S&P, Moody's, and other independent credit rating agencies. Since there is a higher risk that these issuers will not meet their financial obligations, the high yield sector offers high returns in the form of higher interest payments.
Like common stock, preferred stocks represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Unlike common stock, a preferred stock pays a fixed dividend that does not fluctuate (unless it is cut or eliminated). In that sense, it is like a debt.
Commodity and Currency ETFs
The advantage of adding an alternative asset class such as commodities to your portfolio is that they tend to exhibit a low correlation with traditional stock and bond investments. Low correlation between two asset classes means that when one is going up, the other may or may not be following, and could be heading in the opposite direction. That lowers overall portfolio volatility.
Commodities are common products such as food, basic materials, and energy-related items that are used every day. Food products include items such as sugar, corn, and oats; basic materials include items such as steel and aluminium; energy is traded in the form of crude oil, natural gas, and electricity. Another category includes precious metals such as gold, which has little manufacturing value, and silver, which has slightly more. All together, these resources make up the global commodities market.
To make investing in commodities practical, most people invest in contracts that lock in future prices. Those contracts are called futures, forwards, and other acts. Commodity futures do not represent direct ownership to actual commodities. They are an obligation to buy commodities in the future based on a price that is negotiated today. A contract is a standardized agreement to buy or sell a specific commodity type and quantity at the future delivery date and at a price agreed upon when the contract is purchased. Only a small amount of money is needed to secure the contract and that gives commodity futures investors a large amount of leverage.
The futures price starts with the current spot price and adjusts for interest rates, known seasonal changes that affect supply and demand, possible storage expenses, and other costs-of-carry expenses. If spot prices are expected to be much higher at the maturity of the futures contract than they are today, the current futures price will be set at a high level relative to the current spot price. That is known as a market in contango. Lower-than-expected spot prices in the future will be reflected in a low current futures price. That is known as a market in backwardation.
Commodities truly are a trading vehicle, not a long-term investment vehicle. Timing is everything.
Portfolio Management using ETFs
Portfolio Management Strategies
Passive investing is a straightforward strategy. It begins by choosing an assortment of broad asset classes that fit your long-term financial goals, and constructing a target asset allocation using those asset classes that are consistent with your goals. The next step is to select low-cost ETFs that represent those chosen asset classes and to buy them in the correct quantity in your portfolio. The target asset allocation is maintained through regular rebalancing of the ETFs to bring the portfolio back in line with your goals. There is no attempt to market-time or predict the next winning sector within the markets.
One reason a buy-and-hold works is because the costs are low.
[...] a life-cycle strategy adjusts a portfolio as investors move through various stages in life. Life cycle investing is a passive approach in that the allocation to asset classes remains constant at each stage for the duration of the stage.
Active investing is all about achieving returns that are superior to the financial markets. [...] Unfortunately, it is very difficult to beat the market. Few people can do it consistently enough to achieve the long-term returns needed to justify the time and expenses.
There are two ways an investor can measure investment performance: nominally and risk-adjusted. Beating the market nominally means outperforming on a percentage basis. Superior risk adjusted performance means beating the market after accounting for portfolio risk.
Active strategies may or may not achieve the goal of beating the markets. One fact about active strategies, however, is certain: They are more expensive than passive strategies in many ways. First, ETFs that follow custom indexes have higher fees than market indexes. You will pay more if you attempt to beat the market with custom index ETFs. Second, an active strategy tends to have a higher turnover of ETFs in a portfolio. That results in higher commissions. Third, active strategies take time.
Passive ETF Portfolios
Passive investing is all about holding a portfolio of ETFs that most follow low-cost market indexes. The portfolio is designed on the basis of an investor's long-term goals, and the investments are held for a very long time. Passive investors do not attempt to time markets by forecasting economic changes or charting prices. Nor do they attempt to rotate among market sectors or styles in search of superior returns. The only trading done in the portfolio is when asset class rebalancing is needed or when cash is added or withdrawn.
The return objective of passive management is to achieve the return of the markets.
Investors who understand passive strategies but are not ready for a full market matching approach may divide their portfolio into a portion that uses only ETFs that track market indexes and ETFs that are more aggressive. The core and explore technique (also known as core and satellite) is a strategy whereby investors own a core portfolio of market index ETFs that charge low fees and also buy a few costlier ETFs that follow custom indexes. The hope is to achieve market performance in the core portfolio and achieve superior returns in the custom portion.
The most important long-term decision you will make in a buy-and-hold strategy is the long-term mix between stock and bond index funds. That decision will explain a majority of portfolio risk and return over the long term. It is thus very important to select a good allocation right from the start when using a buy-and-hold strategy.
Correlation is the tendency of one investment to affect the movement of another. If one investment moves in harmony with another, they have a positive correlation. If the two investments move in opposite directions they have a negative correlation. If the two investments move independent of each other they have no correlation.
There is no benefit to diversifying into two ETFs that invest in the same asset class and have a high positive correlation with each other.
If you create a core and explore portfolio, the more exploring you do, the higher the cost goes with no guarantee of higher returns.
Life Cycle Investing
Life cycle investing is a technique that adjusts the asset allocation of a portfolio over various stages in life. Often people are more aggressive investors when they are young because they have little invested and have an abundance of working years ahead of them to make up any losses. Investors grow more conservative as they enter middle age and realize the limits of their mortality. People are the most conservative when nearing retirement.
The definition of aggressive and conservative investing varies from person to person.
The key component for starting to accumulate wealth is savings consistency. For early savers, the most important component of investing is a consistent savings plan. The management of those savings is also important, but having a regular savings plan comes beforehand.
Young investors can and should be aggressive in their investment allocation because they have many years before they will use the money in retirement. A more aggressive portfolio is expected to compound at a higher rate of return, thus providing more money at retirement.
Young investors also have a time advantage that allows them to make up for past investment mistakes. They also have a valuable commodity that retirees no longer have. That is their human capital. Young people can and should invest in their education and training, thus increasing the rate of return on their most valuable possession, which is the value of their labor.
On the other hand, young investors have the unfortunate position of being the most inexperienced investors in the marketplace, and that often costs them dearly.
The transition from full-time work to retirement signals a new investment phase in a portfolio. The portfolio will convert from accumulation to distribution. That means investors will soon stop putting money in and soon start taking some out.
Active Portfolio Management with ETFs
Active portfolio management using ETFs is a strategy of selecting funds for a portfolio with the intent to outperform a market benchmark.
All active strategies work some of the time, but no strategy works all of the time. Whichever active strategy you decide to use, be consistent, be cost conscious, be patient, and be realistic about your prospects for beating the market.
Top-down investors begin with a space shuttle view of the global economy. The idea is to find the macroeconomic trends in the global marketplace and try to determine which countries and which industries will benefit most from those trends. An ETF investor would then select funds that represent those industries and countries. If the analysis is correct, the portfolio will outperform its benchmark.
Bottom-up ETF investors conduct extensive research on industries and countries to build value-based opinions. Economic factors do matter, but fundamentals matter more. In fact, a downturn in the stock market may provide bottom-up investors with the safety margin they need to buy an attractive industry ETF.
Momentum investing is a strategy best explained by Isaac Newton's first law of motion, "A body in rest tends to stay at rest, and a body in motion tends to stay in motion, unless the body is compelled to change." To momentum investors, the trend is your friend.
Technical analysis is the study of stock price patterns for the purpose of forecasting future price trends. Price charts are the primary tool in technical analysis. A chart graphically represents the price movement over a specific period of time. Trading volume can also be included to verify the strength of a trend.
Special Portfolio Strategies
Pairs trading is the selling short of one category of ETF while buying another category by an equal amount. You win when the ETF you bought outperforms the one you sell.
Operational Tips for ETF Investors
The ETFs in a portfolio that represent different asset classes in your portfolio will shift from their original allocation, starting the day after you purchase them. ETFs need to be rebalanced back to their targets regularly so the drift does not become too large. Rebalancing also puts the risk of the portfolio back in line with your investment objectives.
It is a good idea to rebalance at least annually, especially if the markets have been particularly volatile. The easiest way to do rebalancing is to pick a time during the year when it will always be done. [...] Another method is to check the allocation of the portfolio occasionally to see whether your ETFs are off target by a certain percentage.