This is what every ETF investor needs to know today
The exchange traded fund (ETF) revolution is well underway… Last week, we wrote about how the ETF industry has exploded over the past few years. A record US$3.4> READ MORE
The exchange traded fund (ETF) revolution is well underway… Last week, we wrote about how the ETF industry has exploded over the past few years. A record US$3.4> READ MORE
A decade ago, exchange traded funds (ETFs) were barely on investor radars. But since then, the ETF industry has exploded. ETFs are now the bread-and-butter tool> READ MORE
There’s a small difference smart investing – and investing in a way that will lose you money. And there’s a very big difference in the results: A> READ MORE
Gaining exposure to a stock index is one of the best ways for the average investor to access the stock market. It's simple, low-cost and provides instant> READ MORE
Today I’m sharing an article written by my friend Tama Churchouse, who with his father, Peter, runs Churchouse Publishing in Hong Kong. Peter and Tama write The> READ MORE
Are you looking for the best ETF to buy? There are scores to choose from, but let me tell you which ones you need to steer clear of. Caveat emptor is Latin for> READ MORE
A popular ETF-like investment is designed to protect against portfolio losses in the event of a stock market crash. But most investors have no idea that holding> READ MORE
Today I’m sharing an article written by my friend Tama Churchouse, who with his father, Peter, runs Churchouse Publishing in Hong Kong. Peter> READ MORE
The exchange traded fund (ETF) revolution is well underway…
Last week, we wrote about how the ETF industry has exploded over the past few years. A record US$3.4 trillion in assets under management (AUM) are now held in ETFs. That’s a nearly 17-fold increase since 2003. Investors have already sunk $391 billion into ETFs so far in 2017, according to industry consultancy ETFGI, surpassing last year’s record in just seven months.
There are now over 1,200 ETFs listed on the New York Stock Exchange. And about 5,000 ETFs around the world – up from just 450 in 2005.
This growth is part of the larger trend of passive investing. This has been great for everyday investors… their portfolio performance has been a lot better than actively managed funds. But passive investing is becoming a snake that’s eating itself… and the unintended consequences of a good thing could turn into something bad.
Passive investing involves investing with a buy-and-hold strategy through an ETF or index fund that simply tracks an index.
It works – well. Depending on the fund, somewhere between 71 percent and 93 percent of active U.S. stock mutual funds have closed or underperformed the index funds they are trying to beat, according to Morningstar.
What’s more, passively managed funds are a lot cheaper… expenses can be just three or five percent of the fees of actively managed funds. Over time, that kind of expense difference can have a huge impact on performance.
And over the past two decades, the S&P 500 has returned over three times more than the average U.S. investor. The average U.S. investor has earned just 2.3 percent over this time… far behind the 7.7 percent for the S&P 500 and just ahead of inflation at 2.1 percent, as the graph below shows.
So, the average investor might as well have left his cash in the bank – he would have at least not spent money on trading fees. Most fund managers don’t beat the market either… even though that’s their job.
As a result, passive investing is in the midst of a big boom. Over 40 percent of all funds under management in U.S. equities are passive investments. Industry estimates suggest that number is expected to grow to 50 percent by 2018.
At Stansberry Churchouse Research, we’re fans of ETFs. Most of the time, ETFs are good for everyday investors. Remember, ETFs are simple, low-cost and often outperform more active funds.
But at a certain point, if too many investors follow the same benchmark, the benchmark becomes the tail that wags the dog.
For example, the continued flood of money into index-tracking funds is having a big impact on overall market liquidity. And it’s also distorting the valuation of stocks that are in the indices.
Just consider… Vanguard Group (one of the world’s largest investment companies) now owns at least a 5 percent stake in 491 stocks in the S&P 500… that’s up from just 116 companies in 2010. And Vanguard now owns almost 7 percent of the entire index, according to the Financial Times.
And since 2009, clients at Bank of America have dumped US$200 billion worth of individual stocks… and bought US$160 billion worth of ETFs instead. ETFs now make up 24 percent of trading in U.S. equities… that’s up from 20 percent back in 2014, the Financial Times reports.
Last summer, investment firm Sanford C. Bernstein released a report titled “The Silent Road to Serfdom: Why Passive Investing Is Worse than Marxism”. That’s a bit much – but its main point was that index investing can lead to mispricing of stocks.
No less an authority than the grandfather of passive investing, Vanguard Group founder John C. Bogle, thinks that indexing can get too big for its own good. “What happens when everybody indexes?” he asks. “Chaos, chaos without limit. You can’t buy or sell, there is no liquidity, there is no market.” (Not surprisingly, he only sees this danger if passive investing gets a lot bigger than it is now, though.)
In short, Wall Street is worried that passive investing is undermining basic market principles – that good companies’ share prices should rise in value as their businesses grow, and bad companies’ share prices should go bust.
Passive investing means investors are focusing less on company fundamentals – they’re less interested in distinguishing between well-run, growing companies and poorly managed companies. They’re not focused on determining what shares are cheap and which are overvalued. Instead, they’re throwing their money at an index, regardless of its composition.
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In other words, no one is kicking the tires of sectors and companies to check their fundamentals… passive vehicles are just investing in 500 stocks at a time, with capital allocated to each stock depending on nothing more than their market cap, regardless of changing circumstances.
As the Wall Street Journal recently explained in an article titled “The Dying Business of Picking Stocks”:
“Passive funds are designed only to match the markets, so investors are giving up the chance to outperform them. And if fewer managers are drilling into financial reports to pick the best stocks and avoid the worst – index funds buy stocks blindly – that could eventually undermine the market’s capacity to price shares efficiently.”
Also… the law of passive investing means that the de facto asset managers of hundreds of billions of dollars become none other than the people who create the indices that are followed by ETFs. The rules that govern what stocks are allowed into the golden gates of the biggest indices are probably among the most important – and least scrutinised – investment dictates in the world of finance today.
(We’ve already seen how MSCI, one of the world’s biggest index companies, calls the shots with China’s A shares. And that’s only a tiny window into the outsized influence that MSCI and its peers have on markets.)
When it comes to ETFs – just like with beer and fast food – moderation always works best. So use ETFs by all means – but don’t use them exclusively.
Also remember, not all ETFs are good. Some, like these ETFs in Vietnam, have a terrible record of tracking their benchmark index. Just because an ETF promises to track an index, it doesn’t mean that it will deliver on that promise.
And tracking error is just one of the risks that come with investing ETFs. As the ETF market has grown, providers have developed more exotic – and risky – products to stand out in this increasingly crowded field.
Leveraged ETFs (that claim to double or triple the returns of an index) and inverse ETFs (that do the opposite of what an index does) are some of the riskiest investments around. Leveraged and inverse ETFs use derivatives, and this allows managers to stimulate or multiply the returns of the index.
These products track daily returns, so short-term traders can make a quick profit. But over time, these ETFs can seriously underperform their index (especially if it is more volatile), as we’ve written before.
And maybe most importantly, index investing isn’t the final word. There’s still a place for stock analysis and selection. It’s not for everyone, of course. But if you know what you’re doing – or, you find someone who really does know what he or she is doing – listen to them.
That’s why we launched The Churchouse Letter – to help our readers find undervalued stocks and investment opportunities around the world. These opportunities aren’t on the radar of most investors and aren’t talked about in the mainstream media. So far, we’ve helped our readers make gains like 87 percent in one tobacco company… 63 percent in a broad China ETF… and 55 percent from an environmental play.
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Publisher, Stansberry Churchouse Research
A decade ago, exchange traded funds (ETFs) were barely on investor radars. But since then, the ETF industry has exploded. ETFs are now the bread-and-butter tool for everyday investors looking for an easy way to invest in a particular geographic region, market, sector… you name it.
A record US$3.4 trillion of assets under management (AUM) are now held in ETFs. That’s a nearly 17-fold increase since 2003.
And this trend isn’t slowing down anytime soon…
First, investors have been disappointed with the relative high-fees and underperformance of active funds (that is, funds where managers select stocks themselves). This has made ETFs, which are low-cost passive funds that simply track a particular benchmark index, more attractive.
For example, analysis from index provider S&P Dow Jones in 2016 showed that 99 percent of actively managed U.S. equity funds sold in Europe have failed to beat the S&P 500 over the past 10 years.
So ETF providers have an easy case to make to investors – why pay more in fees to underperform when you can track the benchmark for nearly free?
Second, the number of ETFs has increased substantially. There are now around 5,000 ETFs listed globally, up from a few hundred in 2003.
Plenty of those ETFs overlap – that is, multiple managers offer ETFs that track the same underlying index – but the everyday investor is truly spoiled for choice when it comes to ETF investing.
To demonstrate just how much choice we have, consider this: there are now more market indexes than there are stocks listed in the U.S.
Today, there are around 3,600 stocks listed on U.S. exchanges (not including the over the counter market), but there are around 5,000 indexes. Not all of these indexes have ETFs attached to them. But to create an ETF, you first need to create an index for it to track.
So the growth in ETF investing isn’t over yet.
At Stansberry Churchouse Research, we’re fans of ETFs. We think they’ve radically democratised the investment process for everyday investors. But like everything in investing, there are some things to watch out for.
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Here are three things you should consider before you buy any ETF:
ETFs charge a fixed percentage annual running cost to shareholders. This is known as the expense ratio. Whilst an actively managed fund might charge, say, 1 percent of AUM and a percentage of profits, ETF expense ratios are typically less than 0.50 percent. And expense ratios continue to decline…
First, because of scale. As ETF providers gather more AUM, their costs as a proportion of the overall fund size decrease. For example, let’s say it costs US$1 million annually to run, administer and market a particular ETF. That’s 1 percent of a US$100 million ETF. But it’s 0.1 percent of a US$1 billion sized fund.
The second reason expense ratios are falling is competition. Investors are wising up to the impact that fees have on their overall long-term performance. And when you’re looking at two near-identical ETFs that both track the same index, which one are you going to pick? The one with the lowest expense ratio.
But remember, different underlying ETF assets come with different associated expense ratios. If the ETF tracks a major benchmark developed market equity index like the S&P 500, the expense ratio should be low.
But if it holds a wide range of emerging market stocks, expect the expense ratio to be higher. It’s operationally more expensive for an asset manager to replicate a basket of stocks across multiple exchanges, and the expense ratio reflects that.
So how do you know what’s expensive and what’s not? When I want to establish a baseline expense ratio for a particular type of ETF, I check fund manager Vanguard’s ETF page. (Go here to see for yourself.)
Vanguard is renowned for offering the most cost-effective ETFs. It currently offers 55 ETFs across a range of underlying asset classes and sectors. So when I’m comparing the costs of ETFs, I use Vanguard as a starting point for expense ratios.
Liquidity is the ease with which you can buy and sell a security in the market without affecting its underlying price.
For most of us individual investors, our individual buy and sell orders don’t visibly move the market. But they can if we’re looking at thinly-traded small-cap stocks.
And some ETFs can suffer from a lack of liquidity just as easily.
The first sign that an ETF you are looking at might not be easy to trade in and out of comes from looking at its AUM. A small ETF is far likelier to suffer from low liquidity than a large multibillion-dollar fund.
The second factor to consider is the nature of the underlying securities in the ETF. If your ETF holds a basket of large-cap developed market stocks, then liquidity won’t be a problem.
If, on the other hand, you’re looking at an ETF like the iShares Barclays USD Asia High Yield Bond Index ETF (Exchange; SGX, Ticker; AHYG), which is an ETF that is small (US$75 million) and holds relatively illiquid assets (Asian high-yield bonds), then liquidity is going to be a problem. (According to Bloomberg, the recent volume of this ETF is less than US$30,000 day, which is very low.)
If you choose to buy a relatively illiquid ETF, please make sure you use limit orders. So when you place your buy or sell order, specify the maximum purchase price (or minimum selling price) you are willing to accept.
I can’t stress this enough – when you are buying an ETF, you’re not only investing in a basket of underlying securities, but ALSO the mechanics of how the underlying index works.
In the early days of ETF investing, this was less of a consideration. Most of the first ETFs sought to replicate standard benchmark indices, like the S&P 500.
But, as I mentioned earlier, there are now more indexes than U.S. stocks and they cover every imaginable type of securities you can think of.
Are you bullish on “cloud computing”? Well, there’s an index for that – the ISE Cloud Computing Index. There’s an ETF for that, too – the First Trust Cloud Computing ETF (Exchange; NYSE, Ticker; SKYY).
If Catholics would prefer to combine their investing with their religion, then look no further than the S&P 500 Catholic Values Index, and the Global X S&P 500 Catholic Values ETF (Exchange; NYSE, Ticker; CATH).
Beyond all of these different sectors and themes, there’s a growing list of “smart beta” indexes. These indexes include more complicated methodologies for how the underlying stocks are selected.
Most indexes use a simple market cap weighted methodology. They take a basket of stocks, and weigh them according to their respective market cap.
But smart beta indexes use factors like trailing volatility (for “volatility targeting” or “volatility reduction” indexes), recent price performance (for “momentum” indexes), or historical dividend increases (for “dividend aristocrats” indexes). These smart beta indexes are applying these methodologies to hopefully provide investors with enhanced returns.
However, investors need to tread very, very carefully with smart beta indexes and smart beta ETFs. They might sound appealing, but you need to ensure you take the time to read through the index construction documents so that you understand what you’re getting into.
As I wrote recently, you can’t just take the name of an ETF at face value and assume it is giving you what it says it is. Always read the label of your investments.
(We’ve recommended smart beta ETFs in The Churchouse Letter in the past – but they require a lot more due diligence and research than ETFs that simply track regular indexes).
So if you’re looking to invest in an ETF, make sure you do your homework. Read the label, and make sure you know exactly what you’re getting into by answering these three questions first.
There’s a small difference smart investing – and investing in a way that will lose you money. And there’s a very big difference in the results: A comfortable existence or scrimping to get by and dreading retirement.
What am I talking about?…
Imagine you’re at the supermarket buying some yoghurt. You’re health-conscious, watching your weight, just trying to eat right. You see some single-serving pots of “Yoplait Greek Fat-Free Blueberry Yoghurt”.
Perfect, you think. Fat-free means it’s more or less healthy. Right?
But… if you take the time to read the label you’ll see that two small pots of this stuff contain the same amount of sugar as a regular 12-ounce (355ml) can of Coke.
That’s nearly 10 teaspoons of sugar. You’re buying junk food without even realising it.
Investors make the same kind of mistake all the time. They don’t pay enough attention to fees or financial advisor costs when it comes to brokers. They don’t pay enough attention to structured derivative product fees in particular. (Believe me, structured products are like sausages – you don’t want to see how they get made.)
When it comes to ETFs, what it says on the label and what it does in practice can be two completely different things. The only way you can adequately inform yourself is by understanding the contents. And to do that, you need to understand the underlying index.
Let me explain.
An ETF is just an exchange-traded fund that tracks a particular underlying index. The underlying index defines the rules which dictate the stocks or financial securities that are included in the ETF.
If the name of the ETF is what you see on the food label, then the underlying index is basically the list of ingredients and the recipe. The best ETF to buy is one that really contains what the label – that is, the name – suggests.
Let’s say you’re looking to diversify your fixed income portfolio. You think about adding in some China exposure. The growth story is attractive, and it’s not a bad idea to get some exposure to both the Chinese economy and currency, the renminbi (or yuan).
You google “China bond ETFs” and you come across the PowerShares Chinese Yuan Dim Sum Bond ETF (NYSE; ticker: DSUM).
You recognise the name PowerShares as one of the leading ETF providers. That’s a good start. But since we’re investing smart, let’s look at the ingredients.
If you’re not sure what “Dim Sum” means, a quick internet search tells you that it’s a popular Hong Kong cuisine consisting of small steamed or fried dumplings. (If you haven’t tried it, you should.)
A slightly more refined internet search tells you that “dim sum bonds” are renminbi-denominated bonds issued outside of China.
You note the expense ratio (that is, the annual fee ETF charge) of 0.45 percent is high. But this is a specialised foreign currency fixed-income ETF, so that’s understandable.
Finally, because this is a bond ETF after all, you check the yield. The Invesco website (PowerShares was acquired by Invesco in 2006) indicates the ETF yields around 4.3 percent before fees.
Everything looks good, so you put the order in with your broker. This “Chinese Yuan Dim Sum Bond ETF” appears to do everything its name suggests. You’ve diversified into China.
Is this a smart investment? Not really…
Let me ask you a question:
What do the British government, Korean financial institution Shinhan Bank, oil giant British Petroleum, Hong Kong financial services company Southwest Securities, New Zealand dairy cooperative Fonterra, German carmaker Volkswagen, and Malaysia’s national mortgage corporation Cagamas all have in common?
Absolutely nothing whatsoever, except that you now own some of their debt. These entities have all issued offshore renminbi bonds which are included in this ETF.
That’s the only thing they have in common.
If you dig into the prospectus you’ll see that the “recipe” outlined by the underlying index means you can throw any “ingredients” into this ETF.
The bonds just need to be issued and settled in renminbi outside of China, have a minimum maturity of one month, and an outstanding notional amount of at least one billion renminbi (US$145 million).
How about a minimum credit rating requirement?
No, none required. As a result, nearly two-thirds of the bonds in this ETF aren’t even rated at all. Bonds can be issued by governments, corporations, agencies or supranationals.
As an investment, this makes no sense to me. All this ETF does is provide you with a bunch of bonds whose sole commonality is being issued outside of China in renminbi!
You might as well buy shares in a “Stansberry Churchouse Financial Fruit ETF”, a fund giving you exposure to stocks that bear the name of a fruit. Holdings could include Apple Inc., Orange S.A., Grape King Bio Ltd., and Maui Land & Pineapple Company.
What’s more, in the Dim Sum ETF, the “recipe” says that nearly anything can be thrown into the fund over time. You see, as the bonds in the ETF mature, they will be replaced with others – but you have no idea what. It could be any company, anywhere in the world, with any credit rating, just so long as the bond is issued in renminbi outside of China.
To be clear, I’m not saying that PowerShares is misleading you any more than Yoplait is with its yoghurt. Their respective labels are both technically correct.
But just because an ETF provider is a big household name, it doesn’t mean what they’re selling makes sense. (That’s also true with Vietnam’s ETFs.)
Always spend a few more minutes and properly read the label.
P.S. At Stansberry Churchouse Research, we give you a step-by-step guide on how to invest money in stocks and ETFs that gives you good exposure to Asia. To download our beginner’s guide, click here.
Gaining exposure to a stock index is one of the best ways for the average investor to access the stock market. It’s simple, low-cost and provides instant diversification. Plus, study after study has shown that even the best of unit trusts and investment funds do not consistently outperform their corresponding benchmark index.
But you can’t buy an index directly. You need to use an investment product, like an ETF or index fund, to “own” them. It’s also possible to actively trade indices using derivatives (more on these later) or CFDs (contracts for difference).
ETFs and index funds are good for investors that want to invest in an index over a long time period – the buy and hold investor. As mentioned previously, professional money managers’ returns over time have not been able to consistently outperform these other passive investments.
Trading CFDs on indices are for investors that want a little more action – and who understand how these specialty products work. Actively trading index CFDs also requires more time, effort and analysis than just buying and holding an ETF. So, this is not for everyone. (An example of how trading indices using CFDs works can be found here.)
Regardless of whether you want to buy and hold an ETF, or actively trade CFDs, you will be exposed to a variety of risks. Here are four of them.
This applies when financial products such as swaps or derivatives are used to mimic an index. A common example is “synthetic” ETFs.
Here’s how a synthetic ETF works: Instead of holding the underlying securities of an index, the ETF investor owns “swaps” and other collateral which are used to replicate the holdings.
A swap is a contract with another financial firm or “counterparty” that promises to pay an index’s return to the fund. Using derivatives – rather than actually buying the underlying asset – reduces the fund’s costs, and those savings are passed on to investors.
While there are regulations that may limit an ETF’s exposure to any one counterparty, the fact remains that if a counterparty should become unable to pay, the investor in a synthetic ETF could lose money. If that institution goes bankrupt, the ETF loses money and this will be passed on to its investors.
If you have exposure in an index that is in a different currency than what’s in your account, such as U.S. dollars, the change in exchange rates will affect your performance.
For instance, let’s say you use Singapore dollars to buy a USD investment that tracks the U.S. S&P 500 Index. If the ETF goes up 15 percent in value (net of transaction costs), but the Singapore dollar gains 2 percent in value compared with the U.S. dollar, you only make 13 percent (if you sell the ETF at that time).
But if the Singapore dollar loses 2 percent compared to the U.S. dollar, your return would be 17 percent. So, foreign exchange risk can work in your favour as well.
To avoid foreign exchange risk, look for index products that are hedged to the other currency. That means there is little risk from changes in foreign exchange rates.
This especially applies to ETFs. Most people buy and sell the most liquid – that is, the most heavily traded – ETFs. But there are a lot of ETFs that have very low liquidity – that is, there not many willing buyers or sellers in the ETF at the exchange.
That can be a problem if you need to sell or buy that ETF in a hurry, or if you hold a large number of shares in an illiquid ETF.
When trading volume is low, your order may take a while to get filled and you may not get the best price. So, look for the ones with the highest daily trading volumes.
If you are using any investment product that uses leverage or derivatives, for example “inverse” ETFs you need to be careful the impact of leverage on the price of the ETF. Since Singapore approved rules for leveraged and inverse ETFs earlier this year, expect to hear more about them in coming months.
Here’s why these financial instruments should be used only by experienced investors who can tolerate a lot of risk. We’ll use leveraged and inverse ETFs as an example:
Leveraged ETFs seek to engineer gains that are 2 or 3 times that of the underlying index. An example is the UltraPro Short S&P 500 ETF (New York Stock Exchange; ticker: SPXU). It aims to earn 3 times the opposite of what the S&P 500 index returns on a given day. So, if the S&P 500 loses 1 percent in a day, SPXU would gain 3 percent that day.
Inverse ETFs do the opposite of what the index it’s linked to does. For example, the ProShares Short S&P 500 ETF (New York Stock Exchange; ticker: SH) is designed to go up if the S&P 500 index falls, and go down when the S&P 500 rises. So, if the S&P 500 falls 1 percent, SH rises 1 percent… and if the S&P 500 rises 1 percent, SH falls 1 percent.
Leveraged and inverse ETFs use derivatives. These are instruments that “derive” their value from an underlying asset – like gold, an individual stock or a stock index. Derivatives allow ETF managers, to gear up or down the returns of a target index.
Unless you’re a day or short-term trader, leveraged index products might not be worth the added risk and volatility.
But don’t let these risks stop you from investing in a stock index using an Index CFD. If you understand what you’re buying and are aware of the risks involved, index investing, or trading, can be a very profitable strategy.
This article was sponsored by IG, the world’s No.1 CFD provider (by revenue excluding FX, 2016). All views expressed in the article are the independent opinion of Stansberry Churchouse Research.
Today I’m sharing an article written by my friend Tama Churchouse, who with his father, Peter, runs Churchouse Publishing in Hong Kong. Peter and Tama write The Churchouse Letter, a monthly publication about investing in Asia, along with a free email called Peter’s Perspective, which you can sign up for here. Today, Tama writes about why now is the best time to start learning how to trade bitcoin.
By Tama Churchouse
Last week the top U.S. securities regulator, the Securities & Exchange Commission (SEC) rejected the application for the first publicly traded bitcoin ETF.
Leading into the ruling by the SEC, the price of digital currency bitcoin had rallied 28 percent so far this year. Much of the rise was due to speculation that SEC approval would have led to a rush of capital into the digital currency. (Right now, it’s not easy to buy bitcoin. Last week, we wrote about why you should try anyway.)
Following the SEC announcement, the price of bitcoin fell sharply from around US$1290 to sub-$1000, before bouncing back to back over US$1200.
Is this the end of bitcoin?
The key question now is: Is the SEC’s refusal to grant ETF approval the beginning of the end of bitcoin?
No. And here’s why:
Bitcoin is responding to this news like a regular financial asset.
The price of bitcoin has been volatile, sure… but it’s also behaving like a regular, developing financial asset. It drops on negative news, and rallies on positive news. There are more and more people involved in buying and selling it, and liquidity (that is, the amount of market activity with bitcoin) continues to improve.
As the chart below shows, within a single day, the price of bitcoin fell 18 percent immediately after the SEC decision. But it recovered quickly and is now around 5 percent below its all-time highs.
Bitcoin allows for the transfer of real monetary value between two people that can be indisputably corroborated without the need for approval from any centralised entity. We can now securely and provably exchange real monetary value outside of existing monetary systems.
This is a phenomenal triumph. It represents a step change in how we undertake financial transactions. Nothing about this achievement has changed following the SEC ruling on a bitcoin ETF.
The door is open
The SEC never said “never”. They noted the following:
“The Commission notes that bitcoin is still in the relatively early stages of its development and that, over time, regulated bitcoin-related markets of significant size may develop… Should such markets develop, the Commission could consider whether a bitcoin ETP would, based on the facts and circumstances then presented, be consistent with the requirements of the Exchange Act.”
Bitcoin remains early in its development, with a total market cap of US$20 billion… that’s about the same as Suzuki Motor (Tokyo Stock Exchange; ticker: 7269) or Dollar General (New York Stock Exchange; ticker: DG).
It’s harder to find reasons NOT to own bitcoin
Here are some of the main reasons to ignore bitcoin I frequently hear:
First off, not buying bitcoin because there have been some major hacks and scandals, particularly exchanges (the largest being that surrounding Tokyo-based Mt. Gox in 2014), is like not using a bank because JPMorgan had 83 million accounts compromised by hackers in the same year. It’s like not buying anything with credit cards anymore because department store Target had 40 million credit card numbers stolen in 2013. Cybersecurity breaches are unfortunately commonplace. Bitcoin isn’t more affected by them than your local shop or bank.
Secondly, whilst bitcoin can make sending and receiving money easier for criminals, bitcoin transactions are not anonymous. There’s also no evidence that anything more than a fraction of bitcoin transactions are in any way connected to crime. And the most common medium of wealth transfer for illegal activity?… cash, just like you have in your wallet.
Third, there is a lack of regulatory oversight with regards to how bitcoin is bought, sold and traded. But the bitcoin infrastructure is completely open to scrutiny by some of the world’s smartest people. Bitcoin and blockchain are defined by code. But companies we invest in can go bankrupt. Executives can lie. Employees can cheat and steal.
Bitcoin is not vulnerable to the vast majority of issues that investors face when buying a stock or a bond. And don’t forget… the whole point of bitcoin in the first place is that it was designed to get around the need for any regulation at all.
It’s still a good time to buy
If anything, the SEC’s reticence keeps bitcoin out of a lot of investor portfolios for a while longer. This means you have more time to get familiar with it, and start accumulating some.
I wrote previously that you should buy US$100 of bitcoin. It’s the best way to familiarise yourself with how it all works.
In coming weeks I’ll put together a video on how anyone can buy some bitcoin, walking you step-by-step through the process of buying, storing and trading bitcoin.
In the meantime, good investing,
Are you looking for the best ETF to buy? There are scores to choose from, but let me tell you which ones you need to steer clear of.
Caveat emptor is Latin for “Let the buyer beware”. The term has been used since the 16th century to warn of the risk that a product may have defects, or not meet expectations.
It’s good advice if you’re buying a used car or purchasing consumer electronics online. And buyer beware is also an important warning if you’re searching for the best ETF to invest in.
A glaring example is the performance of the Vietnam ETFs that claim to track the Vietnam Stock Market, but in fact do not.
Vietnam ETFs: A history of underperformance
Vietnam stocks have been on a roll – at least as measured by the VN Index, which tracks the 304 largest stocks listed on the Vietnam’s two stock exchanges, in Ho Chi Minh City and Hanoi. Since the beginning of 2016, the VN Index is up nearly 30 percent.
So you might think that investors in the two big ETFs that track Vietnam stocks are feeling good.
But no. The two “Vietnam ETFs” have done a terrible job of tracking the Vietnam market. Since 2009, as the graph shows below, the VanEck Vectors Vietnam ETF (New York Stock Exchange; ticker: VNM) has dropped 37 percent and the db X-trackers FTSE Vietnam UCITS ETF (London Stock Exchange; ticker: XFVT) has dropped 54 percent.
The abysmal performance of these ETFs – compared to the market they claim to track – is just one instance of an increasingly common occurrence: ETFs failing to meet their stated objectives.
Despite shortcomings, ETFs remain popular worldwide
Globally, the number of exchange-traded products (ETPs) has surged from 500 in 2005 to nearly 6,700 today. ETPs include ETFs and a similar product, exchange-traded notes (ETNs). The total value of assets managed by ETPs has grown from US$400 million in 2005 to US$3.8 trillion today.
ETPs have boomed because it’s easy and convenient to buy a sector, index or strategy via a single, exchange-traded investment. For instance, if you only have a small amount of money (relative to other investors), it’s nearly impossible (and expensive) to buy all the individual stocks in the S&P 500. But by buying shares of SPY (State Street’s SPDR S&P 500 ETF), an investor can do just that – cheaply and easily.
There are two main kinds of ETFs – active and passive. Active fund managers rely on their own research and judgments to make investment decisions. Passive ETPs attempt to track specific indices of securities. For example, SPY is the largest ETF in existence, with US$234 billion under management, and it passively tracks the S&P 500 index, mimicking that index’s returns very closely.
However – as the Vietnam ETFs show – just because an ETF claims to track a given market, doesn’t mean it accomplishes what it promises.
ETFs are one of the best investment vehicles to buy. But something called tracking error is a big risk
As I’ve written about previously, there are many risks to ETF investing.
Tracking error is just one of these ETF risks. Some funds mimic their benchmark index better than others. The shortfall between an index’s performance and the ETF that tracks that index is called the tracking error.
One problem is: Sometimes an ETF does not own all the securities in the index it’s supposed to replicate.
You might assume that to replicate an underlying index, ETFs buy each index component in a proportion equal to its weighting in the benchmark. Some ETFs use this “full replication” strategy. Others employ “sampling” techniques, which means constructing a portfolio that is similar to the index but actually holds a different mix of securities.
Differences between the composition of the underlying index and the ETF portfolio can result in tracking error.
This is where the Vietnam ETFs get into trouble.
Vietnam’s unique tracking error
Vietnam is a communist country where the government, via State Operated Enterprises (SOEs), owns most of the shares of many publicly traded companies. As a result, the number of shares actually available for trading – which is called the float – can be tiny for many stocks. For many of the top companies on the Ho Chi Minh Exchange, less than 5 percent of outstanding shares freely trade.
This makes shares of a company very illiquid (that is, they don’t trade much) and volatile. That’s a big problem for an ETF manager who is trying to buy and sell millions of dollars’ worth of shares to replicate an index.
The structure of the VN Index makes tracking Vietnamese markets problematic. It’s a market cap- weighted index, which means that the weightings of stocks in the index are based on a stock’s market value (share price times the total number of shares). To accurately track the index, an ETF manager would have to regularly rebalance its holdings, as market caps change.
For instance, if a thinly traded stock rises quickly in value, a manager tracking the index would have to buy more shares to maintain the proper weighting in the index. However, if shares available for purchase are limited because of state ownership or other float restrictions, then rebalancing an ETF to track the index is problematic.
This makes it virtually impossible for an ETF manager to closely replicate the VN Index by buying shares of the companies that comprise it. But there’s strong demand for Vietnam ETF products. So the issuers of the ETFs decided to create their own, separate indices rather than attempt to replicate the VN Index.
However, by creating their own benchmarks that comprise more liquid Vietnamese stocks, and even adding in some non-Vietnamese stocks, the indices tracked by the ETFs have lagged behind the actual VN Index (which, after all, is the most widely-used measure of the market) by a huge margin.
For instance, in the last few months of 2016, two Vietnamese companies – Faros Construction and Saigon Beer – were the big drivers of the VN Index. But the Vietnam ETFs VNW and XFVT held no shares in either one of these high-fliers.
Invest in funds – not ETFs – to gain exposure to Vietnam
For those who didn’t do their homework before investing in “Vietnam ETFs”, the awful performance of these funds compared to the Vietnam stock market no doubt came as a shock.
Unfortunately, Vietnam’s markets are mired in a bureaucratic swamp, which makes it difficult for an individual investor, let alone a foreign investor, to gain exposure to this emerging market directly.
If you’re set on exposing your portfolio to Vietnam, I recommend that anyone investing in Vietnam avoid the ETFs and consider actively managed mutual funds, which have had superior performance.
One of my favorite ways to invest in Vietnam equities is via the AFC Vietnam Fund, an open-ended fund that focuses on small to medium companies in the country. The AFC Fund’s performance has been stellar: It’s up 45 percent over the last three years through March. Over the same period, the VN Index is up 28.5 percent and the VanEck and db x-trackers ETFs are down 29 percent and 17 percent respectively.
With the open-ended AFC Fund, you’ll have higher fees, and you won’t be able to sell as quickly as you do with an ETF. Personally, I would rather pay higher fees to make money, than lower fees to lose money.
However, the AFC Vietnam Fund could be hit with liquidity issues during economic downturn, since the fund contains a number of small companies. And investing in country-specific funds is a concentrated bet on one market – and it’s not for everyone.
ETFs offer a way for investors to easily take advantage of specialized investment themes or strategies. But don’t take ETFs at face value – these funds don’t always do what they claim. Before investing, take time to read the fine print and carefully consider all the risks. Let the buyer beware.
A popular ETF-like investment is designed to protect against portfolio losses in the event of a stock market crash. But most investors have no idea that holding this Exchange Traded Note (ETN) is likely to cost them more money than any market crash ever could.
The “fear” index
A few days ago, I discussed how the VIX – sometimes called the “fear index” – is near historical lows. The VIX measures demand for options in S&P 500 stocks used by big investors to insure their stock portfolios against loss. A high VIX reading indicates investors expect high volatility in coming weeks, and their demand for insurance is driving option prices higher.
However, recent low VIX readings (around 11) suggest that there’s less demand than usual for options protecting against market declines. Often in the past, this lack of worry by investors has been “the calm before the storm.” The last time the VIX was below 11 was in 2007, just months before the global economic crisis broke out.
But while markets rally and complacency grows, risks to the global economy are building. Stock valuations are high, especially after the “Trump rally” has pushed the S&P 500 up nearly 10 percent since the election. Also, interest rates are heading higher. After seven years of printing money, the U.S. Fed has signaled the “era of easy money” is coming to an end. And U.S. President Donald Trump is intent on extensive changes to U.S. policy, but his confrontational style has ignited lots of controversy and created high levels of policy uncertainty.
Yet, despite these risks, the fear index is stalled near 11. In past crises, the VIX spiked to levels of 40 and even 80. (If you could buy the VIX like a stock, the potential upside would be enormous, because if stocks fall, VIX profits could offset losses.)
Unfortunately, unlike the S&P 500 or other indices, there’s no way to invest directly in the VIX index. Of course, that hasn’t stopped financial engineers from creating derivative products that try (mostly unsuccessfully) to track the VIX.
VIX futures and options on futures have been around for years. However, futures in general are risky – and futures on volatility even more so. These instruments are only for experienced traders who can afford to lose their entire investment very quickly.
The VXX: The worst performing “fear tracker”… ever
In January 2009, at the height of the financial crisis, a retail product was created to track the VIX. VXX – the iPath S&P 500 VIX Short Term Futures ETN – was launched. What followed was possibly the worst performance of an ETF-like product in history. You can see how bad VXX performed in the graph below since its inception in 2009.
If you had bought VXX when it began trading in early 2009 and held it until today, you would have lost 99.94 percent of your money. To put this in terms of money, if you had invested $1,000 then, you’d have $6 left.
Despite that the ETN has done four separate 1-for-4 reverse splits, which should have quadrupled the stock price, it still trades for pennies. (That’s why the graph above shows the share price as being tens of thousands of dollars – the graph reflects the reverse splitting of the stock after it fell.)
How is such nightmarish performance possible? And why does VXX continue to trade tens of millions of shares per day, and still have US$1.2 billion in assets?
First of all, VXX is not an ETF (an exchange-traded fund) – it’s an ETN (an exchange-traded note). There are big differences, most importantly: While an ETF is a fund that usually holds the actual securities of the index it tracks, an ETN is an instrument that seeks to track the performance of an index. What that means is that it doesn’t hold actual shares of, well, anything.
For instance, if you buy a share of EEM (iShares MSCI Emerging Markets ETF), you own a bit of each stock in the MSCI Emerging Markets Index. But if you buy a share of the VXX ETN, you own interest in a promissory note from iShares. With your money, the institution will attempt to track the VIX index. (We wrote about the dangers of ETNs previously.)
Also, VXX seeks to track the VIX over short periods – that is, days. It does this by always holding VIX futures. The fund does not attempt to track VIX over the long term, though many investors don’t realize this. We’ve discussed hidden ETF risks before.
The futures contracts the ETN holds increase in value if the VIX goes up. But futures contracts have expiration dates, so VXX must periodically sell expiring futures and buy new ones.
VXX usually buys futures with two months or so until expiration. But with each passing day, the time value in the contract prices decrease. As expiration approaches, the fund “rolls” the expiring futures contract (which have lost most of their time value) into new, further-out contracts with lots of time premium.
VXX is almost always buying futures, which are decaying in value, buying high and selling low. This guarantees that the price of VXX falls over time.
The obvious question is: Why would anyone buy VXX?
The reason is that if a speculator times a market drop perfectly, VXX – and other VIX-related ETNs – can generate huge returns over a very short time. For example, after the Brexit vote on June 23, 2016, the S&P 500 plunged by 3.6 percent, and the VXX jumped to 26 from 17 – a gain of 52 percent.
But unless you know exactly when stock markets will crash (please contact me if you can, in fact, predict the future), VXX does nothing but eat your money. My advice: If you’re in search of this kind of gambling action, go to the casino where you can at least have some fun while you lose money. And forget about buying VXX or other VIX-related ETNs.
What about the other way?
But wait, I hear you saying: “If over time VXX decays nearly every day on a death march to zero, what if I short it, and profit from the constant price erosion?” (If you “short” a stock, you sell it first, then hope to buy it at lower prices, profiting the difference.) As it happens, you wouldn’t be the first person to have thought of this.
While sound in theory, there is a problem with this strategy. On most days, the price of VXX will drip lower. Week after week you’ll accumulate small profits. But then, out of the blue, an event like Brexit comes along, stocks tank, and investors desperately buy options for insurance – and the VIX soars, along with VXX. You could lose 50 percent on your short VXX position literally overnight.
And who knows what sort of market crashes will happen in the future? You might wake up some morning and you’ve lost 90 percent of your money shorting VXX.
The XIV: A “fear tracker” for experienced investors only
There’s even an ETN that investor’s use as a way to profit from VXX decay. The ETN is XIV (VelocityShares Daily Inverse VIX Short-Term ETN). XIV in essence “shorts” the VIX. Here’s how this instrument is described by the note’s issuer:
“XIV offers extremely liquid inverse exposure to short-term VIX futures in an ETN. The fund accurately delivers -1x exposure – one day at a time—to first- and second-month VIX futures. This fund does not provide inverse exposure to the VIX index itself, which is truly uninvestable.”
So, XIV is attempting to track the inverse return of the VIX on a daily basis. However, over long time periods, just as VXX continually loses from the decay of VIX futures’ time value, XIV tends to profit from the decay. Since the VXX goes DOWN most weeks, the XIV goes UP most weeks. In fact, since its inception in December of 2010, XIV is up over 500 percent.
But before you rush to buy XIV, consider this: From August 9 to August 30 of 2015 – during the China market meltdown – XIV fell from 48 to 23. That’s a 52 percent drop in 3 weeks. And that’s just one of XIV’s crashes. Keep in mind that a 50 percent decline in an investment requires a 100 percent gain to recoup the loss. An 80 percent loss requires a 500 percent gain to get up to breakeven.
The fact is, XIV is too volatile to make it a realistic buy-and-hold investment. Indeed, any investor putting money into VIX-related ETNs is playing with dynamite.
How to profit from “fear” without buying dangerous ETNs
Rather than gambling with VIX products, a more sensible reaction to the low VIX is to make your portfolio more defensive. For example, you could raise some cash, consider taking some profits on high-flyers, and hold off on new purchases until markets show better values.
Also, buy some gold. Buying gold bullion, physical gold ETFs, or gold stock ETFs, is the preferred strategy for insuring one’s portfolio against rising market risks. It’s also a smarter, less risky way to speculate on possible market turmoil. When the VIX spikes higher, you can bet that the price of gold will also rise.
For instance, from June of 2007, when the financial crisis first broke, to the March 2009 bottom, global stocks dropped about 45 percent. But the price of gold rose about 40 percent over the same period.
And unlike wildly volatile VIX ETNs, gold is an asset that you can hold long term. Precious metals are not correlated with equities, and add stability to you portfolio, while providing protection against future inflation.
The historically low VIX index combined with lots of uncertainty could be foreshadowing market volatility. But don’t buy VIX-based ETNs – they’re complex, unreliable instruments with too much risk. During periods of fear and uncertainty, investors have traditionally turned to gold as a storehouse of wealth.
I’ve written about gold before, and in the upcoming issue of the Asia Alpha Advisory I’ll tell subscribers about my favourite ways to invest in gold. (Go here if you’re not a subscriber but want to be… you’ll hear me talk about one of my favourite markets as well.)
Today I’m sharing an article written by my friend Tama Churchouse, who with his father, Peter, runs Churchouse Publishing in Hong Kong. Peter spent decades as the Head of Asia Research and Regional Strategist at Morgan Stanley in Hong Kong, and is a fantastic source of stories and insight on investing in Asia. He’s a frequent guest on the major financial news networks, so you might have seen him or heard his market insights before.
Tama began his career in the trenches of the banking world – and here he explains why bond duration can make “safe” U.S. government Treasuries as risky as emerging market stocks.
Peter and Tama write The Churchouse Letter, a monthly publication about investing in Asia, along with a free email called Peter’s Perspective, which you can sign up for here.
Treasuries – that is, U.S. government bonds – are as risky as emerging market stocks.
Many investors would call me crazy for saying that.
At the very least they’d ask what the “catch” is.
But this is no play on words.
When I say emerging market stocks, that’s exactly what I mean… Russia, Brazil, China, South Africa, India, Mexico, Malaysia, Thailand… bona fide emerging markets.
And when I say Treasuries, I mean U.S. government bonds… backed by the full faith and credit of Uncle Sam. And with no leverage, before you ask.
So how can these two asset classes possibly be equally risky?
Emerging market stocks are widely acknowledged to be one of the most volatile asset classes you can own.
Just look at the performance of MSCI’s emerging market benchmark index in the chart below. It fell by 35 percent from April 2015 through early 2016.
In fact, since 2010, emerging markets have experienced corrections of 18 percent (twice), -12 percent, -17 percent, and -35 percent… it’s been a rough ride.
Before I explain further, let me turn to Vanguard.
Founded in 1975 by Jack Bogle, and with nearly US$3 trillion under management, it’s one of the biggest global fund management companies.
Vanguard offers a suite of very low-cost ETFs, across a range of asset classes.
In trying to assist individual investors, the company designates a risk level to each ETF.
All ETFs are categorised from 1 through 5, with 1 being the least risky, and 5 being the riskiest.
First let’s look at Vanguard’s FTSE Emerging Markets ETF (New York Stock Exchange, ticker: VWO).
With roughly US$61 billion of assets, its top 5 country allocations are as follows: China, Taiwan, India, Brazil and South Africa.
Not surprisingly – given the volatility of emerging markets overall – Vanguard rates this as a risk level 5 ETF.
Now let’s take a look at one of their U.S. Treasury ETFs for comparison.
The ticker is EDV on the New York Stock Exchange.
As I mentioned, it is composed purely of U.S. Government bonds. It currently holds 77 of them.
It’s pretty cheap as well, charging an annual expense ratio of 0.07 percent.
And it’s also designated by Vanguard as a Risk level 5 ETF… the highest possible.
Because it’s the Vanguard Extended Duration Treasury ETF.
This ETF holds “Separate Trading of Registered Interest and Principal of Securities”, otherwise known as STRIPS.
First introduced in 1985, STRIPS are U.S. Treasury bonds that have carved out the interest and principal payments into individually tradeable securities.
For example, a 30-year Treasury can be broken down into 60 semi-annual interest payments, and a single principal payment at maturity.
STRIPS are zero-coupon bonds (bonds that don’t pay interest but are issued at a discount to face value). And what Vanguards Extended Duration Treasury ETF does is focus on long-dated zero-coupon bonds (STRIPS). STRIPS normally mature at terms up to 30 years.
The truth is most investors simply don’t spend much time on fixed income (i.e. bonds) at all.
How much airtime do CNBC and Bloomberg devote to fixed income versus the equity market? It’s fractional.
As a result – in part based on our experience at Churchouse Publishing – a large number of readers don’t have good understanding of fixed income risk. But credit and interest rate risk are the two of the biggest risks that investors need to consider.
Now, credit risk is easy enough to understand.
We intrinsically understand the difference between lending to the U.S. government by buying their bonds versus buying those issued by, say, an Australian mining company.
But when it comes to interest rate risk, things become a little less clear.
The duration of your bond portfolio is a key determinant of how much risk you’re exposed to.
Duration, which is measured in years, tells you how long it will take for the interest payments generated to repay the invested principal. Duration will indicate the approximate change in price of a bond for a given change in interest rates.
Because zero coupon bonds offer the entire payment at maturity, they always have durations equal to their maturities. So therefore their durations are higher than coupon bonds.
If your bond duration is 5 years and interest rates rise by 1 percent, the price of the bond falls by approximately 5 percent (and vice versa).
The duration of say the iShares 7-10 Year Treasury Bond ETF (New York Stock Exchange; ticker: IEF) is around 7.63.
And the Vanguard Extended Duration Treasury ETF (New York Stock Exchange; ticker: EDV)?
The duration is 24.5.
So for every 1 percent move in interest rates, you can expect roughly a 25 percent price move in your ETF.
That’s why a portfolio of U.S. Treasuries can be just as risky as emerging market stocks.
With the U.S. Federal Reserve in the midst of raising rates, it’s worthwhile checking out the duration of your fixed income portfolio – and making sure you know how much interest rate risk you have on the table. Because just because something’s a bond, it doesn’t mean it’s any less risky than – say – emerging market stocks.
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