From the January 2009 issue of Wealth Manager Web • Subscribe!

January 1, 2009

SKINNY-DIPPING

Warren Buffett says that "it's only when the tide goes out that you get to see who has been swimming with their trunks off." Well, the high tide that kept many asset classes afloat has disappeared, and we are now seeing who has been swimming naked on Wall Street. Are exchange traded funds among the many investment vehicles that have been skinny-dipping?

Yes and no. This bear market has certainly revealed some warts on what had been arguably one of the biggest success stories in Wall Street history. ETFs as a group have not been immune to the market carnage. Nor has the ETF structure itself come through this debacle unscathed.

Still, some of the major benefits of ETFs--transparency and liquidity--have shown themselves to be even more valuable during this market decline, which is good news for the industry.

Given that this is really the first important trial by fire, let's take a look at what we've learned about ETFs:

ETFs can go down. I know this sounds a bit silly to say, but the reality is that most investors and advisors had not experienced losses in their ETFs until the latest decline. Look at the facts: The biggest growth for ETFs, the period when they moved into the relative mainstream of investing, occurred from the end of 2002 through 2007. Over that time, the number of ETFs grew from just over 100 to more than 600, with assets increasing approximately six-fold from $102 billion to $608 billion. Over that five-year period, stocks had very few sustained declines--let alone the type of mauling seen in 2008.

In that environment of steadily rising stock prices, ETFs developed a bit of a reputation for being "bullet-proof" investments. Well, that reputation has taken a hit. With only very few exceptions, ETFs are index funds. If the index declines, so will the ETF. And that happened big-time last year. Just how badly have ETFs performed? As a group, no better or worse than the broad market, which is what you would kind of expect from products based on indices. In the brutal month of October, the S&P 500 declined 16.8%. U.S. ETF assets declined 16.7% that month. To be sure, not every ETF declined. Still, for the year through October 31, all equity market-cap size categories--small-, mid-, and large-cap--were down more than 32%. Every single equity sector category was down at least 13%, with seven of the 10 sectors down more than 30%. And in the international sector, ETF assets fell more than 44% through October. Bottom line: If you thought you could hide from a steep market decline in ETFs, you found out you couldn't. Of course, you should have known this ahead of time. But I assure you that your clients never thought their ETFs would go down so much. As usual, the lesson is that you can't educate your clients enough about what they own and the risks of ownership.

?The ETF structure is not immune to the type of pricing irregularities that affect other closed-end investments. Because of their structure and the arbitrage mechanism involved in their creation and redemption process, ETFs trade at or very, very close to their net asset value. At least that is the theory, and this theory was reality for ETFs up to 2008. However, the market machinations over the last year have exposed ETFs to some of the irregular pricing developments that impact other closed-end funds. Some bond ETFs have seen unusually high discounts as a result of the problems in the credit markets. For example, during the third quarter, the iShares Lehman Aggregate Bond (AGG) ETF had discounts as high as 8% of net asset value. The pricing issues were even more acute in the high-yield market. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) traded at a premium of nearly 5% and a discount of 28% on two separate trading days last October. Another driver of pricing issues was a temporary ban on short selling in financials. The ban caused Rydex Investments and ProShares Advisors--two ETF sponsors offering "inverse" funds that allow investors to bet against financial stocks--to temporarily halt the creation of new shares for these inverse ETFs. While these inverse ETFs don't actually short stocks, the ETF sponsors were concerned about their ability to get the swap agreements and other instruments that allow them to provide short exposure to financials. When an ETF doesn't create new shares, the ETF may trade at a premium to the net asset value since there is no new supply of shares to meet increased demand. This is exactly what happened when some of these inverse financial ETFs traded at hefty premiums following the short-sell ban. To be sure, such significant premiums or discounts caused by market dislocations or changing regulations were usually short-lived. Still, the fact that they existed at all was a surprise to many ETF investors and sponsors.

?ETFs/ETNs are impacted by investor confidence. I bring up exchange traded notes here because they are often viewed as "ETF-like" investments. Indeed, both ETFs and ETNs offer intraday trading and fairly precise tracking of an index. However, the one big difference is that ETNs are senior unsecured debt that is linked to a specific market index or return stream. The note's underwriter commits to deliver the return of the index or return stream less the ETN expenses. Unlike ETFs, which are comprised of underlying securities, an ETN is really a note of sorts that promises the holder an index return. Thus, ETNs are subject to the credit risk of the underwriting firm, a fact that was probably not fully understood by retail investors--and perhaps some advisors as well--yet it has become a major issue for ETNs. Indeed, because of the problems facing many banks--and banks are the major creators of ETNs--investors have become much less enthusiastic about owning ETNs. According to Morningstar data, investors pulled approximately 8% of total ETN assets during the month of September. Updated numbers weren't available at the time of this writing, but my guess is the hemorrhaging in ETN assets has continued. In short, with investor confidence plumbing new lows by the day, ETNs will be a very tough sell.

Interestingly, investor confidence also affects demand for ETFs that sport names that bring fear to investors. I can't help but think that investor demand for any ETF with "Lehman" in its name--even if the "Lehman" referred to an index and not the sponsor--was not affected by investor skittishness. Again, the lesson is: Educate, educate, educate your clients.

But while the crazy markets over the last several months have put the spotlight on some deficiencies in ETFs, I think the good makes up for the bad:

?In volatile markets, transparency is huge. ETFs offer that transparency. During a time when investors and their advisors were wondering just what was owned in that bond mutual fund that was blowing up or in that money market fund that was rumored to be breaking the buck, there was no guessing what an ETF held. An advisor could go to the sponsor site and drill down to see what the ETF held on a daily basis. Given that most of you were probably spending 90% or more of your time on the phone talking with clients, knowing what your client's ETFs held and being able to give them that information was a huge advantage over advisors using open-end mutual funds and not really knowing why the fund was down 50%. Difficult markets require that advisors know why an investment is behaving the way it is. Because of their transparency, such attribution analysis is possible with ETFs. It isn't with other fund investments.

?ETFs provide a way to place a negative bet. The old adage that "there's always a bull market somewhere" has been put to the test during this decline. Indeed, whether large or small, U.S. or international, stocks or bonds or commodities, everything has taken a hit over the last 12 months. The only strategy that had the potential to provide gains was playing the short side. The fact is, however, that most advisors and their clients are uncomfortable shorting stock. And if you manage a lot of retirement money, shorting stock is prohibited in IRAs and 401(k)s. Fortunately, ETFs provide a user-friendly way to play the short side via the "inverse" ETFs that have been coming to market in big numbers over the last year. To be sure, I'm not necessarily advocating the use of inverse ETFs.

Obviously, these ETFs have their own set of risks--especially during market advances. Still, it is nice to have the option of betting against a market, if for no other reason than to help hedge long positions.

?Taxes will matter big-time this year. I can't think of anything that will tick off your clients more than seeing their portfolios decline 35% in 2008 and still having to pay capital gains taxes on mutual fund distributions. That's the sort of thing that will get you fired. On the other hand, ETFs should continue to be relatively tax friendly versus open-end mutual funds for 2008.

?Intraday liquidity provides much more flexibility during volatile markets. For the 10-year period ending Dec. 31, 2007, the Dow Jones Industrials never once had a daily price change of more than 9%. In 2008, daily price swings of more than 9% happened no less than six times. And 2008 saw no fewer than 20 days of more than 5% changes in the Dow.

The upshot is that 2008 experienced what used to be a year's worth of price movement condensed into single trading days. In such a volatile market, having the ability to trade ETFs intraday is a huge advantage over open-end mutual funds. Indeed, the intraday trading afforded by ETFs lends much greater timeliness and precision to such important decisions as funding client withdrawals and rebalancing portfolios.

I don't think any of us would be shocked if the market continues to face headwinds for the foreseeable future. And it's likely that ETFs as a group will experience their share of tumult. But it is worth noting that ETFs have come through their first real test a little scuffed up but still standing. And that resiliency is something that should be reflected in increased investor interest as the market rebounds in earnest.

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (HarperBusiness). David Wright, CFA, provided research assistance for this article.

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