This has been a column for stock-pickers in the New Economy fields of technology, telecommunications, and services. While the market has taken its toll on some of the issues featured over the past year, others have delivered and will likely continue to do so for years to come. Now, I want to expand the New Economy Advisor’s focus beyond single stocks.
Time and again, I’m taken aback by how little some of us know about the most common tools of our trade. If I were asked by my auto mechanic, “Jim, is this a Phillips or a flathead screw?” he wouldn’t be my mechanic for long. But what if a client were to ask you a relatively simple question–like, “When did exchange traded funds come into existence?” Or a more complex one, like “Is the huge daily volume on the Qubes indicative of investor interest or necessary arbitrage?” Can you come up with the answers, not to mention explain how ETFs can be used? If you can’t, you should take Socrates’ counsel–”know thyself”–to heart, and update it. “Know thy instrument” is advice any advisor needs to heed. This is especially true now that ETFs have garnered some $70 billion in assets and on some days rank among the nation’s most actively traded equities.
Most investors, in their bid for better returns, overlook why the particular instrument they’re investing in was constructed in the first place, let alone how it is constructed today. Many advisors do the same. I’m not saying you need to know how to put together a plane in order to fly one. But understanding the structural limitations and possibilities of the plane you’re flying or the instrument you’re buying for a client is a necessary ingredient to happy landings. And in order to benefit from ETFs, which come in many flavors, you definitely have to know how they’re built.
|The Leading ETFs|
ETF –Composition –2001 Ret.*
Qubes (QQQ)– 1/40 of the Nasdaq 100 Index — -28.5%
SPDRs (SPY)– 1/10 of the S&P 500– -10.3
MidCap SPDRs (MDY) –1/5 of the S&P Midcap 400– -1.6
Select Sector SPDRs– 1/10 of the relevant index– NA
DIAMONDS (DIA)– 1/100 of the Dow Jones Industrial Avg.– -4.2
HOLDRs– Index ratios depend on ETF –NA
iShares –Index ratios depend on ETF –NA
*Through Dec. 13, 2001
Source: Investment Advisor, Morningstar Inc.
Compared with mutual funds, which date to 1924, ETFs are a much newer form of pooled investment. They are built on the work of Berkeley professor Nils Hakansson, who in 1976 wrote of the possibilities of a SuperFund index which could be broken apart into securities with varying risk and return characteristics. In 1990, Leland, O’Brien, Rubenstein Associates obtained permission from the Securities and Exchange Commission to create a product, called Super- Trust, which made its debut in 1993. This was, in essence, the first ETF. Based on the S&P 500 index, it was traded like a stock, but also offered and redeemed shares like a mutual fund. But SuperTrust was primarily sold as part of a strategy to provide portfolio insurance against market declines, just when demand for hedging instruments was dropping due to their role in magnifying the 1987 market collapse. Also hurting SuperTrust were its complicated structure, limited liquidity, and three-year term. By 1996, SuperTrust was dead.
Still, demand for index investments was growing, with the total of mutual fund and institutional index investments reaching $200 billion by the end of the 1980s. The American Stock Exchange took advantage of the legal groundwork laid by the SuperTrust, and in 1992 received SEC approval to offer Standard & Poor’s Depositary Receipts (SPDRs), an S&P 500 index ETF. “Spiders” were a huge success, and are now second only to the Nasdaq 100 Trust (QQQ, or “Qubes”) in terms of assets and trading volume. Other ETFs track everything from the Dow Jones Industrial Average to mid-cap and Internet stocks.
Since an ETF is a hybrid, partway between an open- and closed-end fund, transactions are usually made between investors via a stockbroker. Unlike mutual funds, ETFs don’t continually buy and sell shares. But a fund may buy and sell large blocks of shares, called creation units, primarily to institutions engaged in arbitrage. This keeps ETF prices from getting far out of line with their net asset value.
Arbitrage Narrows the Spread
ETF net asset values are priced in real time, throughout the day, while mutual fund NAVs are priced once daily, or, in some cases, at hourly intervals. If the market price of an ETF falls below NAV, arbitrageurs can buy a block of ETF shares, sell it to the fund company, and get in return the ETF’s component stocks, plus a small amount of cash, mostly from stock dividends. The arbitrageur can then sell the individual stocks for a profit. If an ETF’s market price exceeds NAV, arbitrageurs can buy a basket of index stocks and sell them to the fund company for newly created ETF shares. Usually the fund company only does this in units of 50,000 shares, but Merrill Lynch’s HOLDRs (for Holding Company Depositary Receipts) do not have this same minimum. All told, ETF prices for the more heavily traded SPDRs, QQQs and DIAMONDS (ETFs on the Dow) are generally within a half-percent of NAV. More specialized and thinly traded products can deviate somewhat more widely.
|The Market Mosaic|
IWM/iShares Russell 2000
MDY/S&P Mid-Cap SPDR
XLB/S&P Basic Industries
XLP/S&P Consumer Staples
XLV/S&P Consumer Services
Although regular stock trading ends each weekday at 4:00 p.m. Eastern time, many ETFs, including most of those based on broad-based indexes and the iShares sector funds, continue to trade until 4:15. So published discrepancies between an ETF’s net asset value, which is set at 4:00, and its market price may reflect that 15-minute discrepancy more than any real deviation between market prices and NAVs. This is even more true for most foreign market ETFs, with Asian markets, in particular, not open when ETFs are being traded.
In addition to their simplicity, ETFs can be sold short. They are also a bargain, with management fees that tend to be lower than actively managed mutual funds and even most index funds. Expense ratios range from as little as 0.09% for the iShares S&P 500 Index and 0.12% for the similar SPDRs, to about 1% for some of the iShares international products, which track Morgan Stanley Capital International global indexes. By contrast, the Vanguard 500 Index mutual fund’s expense ratio is 0.18%. But the fund is bought and sold at NAV, with no brokerage commission. Vanguard 500 Index also levies a fee of $10 per year on accounts under $10,000, and has a $3,000 minimum initial investment. ETFs don’t have such minimums, but even a $15 commission amounts to 1.5% of a $1,000 account.
Thus, an investor starting out with just $3,000 would probably be advised to buy an S&P 500 or total market index mutual fund, rather than one or more ETFs. Index mutual funds may also be a better bet for investors with accounts under $100,000 who use dollar-cost averaging. Even at a bargain-basement broker’s charge of $8 per trade, monthly purchases would mean $96 a year in commissions.
What Am I Bid?
As with stocks, in addition to commissions one may have to “pay” a bid/ask spread when trading ETFs. These spreads vary from zero for SPDRs and QQQs, under normal market conditions, to close to 1% for the least liquid sector offerings and even close to 4% for the most illiquid foreign markets, like the iShares MSCI Brazil index. Note that the round trip bid/ask cost of close to 1% on many sector ETFs is comparable to the 0.75% that Fidelity charges on Select sector funds. But Fidelity only levies its charge on positions sold out within 30 days. Fidelity Select funds also levy a 3% sales load, but that is only charged once if the money is kept within Fidelity. So for rapid sector traders, Fidelity’s Select funds are comparable to sector ETFs, provided the trader doesn’t mind being limited to hourly pricing and doesn’t need unmanaged indexes or multiple Internet sectors. For sector traders who flip positions after a month or two, Select funds would be the cheaper option, while those who are apt to hold on to a sector for the long term will likely prefer ETFs to avoid paying the much higher expense ratios of Select funds.
Using a selected group of ETFs, you can make your own daily map of the market in real time. To do so, I use these ETFs.
To map the indexes that form the overall mosaic of the global market, classified by their construction and by the market cap of the companies they track, I have organized these mainstream indices by market capitalization. Then there are the specialized indexes, some of which track specific industry segments, and some which are idiosyncratic. But they all relate to a better understanding of investing in any ETF.
A Remedy For Clients’ Portfolios?
A low-cost, safer way to invest in biotech is through Merrill Lynch’s Biotech HOLDRS
Many biotechnology stocks have seen a sharp recovery this year after a grim 2000. One low-cost way of investing in biotech is via Merrill Lynch’s Biotech HOLDRS, which trade under the symbol BBH. Like all ETFs, it’s an index portfolio. That doesn’t mean that when the BBH was put together, Merrill didn’t have some leeway in choosing stocks.
But the investment bank’s decisions were quite conservative and in line with indexing principles.
Merrill picked its biotech stocks based on market capitalization ($840 million or more) and liquidity (average daily volume exceeding 200,000 shares and $7.5 million). Other factors considered by most fund managers, including fundamentals such as valuations, technical factors such as momentum, and the scientific and market promise of the firms’ technologies, were not considered.
So Merrill Lynch is not recommending the holdings in the sense that an active manager is. That may sound like a blas? way to pick stocks, but it is the essence of true index investing.
While the stocks are held with weightings similar to their market caps, this is not rigidly true in the way it is for many indexes. For example, Amgen, the BBH’s largest holding, would actually make up about 32% of the portfolio if the 20 holdings were exactly market-weighted. To increase diversification, that position was specifically underweighted, and is currently at 22%.
Another factor preventing an exact market weighting of the portfolio: All of the positions per share are whole share amounts except for the 6.83 shares of Shire Pharmaceuticals Group PLC (SHPGY). That’s due to that company’s merger in May with Biochem Pharma (BCHE) at a fractional exchange ratio.
Although the BBH still has 20 stock holdings after two years in existence, this number is likely to decrease in future years. As the fund’s prospectus states, “under no circumstances” will a new company be added. Of course, holdings will change due to corporate reorganizations such as mergers, buyouts, and spin-offs, and share amounts will also be affected by stock splits. The rub of no new companies in a sector driven by new, new things could prove to be a limiting rather than enhancing factor. Don’t ignore it.
|ETFs on the Web|
amex.com–Click on “exchange traded funds”
ishares.com–ETF info from Barclays Global Investors
indexfunds.com–Tons of ETF info
majestic.vanguard.com/FP/DA/0.8.viper_name_report–Info on VIPRs
morningstar.com–Click on “ETFs”
nasdaq.com–Click on “ETFs”; lots on QQQs
nyse.com–ETF backgrounders, quotes
spdrindex.com–Select Sector SPDRs home page
streettracks.com–State Street Global Advisors’ ETF site
Source: Investment Advisor
Since mergers and buyouts tend to exceed spinoffs over time, and since biotech stocks are likely to diverge substantially in performance in accordance with their success in getting drugs approved and sold, the BBH is likely to become more concentrated in a few issues. With decreased diversification in holdings, the BBH may become more volatile, although there are offsetting factors, such as biotech stocks becoming more like mature pharmaceutical firms with current income derived from the sale of several drugs, and more diverse pipelines of potential new drugs. Amgen and Genentech, which collectively make up 40% of the BBH’s value, pretty much fit this bill already.
BBH, like other ETFs, trades much like regular stocks, with normal commissions. However, HOLDRS do require you to buy and sell in 100-share lots. That’s currently about $14,000, which may be a lot of money for a client to put in a single aggressive sector. But investors in BBH do have the option of buying individual stocks and exchanging them for shares in BBH, or, conversely, trading their BBH shares for individual stocks. That costs $10 for each 100-share lot. The one other fee unique to this product is its quarterly custody fee of $2 per 100 shares, which is deducted from any cash dividends.
There may be times when you would feel “forced” to cancel your BBH and receive the underlying stocks; for example, if you want to participate in a tender offer for one of the stocks. Also, the BBH may suspend trading if one or more of its holdings has suspended trading and in order for you to get to the bulk of your money, you would have to break up your BBH and sell those underlying stocks that are still trading. Also, the BBH may be delisted if the number of its holdings falls from 20 to below nine, or if 75% of the shareholders vote to dissolve the trust, or if the trustee resigns and no replacement can be found. This could happen if, for example, most of the BBH shareholders vote with their feet, leaving the trust too small to be profitable.
Given the volatile nature and uncertain long-term prospects of most biotech firms (ultimately, most any biotech could be wiped out by one or a few failed trials or negative decisions from the FDA), few investors would want to actively choose just a few biotech stocks. But putting together a portfolio of, say, 20 stocks is apt to prove rather time-consuming, at least, unless one is essentially indexing or copying an existing portfolio. This would also be expensive in terms of commissions. Even at $25 per trade, a round trip in a $5,000 position costs 1% of assets. If we keep the average individual stock position to at least $5,000 or $10,000, we’re talking a minimum of $100,000 or $200,000 for a 20-stock biotech portfolio.
|Inside Biotech Holdrs|
Human Genome SciencesHGSI/2.46
Shire Pharmaceuticals Grp PLCSHPGY/1.78
Applera-Celera Genomics /CRA0.83
Source: Investment Advisor
In contrast, the practical minimum size for a BBH position is the same as the allowed minimum: a 100-share lot, which is worth about $14,000 as I write this. So while some larger investors will find a BBH to be a simpler alternative to constructing their own diversified portfolio of biotech stocks, for most the consideration of the BBH is as an alternative to a biotechnology mutual fund. The BBH will cost a single stock-type commission when buying or selling, plus a bid/ask spread of perhaps 0.2%. With a single 100-share lot worth $14,000, at a discount broker the round-trip cost is about a half percent.
But since the BBH is an ETF and a passively managed index fund, while the open-end biotechnology mutual funds are all actively managed and must buy and sell stocks to meet fund redemptions and sales, the BBH has much lower expenses and transaction costs, and virtually no taxable distributions.
So can active management beat passive indexing in this high-growth, aggressive sector? On average, active investors have to match the performance of a market-cap-weighted index, or to be exact, they will lag to the extent they pay commissions, spreads, and other fees. Of course, it could be that there are above-average investors running sector funds, predictably beating the averages, while most other investors lag the benchmarks. The fact that fund companies pay their managers good money to pick stocks presumably means that they believe this is possible, but the history of mutual funds in general would tend to contradict any such theory.
How does active management compare to a passive ETF in the biotechnology sector? We’ve got just two years of BBH history to go on–it came out in November 1999–so the short answer is that it’s too early to tell. However, for 2000 and 2001 through November, while the BBH was down 3.9%, the average biotech fund was up 25%.
An Alternative From iShares
What about iShares’ Nasdaq Biotechnology ETF (IBB)? It’s more broadly positioned than the BBH HOLDR (with 64 holdings, versus the BBH’s 20). But because the IBB holds only NASDAQ stocks, it’s arbitrarily missing a few biotechs including the BBH’s (and the sector’s) second-largest position, Genentech (DNA, NYSE). The IBB’s stock list has a long tail, but it’s a skinny one: After its 16% in top holding Amgen, the next largest holdings are 4.0% each in Immunex and Genzyme.
Although the iShares ETF only dates from February 2001, it tracks a Nasdaq Biotechnology Index (IXBT), for which we have several years of returns data. And for the past two years, it’s up 7.3%. It’s impossible for most people to buy an iShares creation unit (needed to assemble or disassemble the ETF); that business is pretty much left to the professional arbitrageurs, as you need about $5 million to do it. On the other hand, there’s no 100-share minimum for buying the IBB the regular way (i.e., like a stock, at the market price). This ETF’s management fee of 0.5% per year is low compared to a sector mutual fund, but higher than the $8 per year fee levied by the BBH.