on the year was 0.72 percent, as seen in Figure 1.2. Not desirable, but pretty minor considering the stock blew up. ETFs help investors play their themes without the stock selection process undoing the thematic or allocation work up front.
GTAT was also immediately thrown out of the index because it broke the index rules by declaring bankruptcy. This example also exhibits an ETF’s regeneration process – a benefit that doesn’t get brought up too often. Because ETFs track indexes and because those indexes have rules, if a company slips up and breaks the rules, it is going to be kicked out of the index and replaced with a new one.
Not every company burns out; some fade away and before long they are replaced. This Darwinistic process helps your ETF stay in playing shape and evolve with the times. And you don’t have to lift a finger – it’s all done as part of the normal periodic reconstitutions and rebalances and of the index. Figure 1.2 shows the weekly holdings of TAN during October 2014. In the case of GTAT, it was quickly booted out of the index within days of its bankruptcy.
Figure 1.2 TAN’s Holdings Each Week during October 2014
Source: Bloomberg
“ETFs reduce the risk of a WorldCom or an Enron. You have so many risks using just one stock. How do you know there is not fraud risk or an accounting error or a bad product? There’s no way we can do that level of due diligence to figure out if that’s occurring. The ETF is rebalancing. It’s taking out the losers and putting in the winners. We don’t have to do that.”
Bankruptcies and frauds aside, diversification also dampens day-to-day volatility as well. For example, TAN holds 32 companies involved in the solar energy business. Most are newer, younger, and smaller companies. The average standard deviation for each of the 32 stocks is 63 percent. Meanwhile, the ETF’s standard deviation is about half that, at 38 percent. That is still about triple the standard deviation of the S&P 500 index, but it is just much less volatile than the stocks it holds. This is because the stocks neutralize each other somewhat inside the fund. This is a story you will see across many ETFs.
It must be noted that there is a flip side to diversification, and that is single stock investing can pay off big when a stock surges. Single stock selection lets you feel every basis point of a positive return. Using an example from TAN’s holdings, if you were lucky enough to pick SolarCity Corporation (SCTY), you would have been up 246 percent in the past two years, compared to the diversified TAN, which was up (only) 87 percent.
For those who put in the research and time and think they can pick the right stock (at the right time) and outsmart the army of analysts out there, the ETF probably doesn’t make any sense. But in cases where you don’t put in the time and research or don’t want to take on single-security risk, the diversification of ETFs is a huge benefit. This is also why ETFs are not just drawing away assets from other investment vehicles like mutual funds, but also from single security investors.
Easy Asset Allocation
Everyone will tell you that getting your asset allocation is much more important than picking the right securities. The narrower you go in your investment decisions, the less impactful those decisions become. And when it comes to doing asset allocation, ETFs are like hitting the easy button.
“We’ll get broad exposure using ETFs. It’s a really easy, cheap way to accomplish what we are trying to accomplish, which is to own risk factors or asset classes, and it is the smart way to do it.”
ETFs are both broad and precise. They have packaged up virtually every single asset class, strategy, region, country, and even derivative that you can think of. Any investor – both institutional and retail – can now immediately get exposure to everything from real estate companies to short-term high-yield bonds to corn futures to China A-shares.
“What ETFs allow is a more focused or segmented approach than in the old days.”
While asset allocation is typically associated with long-term buy-and-hold investors, it is also employed by managers with shorter horizons as well. You’ve heard of stock pickers. Now there are ETF pickers – except they are called ETF strategists.
“There are many people who pick stocks. If you walk down the streets of Boston, I would expect that 9 out of 10 investment managers you bump into pick securities. Yet at the asset class level, there are fewer people who compare assets. But the macro environments across the globe are not in sync, whether it is the economic cycle, credit cycle, or business cycle. So that creates opportunity to generate alpha through asset selection. ETFs are a perfect vehicle for that.”
This also touches on one of the most fascinating aspect of ETFs, which is how they are at once a replacement for a mutual fund, hedge fund, or an SMA as well as a tool for a mutual fund, hedge fund, or SMA. That makes them a two-headed monster. It’s also why institutional exposure to ETFs can come from direct usage and/or indirect usage via external managers.
“What makes ETFs really different is that in addition to being a funds solution, they are actually a single security or exposure solution. That means they can be used as a substitute for an SMA or mutual fund, or they can be used as part of the SMA or mutual fund. And that’s what makes them unique.
Standardization
We like it when things are standardized. Whether it is USB ports or gas pumps, it is easier when it works the same way regardless of other variables. When it comes to investing, ETFs have standardized every asset class so that they trade like equities. Investors love the fairness and price transparency of equity investing on a stock exchange. ETFs have simply equity-ized every type of investment.
For example, bonds don’t have a common exchange. They trade over the counter (off exchange) in relatively opaque markets, whereas bond ETFs trade like stocks. Some other assets that have been standardized by ETFs include physical gold, oil futures, swap agreements, currencies, and hedge fund strategies. All of these things and more can now be bought and sold on a stock exchange just like shares of General Electric. This has standardized investing, and even more importantly, it has created another venue where investors can buy or sell the ETF’s underlying exposures
While this standardization is mostly hailed as a breakthrough in convenience, it has also brought with it a few concerns. Just like Jurassic Park, when you try and bring ancient beasts into the modern world, you have to be careful. A popular example is junk bond ETFs. Those bonds are pretty illiquid while the ETFs that hold them can be very liquid. This creates a bona fide “liquidity mismatch” and is one of the issues we will look at more in Chapter 9.
This standardization of the financial markets has also challenged embedded taxonomies and structures all over the financial world. Nowhere is this symbolized more than on the Bloomberg terminal keyboard, which is divided by yellow keys for government bonds, corporate bonds, mortgage bonds, money markets, municipal bonds, preferred, equities, commodities, indexes, and currencies, as shown in Table 1.6. Each asset class has different functions, traits, and the like. Meanwhile, the ETF covers all the yellow keys. They are at once everywhere but nowhere.
Table 1.6 The
