Consolidated Retirement SystemETFs also allow investors to access both beta (market return) and alpha (excess return). On one hand, ETFs can be used to grab as much beta as possible for those who simply want to own the market(s). Sort of like the aforementioned Buffett Special portfolio. This is a worthy pursuit for sure, especially for buy-and-hold investors.
But for those investors looking to find alpha, or excess return above the market, ETFs are useful for that, too. Alpha can be generated in two main ways using passive ETFs. First is by organizing your ETFs in such a way that you overweight or underweight different sectors, countries, or factors that you think will outperform. Many have called this “alpha through beta.” This is what ETF strategists have built a $100 billion industry doing.
The other way is through buying an ETF that is designed to try and generate alpha on its own, either through different weighting schemes – frequently called “smart beta” – and/or actively managed ETFs. We will discuss this in great detail in Chapter 7.
Anonymity
As an ETF analyst, I’m always asked, “Where did the flows come from?” or “Who did that big trade?” My answer is always the same: “I don’t know.”
No one knows. Even the issuers don’t know. There’s an anonymity and privacy to ETF investing. Anonymity – and freedom – are advantages that I never really noticed until I spent some time chatting with institutions. These advantages were brought up time and time again in discussions with institutions themselves and the ETF issuers.
While ETFs are bought and sold all the time, it is unknown who is doing the buying and selling. This is a beneficial feature to larger institutions – especially ones doing active management – because it keeps their moves on the down low. Even massive block trades that send billions into an ETF in one shot are anonymous.
“With an ETF, no one knows exactly what you are doing and you can hide behind the ETF without having to show your hand.”
Figure 1.4 shows a list of the largest trades in the WisdomTree Europe Hedged Equity ETF (HEDJ) during a three-month stretch. You can see that five of the trades are over one million shares, yet it is unknown who did them. We know the when, the where, and even the how (exchange order versus creation). But we don’t know the who, and we also don’t know the why. And that’s just how institutional investors like it.
Figure 1.4 The Largest Trades for HEDJ from March 19, 2015, to June 19, 2015
Source: Bloomberg
Price Discovery
If you want to know what the market really thinks about something, just look at where the ETF is trading. This real-time information can be useful both in normal market environments and on days of intense market stress. ETFs are the tip of the spear in terms of trying to figure out how a market is valuing something. They rival the futures market in this aspect.
For example, many international ETFs trade while the markets they track are closed. Suppose news in the United States of new Russian sanctions comes out at 2 P.M. EST. Russian ETFs will trade immediately on that news and inform investors as to what the underlying Russian stocks are worth and where they may open. This also applies to less liquid areas of fixed income as well.
“ETFs in many ways offer opportunities in price discovery in fixed income. Very much the same way when you trade Japan or Germany equity ETFs. When those markets close, that doesn’t mean there isn’t a value or people stop thinking about the situation.”
Day-to-day, ETFs are slowly starting to replace indexes as the proxies for different markets as well. And why not? Unlike an index, you can actually invest in the ETF.
Beyond the day-to-day, there have been some extreme examples where the ETF served as a discovery tool in market-moving events when markets were closed or incredibly stressed.
One example is after the terrorist attacks of 9/11 and SPY. All trading of stock and bonds was halted from 9/11 through 9/17. When trading opened at 9:30 A.M. on 9/17, SPY began trading immediately and effectively, even though some of the stocks in the S&P 500 had not yet begun trading. Because of this, investors were able to use SPY as a price discovery vehicle and make implied valuations on those stocks that not yet begun trading.
Another example is when Egypt’s stock market closed for two months between January and March 2011 due to violent protests in the country. The Market Vectors Egypt ETF (EGPT) continued to trade and serve as a guide as to where the market was trading. Many used the ETF to trade Egypt as volume on the ETF more than tripled during the time – all the while, investors holding individual Egyptian stocks were locked up entirely. They had no venue to unload or acquire those shares. Not surprisingly, the ETF deviated from the net asset value (NAV) and traded at a premium (price goes above its NAV) because the underlying stocks had no updated prices to feed into the NAV calculation. Additionally, creations and redemptions could not be done due to the stock market being closed, as shown in Figure 1.5. We will explore creations and redemptions more in Chapter 3 and premiums in Chapter 5.
Figure 1.5 EGPT’s Price and NAV Graph with Flows at Bottom
Source: Bloomberg
The most recent example was in Greece, where the stock market closed for a few weeks in July as the country was in a debt crisis. Meanwhile, the Global X FTSE Greece 20 ETF (GREK) continued to trade about triple its average volume. When it finally came down, it was very close to what the stocks were priced at when they opened.
The idea that you can invest in, trade or simply monitor an ETF even though the markets the ETF tracks are experiencing issues, can be helpful in terms of pricing and portfolio management.
Fiduciary Vehicles
ETFs have to be approved by the Securities and Exchange Commission (SEC) and most, like mutual funds, are regulated funds under the Investment Company Act of 1940. This means they have to have an independent board of directors and that the manager of the ETFs has a fiduciary obligation to act in the best interest of the fund holders. This is in contrast to other institutional vehicles such as swaps, futures, and other bank-issued vehicles including structured products.
This can be very important to some institutions that have mandates that forbid them from using the aforementioned derivatives.
“It is always nice when you have a pretty prospectus wrapped around an idea. It has all the disclosures and has gone through a vetting process [with the SEC]. There is good governance around the product. It is a nice, neatly wrapped package that can give asset managers a nice turnkey way of getting exposure.”
One quick note, though: Not every ETF is registered under the 1940 Act, and some aren’t even “funds” at all. However, those products only have about 4 percent of the assets. We will further examine
