Archive | October, 2011

ETF Risks in Perspective: Leveraged ETFs

This post is the second of three that will look at the potential risks that ETFs may pose to the stability of financial markets. Last week I discussed synthetic ETFs, which use derivatives called swaps to get exposure to their underlying indexes. Now we’ll examine leveraged ETFs.

Leveraged ETFs are designed to provide double or triple the daily return of their underlying index. The Horizons BetaPro S&P/TSX 60 Bull+ ETF (HXU), for example, promises twice the daily return of the popular large-cap Canadian equity index. If the index goes up 2% during the day, HBP will return 4%, and if the index loses 2%, the ETF’s return will be –4%. In the US, some providers even offer triple-leveraged ETFs, such as the Direxion Daily Large Cap Bull 3x Shares (BGU), which delivers three times the daily return of the Russell 1000 index.

A related family of products, called inverse ETFs, move in an opposite direction to the market. If Canadian large caps lose 2% in one day, the Horizons BetaPro S&P/TSX 60 Inverse ETF (HIX) will gain 2%, and vice versa.

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MoneySense Guide to the Perfect Portfolio

Canadian Couch Potato is pleased to announce the birth of The MoneySense Guide to the Perfect Portfolio. My new book has just hit the shelves across Canada: look for it on the magazine stand at Shoppers Drug Mart, Walmart, Chapters/Indigo and Loblaws stores, or buy it online. At just $9.95, it’s the same price as a single ETF trading commission.

The MoneySense Guide to the Perfect Portfolio is a roadmap for the do-it-yourself investor in Canada. It begins with my best attempt at laying out the case for passive investing: I explain the problems with mutual funds and active stock-picking strategies designed to beat the market, and I encourage investors to focus on the things they can control rather than basing their financial lives around the pursuit of an unlikely goal.

The next two chapters explain the importance of saving, setting targets and making a financial plan. This is an often neglected part of the investing process: it makes no sense to dwell on individual securities or funds unless you have some context for your investments. I look at the importance of gauging your risk profile and explain how you can build a portfolio that is suited to your goals.

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ETF Risks in Perspective: Synthetic ETFs

Not so long ago, ETFs were simple and transparent. But with the tremendous growth in the industry, ETFs have not only become more numerous, but also more complex and opaque. A number of influential bodies—including the International Monetary Fund, the Financial Stability Board, and the US Senate—have expressed concerns about how ETFs might damage the global financial markets. As a Canadian ETF investor, should you be worried about the funds in your portfolio?

In a series of three posts, I’ll take a look at the major concerns and try to give some perspective, with a specific focus on Canadian ETFs. Let’s kick off with a look at the new breed of “synthetic ETFs.”

The problem

Synthetic ETFs use a derivative called a total return swap to get exposure to the indexes they track. The ETF provider enters into a deal with a counterparty (usually a bank) who agrees to deliver the precise return of the index, minus a fee. While the swap structure has many potential benefits—including lower cost, smaller tracking error, and tax efficiency—it also introduces counterparty risk. If the bank fails to deliver the promised returns of the index,

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How ETFs Came Under Fire

ETFs are on the hot seat these days. On Wednesday, a US Senate subcommittee held a hearing to consider the idea that ETFs are contributing to volatility and instability in the financial markets. This is pretty serious stuff. How did the humble ETF, once hailed as the most investor-friendly innovation in decades, become the target of such suspicion?

The brouhaha can be traced back to September 2010, when a little-known investment firm called Bogan Associates wrote a white paper called Can An ETF Collapse?, which got enormous media attention. One CNBC stock-picking guru reviewed the report and referred to ETFs as “a monster that will wreak havoc.” But almost immediately, the Bogan report was criticized as “wildly off the mark and highly irresponsible.” Credit Suisse exposed the report as specious.

Two months later came another alarmist report from the Kauffman Foundation, which argued that ETFs are distorting financial markets and presenting dire systemic risks. Within a day of its release the report was called out for its conflicts of interest and its “serious misunderstanding of how ETFs work.” Media outlets such as IndexUniverse and Forbes wrote scathing rebuttals,

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Qtrade Now Offering Commission-Free ETFs

The discount brokerage price war is officially on. After Scotia iTrade became the first online brokerage to offer commission-free ETF trades last month, Qtrade Investor has followed suit. The Vancouver-based independent has just launched its own zero-commission ETF program, with an even bigger list of choices.

Qtrade’s menu includes 40 Canadian ETFs from Claymore, iShares and Horizons, and even a couple from the new PowerShares lineup. More interestingly, the choices also include 20 US-listed ETFs from Vanguard, iShares and State Street.

Before long-term Couch Potato investors get too excited, however, the list of eligible ETFs does have several gaps. There are few broad-market funds: most have narrow mandates. The most popular broad-market Canadian and US equity ETFs are not there—not even Claymore’s CRQ or CLU, which are included in the Scotia iTrade program—and all of the US-listed ETFs are sector-specific funds. Sorry, no core Vanguard ETFs.

Covering the broad market

The Horizons S&P/TSX 60 (HXT) and Horizons S&P 500 (HXS) are both part of the Qtrade program, and would be fine for covering the large-cap Canadian and US markets,

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Couch Potatoes: Not the Next Financial Time Bomb

I would have been kicked out of journalism school for writing this: “The culprit behind the epidemic of death on our roads is clear: drunk drivers. There are more than 21 million of these in Canada today.” The problem, of course, is that the 21 million figure refers to all drivers, but the context suggest it applies only to the drunk ones.

Now consider these sentences from a recent article by Andrew Ross Sorkin of The New York Times. The article discusses the extreme market volatility we’ve recently experienced and quotes a Wall Street money manager with a theory about its cause: “He says he knows the culprit behind the late-day market swings: leveraged exchange-traded funds or ETFs. These funds, which allow investors to bet on a certain basket of stocks, commodities or an index, are perhaps the hottest rage in investing, with some $1 trillion invested.”

Is it clear that the $1 trillion figure relates to all ETFs in the United States, the overwhelming majority of which are plain vanilla index funds? Probably not. It’s likely that most readers will lump in the Sunday drivers with the drunks.

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What Moneyball Can Teach You About Investing

I can’t seem to get my kids interested in index investing, but they do share my love of baseball. So last week I took my daughter to see Moneyball, based on Michael Lewis’s book of the same name. She was mostly interested in Brad Pitt, but that didn’t stop me from lecturing her about the lessons the film holds for investors. Bear with me while I explain.

If you’re not familiar with Moneyball, it’s the story of the Oakland Athletics and their maverick general manager, Billy Beane. In the early 2000s, the Athletics had a budget of just $40 million, compared with $126 million for the New York Yankees. The A’s would draft good players and turn them into successful major leaguers, but as soon those players became free agents they would leave for big-market teams. When the film begins, Oakland has just been knocked out of 2001 playoffs and lost three of its top players to clubs with deeper pockets.

Before the 2002 season, Beane decides to shake things up. He realizes he can’t beat the Yankees and other big-budget teams at their own game.

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Why Staying the Course Isn’t “Doing Nothing”

On Tuesday I linked to a poll of some 200 institutional investors who were asked about their outlook for global equity markets. The smart money seems to be evenly split between buyers, sellers, holders, and those who “are confused and doing nothing.”

It’s funny that investors who don’t react to market swings are said to be doing nothing. This is one of the enduring myths about index investing: that carefully building a diversified, all-weather portfolio for the long term makes you a naive fool because you’re not constantly “repositioning.”

Staying the course is not “doing nothing.” On the contrary, it’s doing something thoughtfully and productively rather than constantly reacting to the market. The first three quarters of 2011 have been a marvellous example of how diversifying and ignoring forecasts can work so well during times of market stress. To see this idea in action, let’s do a Q3 check-in with the Complete Couch Potato.

No, everything does not go down together

Dumping bonds was supposed to be part of the “reposition your portfolio for today’s market” strategy—actually it’s been a refrain for about three years now. And once again,

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So Much For the Consensus View

The Canadian stock market officially crossed into bear market territory this week, falling to more than 20% below its April high. We’ve already endured five consecutive months of negative returns and October is so far showing no sign of improvement. It’s times like these that test the mettle of an investor. Do you have the discipline to stick to your long-term plan?

Whenever the markets tank, the very idea of a long-term plan gets called into question. The financial media are filled with stories about “repositioning your portfolio” and “how to invest in times like these.” The implication is that smart investors should react to what has already happened, and then try to predict what’s coming next. Investors who preach “stay the course” are ridiculed as naive fools.

The problem with the whole idea of trying to reposition your portfolio is that it you never know whom to listen to. Nothing illustrates this better than a report today from a UK site called Citywire Money. (Hat tip to De Thomas Financial for sending this along.) Last week, it says, Morgan Stanley polled 200 of its institutional investors and asked them, “What best describes your attitude to global stocks right now?” Here are the results:

 20% agreed with the statement: “I am buying now because equities are very cheap and the macro issues are well known.”

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