What is an ETF?
ETF, or Exchange-Traded Fund, is an investment fund whose shares are traded on an exchange. ETFs represent a kind of certificate for the entire portfolio of bonds, stocks, or any other exchange-traded instruments. One share in an ETF is a stake in the portfolio comprising various securities that are combined based on a specific feature or characteristic.
ETFs are usually more stable than shares of specific companies as the former are a portfolio of securities selected by professional traders rather than an individual stock. Weights of individual stocks in the portfolio are also determined by traders: they increase exposure to those securities that grow in value and reduce exposure to underlying assets declining in value.
Here are a few additional distinctive features of an ETF:
- no traditional management fees, only a small fee is charged
- companies behind such funds are interested in liquidity of their ETFs
- low entry threshold (a low as one share)
Toronto Index Participation Fund (TIP 35) was the first ever ETF that was listed on the Toronto Stock Exchange in 1990. The first ETF in the United States was Standard and Poors 500 Depositary Receipts (SPDR) and remains one of the key funds to date.
The Most Popular ETFs
SPY (SPDR S&P 500)
S&P 500 is a stock market index developed and managed by S&P Dow Jones Indices. This ETF is traded under the ticker of SPY and follows the S&P 500 Index that is based on capitalizations of 500 large US companies. S&P 500 is considered the unofficial barometer gauge of the US stock market. Industrial, financial and transport companies with the total capitalization of $11 trillion represent the index core. Equities of companies that are part of the index are listed on the largest exchanges, NYSE and NASDAQ.
It is impossible to be included in the index randomly; to become part of the index, the security shall comply with the following requirements:
- be listed on NASDAQ or NYSE;
- at least 50% of companys stock must be in free float;
- positive total earnings over the previous year;
- market capitalization of at least $5.3 billion.
As the above requirements show, investors can be sure that a S&P 500 company has been profitable at least in the last fiscal year. The latter allows investing in such companies for a period of a quarter or more with higher confidence.
Q:If you have stocks of companies that are part of the S&P 500 index, does it mean that these shares will generate stable returns?
A: It is not quite like that. Stock markets regularly go through financial crises which are cyclical events. The most recent crisis occurred in 2008 when share prices of S&P 500 companies declined substantially. For instance, Apple fell from $189 to $80 and Google from $293 to $146.
In a stable market environment this fund generates fairly high returns. The key thing is that an investor buying a share in S&P 500 ETF invests in the arithmetic average of total financial results rather than in a specific company. This way inclusion of companies in, or their exclusion from, the index affects the overall results only a little.
XLP (Consumer Staples Select Sector SPDR)
This fund includes shares of companies that manufacture essential goods. They include food manufacturers, household products, and tobacco products that are always in demand. Demand for the above goods declines only in case of global disasters and shocks; that is why funds comprising bonds and stocks of such companies may be labeled as «protective».
Even Warren Buffet, the financial market legend, held some of its capital in stocks of Coca-Cola, Walmart, and McDonalds.
Unlike IT startups, these companies show no massive growth and are absolute underperformers during technology booms. However, McDonalds, for example, posted almost 70% share price increase during the 5-year period after the latest financial crisis (through 2013), and Coca-Cola grew by over 27%. During the crisis itself, shares of these companies declined much less than the broad market. And it is understandably so people continue going shopping, drink coke and eat cheeseburgers.
It is true that securities in this fund have lower returns vs SPY, but they also may act as an anchor for investment capital during crisis periods.
AGG (Bloomberg Barclays US Aggregate Bond)
AGG is an ETF mirroring an index that tracks stable-yield bonds during crisis periods: returns from this investment can offset drawdowns in other investments like SPY and XLP. This ETF includes both top-rated US corporate and government bonds that are expected to increase in value amid market shocks.
What Is Volatility?
The above funds demonstrate good returns during calm periods in the stock market, but they can also decline during market shocks. In order to protect investors from losses, synthetic instruments have been created: volatility ETFs (exchange-traded funds) and ETNs (exchange-traded notes).
Volatility is a range of asset price fluctuations expressed as percentage of its value. Put simply, the difference between the lowest and the highest price of an asset in percentage points. The more stable the particular asset, the lower its volatility, and vice versa. As worries build up in the market, the volatility rises: trading volume increases for the overall market or a particular asset. The higher the volatility, the higher the risks related to this asset.
VIX (Volatility Index) measures investors expectations with regard to the stock market changes, i.e. boundaries within which prices will fluctuate. When the market is calm, the index declines, and vice versa, it rallies during turbulent periods, and prices of related ETFs and ETNs follow suit.
Shares in volatility funds are an indication of market expectations as to S&P 500 capitalization for a specific period. When the stock market declines, this instrument may post a 100% rally. Its price rally velocity depends on the stock market decline velocity: if the market declines smoothly and gradually, VXX may record a 10% rally; if, however, the market falls in one or two days, VXX may jump by over 100%. Such correlation makes these products a decent hedge during a crisis.
Popular Volatility Instruments
Instrument issuer is Barclays Funds. VXX is not an equity, it is, however, traded like one. The note issuers obligation is to match S&P 500 VIX Short Term Futures TRI (SPVIXSTR) index performance.
Exchange-traded note issued by Credit Suisse Bank: VelocityShares Daily 2x VIX Short-Term ETN.
This is an ETF from ProShares, a leveraged security: Ultra VIX Short-Term Futures.
ETF and ETN Investments
After figuring out how ETFs and ETNs work, let us look at how to use them to make reasonable investments.
Say, we want to distribute our eggs between multiple baskets but close to each other: our funds will be these baskets. The key principle is fairly simple: instruments in different baskets have to be selected in such way as to be supplementary and complementary to each other. Put simply, if assets in basket A decline, then those in basket B rally; and if both A and B fell out of bed, the prices of assets in basket C spike.
This way, we have 3 baskets with ETFs and one basket with hedge instruments on volatility. How should one distribute weights so that returns are protected from risks? Lets review the logic behind asset allocation under two basic scenarios: growth and decline.
When the broad market is in the growth phase, the portfolio allocation may look as follows: SPY 84%, XLP 5%, AGG 5%, and 2% per each: VXX, UVXY, and TVIX. These approximate figures show the logic behind allocation.
SPY represents an investment in the global stock market and is a high-yield and high-efficiency instrument. Therefore, it will generate the majority of returns when the economy grows.
Stagnation and Decline
The market is stable, and nothing extraordinary is happening. During such periods AGG and XLP are usually rallying, and in view of the volatility increase during the stagnation phase, it is worth increasing the share of volatility securities in the portfolio, whereby the share of SPY is respectively reduced.
If the market is in a decline, SPY prices are falling and volatility rising. And thats a perfect time to play on raising the share of ETN and reducing SPYs share in the portfolio by slightly increasing shares of XLP and AGG.
Volatility instruments act as a strong insurance against drawdowns in other protective instruments: which is to say that securities linked to volatility rise along with market turbulence, while other assets may fluctuate substantially.
Heres a sample allocation for bear markets: XLP 5%, AGG 89%, and 2% per each VXX, UVXY, and TVIX.
This investment strategy allows achieving a rate of return that is slightly below investing in IPOs of promising companies but far exceeds the yield of a banking deposit. Anyway, it is better to invest in the broad market as detailed above to diversify ones portfolio.
We have already discussed risks of each particular instrument above. There is, however, one more risk the counterparty risk, as each fund is managed by a specific company. Even if the instrument you picked grows steadily, it does not always mean that its reliable. Prior to making investments one should make sure that the issuer of a fund or obligation is financially strong. Sometimes a counterparty may be on the brink of bankruptcy, and even the positive performance of a specific instrument, the issuer may eventually be unable to meet its obligations.
Exactly due to the counterparty risk we include three ETNs in our portfolio: VXX, UVXY, and TVIX, that are, in fact, equivalent exchange-traded products. They are issued by different counterparties, which, consequently, reduces the risk of loss if any one of them declares insolvency.
Balance Investment Portfolio
Investing in each of the above instruments requires good knowledge of the securities market. One should have a clear understanding of what the market is doing and how to respond to the changes. If this is out of your depth, youd be better off trusting these matters to your broker.
By buying the Balance portfolio youll be able to review the current portfolio allocation across assets, without the option, however, to affect it in any way. We calculate allocation using special-purpose analytical algorithms, select the most promising ETFs and ETNs, and rebalance the portfolio every week.
The entry threshold is $1,000, and the estimated gain is 20% p.a.
You can invest in the Balance portfolio in the members area on United Traders website.