Processes in performing of intelligent securities
valuations
Screening
When screening and scanning for companies to invest in,
consider inverting how you SEQUENCE the valuation modeling process.
All analysts and investors looking for ideas HAVE TO START
SOMEWHERE. The majority try to screen for low valuations. They are looking for
discounts…..for bargains. It goes hand in hand with Buy Low - Sell High. It
makes sense. They look on the 52 week new low list for stocks that have been beaten
up relative to the market.
Consider the idea that determining the correct valuation of
a company is the final step in the investment analysis process, only to be done
after deciding if you are evaluating a great company.
<Remember Buffett
and Munger teach that the key to their success was taking position in “great
companies” at fair prices instead of “fair companies” at great prices>
Differentiate between
“Price” and “Value.”
PRICE is established by a sometimes manic and sometimes
depressive stock market. Ben Graham suggested that sometimes market prices are
indicative of a company’s value and at other times, market prices are
completely irrational because Mr. Market is often irrational.
“Value” is something that has to be determined by an astute
business analyst who deeply understands the status and trends of relevant management, financial, and business
principles.
When valuation analysis is the LAST thing you do in the
process, you are forced to consider the accuracy of each management, financial,
and business principle variable in your forecast.
Three separate
methods to arrive at a dollar value for a business. They are:
1. Liquidation
Value
2. Market Value
3. Going-concern
Value
“Liquidation
value” requires no consideration of the future earnings of the
business. This approach is most often used when there is a presumption that the
business will no longer be viable or it is going to be sold off.
When future cash flows are difficult to compute, many
analysts will simply use the “market valuation” approach. This involves
comparing the company to other similar publicly traded companies, and applying
a comparable value.
“Going-concern
value” is based on determining the future cash flows the owners of a
business can expect to receive. These future cash flows are then discounted
back to present value using an appropriate rate and time period.
In any going concern analysis, if you cannot determine with
some certainty and confidence what the future cash flows of a given company are,
then you should not attempt to determine a value for that particular company.
Accordingly, if the competitive dynamics, economic goodwill,
and managerial capabilities of a business are not understandable, the values of
all the necessary variables required to do an intelligent valuation calculation
are not at hand.
Summary:
To many investors and analysts, it seems almost
counter-intuitive to not begin an investment search by looking for low
valuations. This is particularly contradictory to the cliché associated with
investing success: “Buy low and sell high.”
Screening for cheap stocks using boilerplate consensus
forecasts or stocks well off of their 52 week highs is very likely to give you
a universe of cheap companies.
While this might seem to be the smartest way to buy “low,”
it has nothing to do with accurately judging the future prospects of the
business.
Caring deeply about valuations is important. However, it is
preferable to care about paying reasonable valuations of great
businesses.
Great businesses are rarely offered cheap relative to the
average business. Quality is almost always a little more expensive.
Most businesses that look dirt cheap are cheap for good
reasons. It is no different than cheap shoes, cheap food, or a cheap house; you
often get what you pay for.
Thinking about
factors that affect value over time
The single greatest premise necessary for proper valuation
comes from Will and Ariel Durant, who were arguably the greatest historians who
ever lived.
In the Economics chapter of their one hundred-page classic
entitled, The Lessons of History, they wrote:
“History is
inflationary”
“Cash is the last thing
a wise person should hoard."
This premise regarding inflation is perhaps the most important
principle of all for determining asset valuations because the persistence of inflation
implies that investments made in shares of companies that require a high ratio
of fixed assets to do business, face greater exposure to inflation.
Why?
- Plant and equipment must be continuously maintained and eventually replaced at higher costs.
- Inventories must be maintained by ever increasing levels of capital outlays.
Cash Generators
versus Cash Users:
It is important to understand that relatively capital
intensive companies tend to be cash users not cash generators.
Examples:
Airline industry:
In order for any airline to maintain its current revenues and transport the same
number of passengers in the future as they have in the past, the company and
its shareholders will have to use valuable cash for plane maintenance, new airplanes,
new baggage cars, etc.
If an airline wants to carry more passengers, they must
purchase more new planes.
Electronic
transaction settlement companies: (Visa or Mastercard). These companies
feature minimal network upkeep costs. They can easily process more transactions
without additional capital investments. In other words, they can continue to
process more and more of yesterday’s transactions without investment in heavy
equipment today.
Summary:
Low capital intensity companies tend to earn much higher
risk-adjusted returns on shareholders’ equity than their high cap-ex
counterparts.
Additional explanations are simple. Low cap-ex companies do
not require heavy debt burdens, dilution due to new share issuance, or augmented
capital from retained earnings to finance purchases of expensive equipment
and/or finance receivables and/or inventory.
**** Perhaps the most
valuable lesson you can learn about valuing various businesses is that all
companies are hurt by inflation, but companies with lower fixed assets are hurt
less.
Identifying Great
Companies
Let’s examine some basic investment principles that can lead
to more intelligent evaluation of common stocks. With these two premises in
mind:
1) history is inflationary
2) lower capital spending requirements are preferable.
These principles can be separated into four major
categories:
- business aspects
- management quality
- financial characteristics
- relative valuation
Know your limitations
- When it comes to evaluating businesses accurately, defining the limits your own capabilities in understanding a given business or industry, on a fundamental level, is critical.
- Try to be honest about what you know as well as what you do not know. This will help you avoid costly mistakes.
- Buffett and Munger suggest that investment success is not a matter of how much you know, but rather how realistically you define what you do not know.
- Nobody is an expert on every subject.
- Developing an acute awareness of how a business operates, including an understanding of sources of revenues, expenses, cash flow, labor relations, pricing flexibility, competition, as well as the previously mentioned capital allocation requirements, must be developed.
- If you are not confident you have your arms around these variables after repeated reviews, terminate your investigation.
Identifying and
Placing a Value on Durable Competitive Advantage and Economic Goodwill
Once you understand the business itself, its revenue
drivers, its suppliers, its customers, its expenses, its risks, etc. accurately
assessing the durability of the company’s competitive advantages is critical to
valuation
There tend to be almost a pyramid principle at work in terms
of durable competitive advantage. There is a small group of great franchises
with durable competitive advantages. And there is a gigantic list of companies
with virtually indistinguishable commodity-type businesses subject to nasty
cycles.
Though a company may have currently displayed the
consistency required, no company is ever assured of permanently retaining
franchise-like characteristics.
When competitors enter an industry the differentiation
between industry products will begin to narrow.
Substitute products can be introduced . If they are viable eventually,
the once-promising franchise, may actually be reduced to a commodity business,
or worse.
To properly value a company we must distinguish between the
commodity-type businesses and the companies with competitive advantages that
can withstand inevitable economic cycles.
Companies seemingly in the driver’s seat on the latest
technology or benefitting from a fashion trend are usually traps; history has
repeatedly proven that remaining at
the forefront of a rapidly changing technology industry or at the forefront of
the latest fads is nearly impossible.
Best candidates for
durable competitive advantages are companies providing a product or service
that is:
1. Preferred or
Required (not discretionary)
2. Unique
(distinguished)
3. Not
excessively regulated by government
4. Produced/provided
by a company for several years
These four traits can often allow the company to regularly
increase the prices of its product or service without fear of losing market
share or unit volume. This is the essence of Economic Goodwill.
Being able to raise prices when demand is flat and capacity
is not fully utilized WITHOUT sacrificing market share position, is one of the
defining characteristics of a business in possession of significant economic
goodwill.
Companies that have achieved solid advances in operating performance over rolling
three-year periods are often indicative of the “pricing power.”
Pay close attention to persistent increases in return on
shareholder’s equity and trends towards increases in profit margins. These are
all signs of economic goodwill and the durability of competitive advantages.
**** Companies
thought to have enduring economic goodwill and durable competitive advantages
must be constantly monitored for threats.
Valuing Economic
Goodwill
It is best to COMPARE and give extra credit for companies
with durable competitive advantages and economic goodwill rather than search
for the widest mathematical valuation discount.
When you find these attributes, can clearly identify them,
and the broad markets experience as sustained general decline in price, the
best candidates for investment are those that compare well on durable
competitive advantage and economic goodwill.
Analyzing and Valuing Management
- It is wise to always assume there are limits on the competence and skill range of ALL management teams.
- Companies that are either solving difficult business problems or fundamentally changing the direction of the company because their previous plans were unsuccessful are poor prospects.
- Sometimes investors forget that the most important duty of a management team is to make wise decisions regarding the allocation of shareholder’s capital.
- The task of capital deployment is very important for growing companies that typically retain a large portion of their earnings. This task becomes even more important, the more mature a company becomes.
All capital allocation decisions have a tremendous impact on
shareholder value over the life of a company. We refer to Warren Buffett’s
self-described mentor Ben Graham for a quick review of the life cycle of
profits to put the capital allocation duties in the proper context:
-
Graham said in the development
stage of a company, the company can, and often does, lose money as it
develops products and establishes markets. In the early development stages, a
company must raise/gather capital.
-
During the rapid growth
stage, a company is profitable but still growing so fast that often it
cannot support the growth and it has to not only retain all of its earnings, it
also might have to borrow or issue equity to finance growth.
-
But, during the maturity
stage a company’s growth rate slows and the company begins to generate more
cash than it needs for development and operating costs. Management must decide
what to do with that cash.
-
In the last stage
(decline) the company suffers declining sales and earnings but continues to
generate excess cash.
It is in the third and fourth stages (maturity and decline),
but particularly the third that the critical valuation analysis dilemma
presents itself:
How wisely will earnings/excess
cash be allocated?
These capital allocation decisions are absolutely critical
to investor success.
There are always logical answers to the question of how
earnings should be allocated. Yet, there is too much room for irrational behavior
within the ranks of management of publicly held corporations.
For the rational management team, if the excess cash, when
reinvested internally, can produce an above average return on equity- a return
that is higher than the cost of capital- then the company should retain all of
its earnings and reinvest them. This is a logical course of action.
However, retaining earnings for re-investment internally at
less than the average cost of capital is a completely irrational management
decision, even though it is quite
common in public companies.
A company that generates cash in excess of its basic capital
needs and generates average or below average returns on capital already
deployed has three options:
1. It can
ignore the problem and continue to reinvest at below average rates.
2. It can buy
growth through acquisitions.
3. It can
return the money to shareholders through dividends or stock repurchases.
Management teams that continuously reinvest excess cash
despite below average returns tend to think their poor capital allocation
results are temporary. Occasionally they are.
However, much more often these managers simply do not have
the decision-making skills in this area to improve their situation. They will
forecast improvements for shareholders in regular communications, but eventually
their poor capital allocation decisions are reflected in lower profits and
eventually substandard stock performance.
The second option, buying growth through acquisition, can
also be a dangerous endeavor, particularly if the business is different from
the company’s primary business. When a completely new enterprise must be
integrated and managed, mistakes are bound to be made due to the management
team’s inexperience outside its area of expertise.
Finally, the third option of returning earnings to
shareholders through dividends is a superior alternative to a bad capital
allocation decision. Share repurchases at prices below intrinsic value is also
preferable.
What is most preferable is a management focused on their core
business with a strong track record of solid capital allocation decisions.
The impact of the Institutional Imperative on valuation
A simple question should be posed of many companies under
consideration. If allocation of capital is so simple and logical, why is capital so poorly allocated on a
routine basis by so many publicly held companies?
Becoming deeply familiar with inherent BEHAVIORAL tendencies
of a management team in conducting capital allocation decisions can provide the
answer to this perplexing question. <Munger’s
25 human behavior tendencies>
Buffett says understanding the “Institutional Imperative” is
critical to analyzing the tendencies of and therefore the quality of
management.
The Institutional Imperative can be defined as a subtle
tendency of corporate management to imitate the behavior of other management
teams. The Institutional Imperative exists when:
- An institution resists any change in its current direction
- Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds
- Any business craving by the CEO, however foolish, will quickly be supported by detailed rate of return and strategic studies prepared by his or her troops
- The behavior of peer companies, whether they are expanding, acquiring others, or even in the setting executive compensation, will be mindlessly imitated
The Institutional Imperative often hinders all necessary
change. Even when managers accept the idea that their company must change or
face the possibility of shutting down, carrying out a plan can be nearly
impossible.
The Institutional Imperative can also produce too much
change. Many managers give in to the temptation to make an ill-advised
acquisition rather than face the financial facts of their current problems.
Still other managers look to change to “shake things up”
rather than focus on day-to-day execution.
Day-to-day execution is to a company what blocking and
tackling is to a football team. Losing football teams don’t block and tackle
and losing companies don’t execute day-to-day.
Be particularly leery of any company that makes an
acquisition that appears to be outside of their area of expertise.
Example: Buffett
says the Institutional Imperative is often in effect in the insurance industry.
-
Like so many other industries, the insurance industry
runs in cycles.
-
From time to time, increased capacity or new
competition leads to price competition, sometimes to the point where prices
fall below the cost of doing business.
-
Many managers in the insurance industry will continue
to slash prices to keep from losing market share even though they are pricing
below cost.
Three factors explain how the behavior of management is
influenced:
- Managers cannot control their lust for activity. Such hyperactivity often finds its outlet in business takeovers. Managers often use the activity to demonstrate to their board that they are doing SOMETHING.
- Most managers are constantly comparing their sales, earnings and executive compensation with other companies within and beyond their industry. These comparisons invite hyperactivity.
3. Most
managers have an exaggerated sense of their own management capabilities.
The Institutional Imperative, as the name implies, is transmitted up and down the chain of
command in corporations.
Junior officers often make projections to affirm the desires
of their seniors.
Rational independent thinking often becomes the exception
rather than the rule.
Often an entire organization can become a slave to the
institutional imperative.
Be constantly wary of management’s allocation of the
shareholder’s precious capital being driven by these destructive tendencies
rather than on sound, logical decisions based on cost of capital and
management’s core competencies.
How do you place a
value on the superior management team variable in an equation or model?
Prefer solid business characteristics first. Great
management generally fail when trying to fix a bad model. However, great
management can add terrific value to a great business model.
Analyzing Financial Statements
Pouring over empirical financial data that is reported on
balance sheets, cash flow statements, and income statements is essential in
forming the foundation to evaluating and understanding both the managerial and
the economic performance of a company.
Shortcuts don't work
here either
Many analysts try to take shortcuts and skip straight to the
bottom line earnings per share figure. Unfortunately, growth in earnings per
share can often mask mediocre company performance.
The astute business analyst realizes there are many
accounting tricks employed by clever CEO’s and CFO’s of publicly traded
companies that can either bolster or smooth out the appearance of earnings
streams.
Accordingly, raw earnings per share figures are often
susceptible to misinterpretation and distortion.
**** Since most
companies retain a portion of the previous year’s earnings, they are constantly
increasing shareholder’s equity, or what shareholders have at stake. And often
when a company announces “record” earnings per share it is not meaningful
without a great deal of additional investigation. If a company increases its
equity base each year by roughly eight percent using retained earnings, and
earnings per share only increases by eight percent, in effect the company is
not producing a growing return for shareholders, even though it is still
reporting “record” earnings per share.
Return on shareholder’s equity is not a number that can ALWAYS
be judged at its face value either. Instead, the primary financial measure for
determining managerial economic performance is the achievement of a high earnings rate on invested capital.
This metric takes into account the return on shareholder’s equity as well as a
company’s debt.
Traditionally preferring companies with little or no debt
that generate high rates of return on shareholder’s equity was the best way to
avoid risky debt-heavy companies.
These days, with a prolonged environment of near zero rates.
Companies that use their access to the long term debt markets to finance
worthwhile projects, can often generate higher rates of return on invested
capital than their debt-free counterparts.
Of course, debt carries higher risks, especially during
economic downturns. Debt levels must be considered when analyzing any company.
However, return on invested capital is a measure that helps
to level the playing field between debt-heavy companies and debt-free
companies.
High Profit Margins
Typically the company with the highest profit margins in a
given industry deserves extra credit in a valuation. These companies are
usually the low-cost producers.
Being the low cost producer is an enviable position during
difficult times.
Managers of high-cost
operations tend to find ways to continually add to overhead, while managers of
low-cost operations are always finding new ways to cut expenses.
Expense cutting should be a regular activity of a company’s
day-to-day operations, not just when it is necessitated by the economic
cycle. High cost, low margin operations
are a huge red flag.
Track long range
market price performance
Over extended periods of time, companies with favorable
financial characteristics, run by capable and shareholder-oriented managers,
will have proof of their capital allocating abilities reflected in the
increased market value of the company.
Check to make sure a stock’s price performance is tracking
what you believe is the performance of a company’s true business value.
If a business has been retaining and redeploying earnings
non-productively over an extended period of time, eventually the market will
simply reduce the value of the shares of the company to reflect the squandering
of shareholder resources…..regardless of what GAAP might indicate.
However, when a company has been able to achieve
above-average returns on invested capital, this success will also be reflected
by an increased stock price over longer periods of time.
Looking at objective financial measures like long term price
performance serves as a good EMPIRICAL cross check of the more subjective forms
of analysis. It helps to confirm objectively what your subjective findings are
in areas, areas in which you can’t simply rely on numerical data to
comparatively value a business.
Appropriate time frames for analyzing financial performance
Placing too much emphasis on twelve month income statements
of publicly traded companies can be dangerous. Longer range metrics should be used
to analyze a company. They are preferable to taking any one empirical number on
a trailing twelve month income statement at face value.
Changes in the balance sheet, income statement, and cash
flow statement taken together over time, can reveal a lot about a company’s
ability to compete in the future.
**** Unless you are a
farmer, there is nothing particularly magical about the number of months it
takes for the earth to travel around the sun one time.
Many analysts get locked into one year figures as if they
were the be-all and end-all time frame measures. To properly evaluate a company
try not to over-emphasize any single year’s results.
Use three, four, or even five year rolling averages to get a
feel for consistency.
All earnings are NOT
created equal
When engaged in screening processes it is important to
recognize that all reported earnings on income statements are NOT created
equal. To normalize the numbers Warren Buffett calculated what he calls “owner
earnings.”
Calculating owner’s earnings is not something that can be
done with pinpoint precision. To calculate owner earnings:
Add a company’s net income, depreciation, depletion, and
amortization (non-cash charges) back into net income.
Subtract its capital expenditures and any additional working
capital that might be needed to maintain the same level of unit volumes. (these
are restricted earnings)
NOTE - Sometimes
calculating future maintenance capital expenditures requires very rough
estimates. However, because this calculation is so important, and because
nobody will do it for you, do your best to estimate this type of capital spending
rather than ignore it.
Calculating the owner’s portion of reported GAAP earnings will
help you level the playing field of analysis between companies with divergent
capital spending requirements. This technique brings you closer to an “apples
to apples” valuation comparison. Many companies are now also reporting
“ADJUSTED EARNINGS”
The purely quantitatively-oriented analyst, who cannot get
outside of his or her purely empirical box, might scoff at the notion of
deliberately engaging in a process that involves subjectively estimating maintenance
capital expenditures.
Warren Buffett has often quoted the legendary John Maynard
Keynes on this point. Keynes said, “It
is better to be vaguely correct about something, than precisely wrong.”
Estimates of maintenance capital expenditures will never be
precise but, at the same time, they will most definitely not ignore these
future costs.
Future costs are just as important to investment analysis as
future profits.
At the end of the day, successfully valuing companies is
similar to successfully playing ice hockey.
The greatest hockey player to ever strap on a pair of skates
was Wayne Gretzky. When asked why he was so successful, Gretzky offered this
explanation. “I don’t skate to where the
puck is, I skate to where it is going to be.”
Price and Value
Re-visited
The concept of “value” investing is always heralded by those
who proclaim its virtues. It is often described as the process of buying shares
in companies that are purported to offer a more reasonable valuation. Too often
this approach features short hand analytical methods that attempt to identify a
relatively low valuation.
Some value investing proponents will overtly favor
gravitating towards a quick and easy approach to business analysis.
Accordingly, they will rely on published financial statistics and forecasts
looking for mythical objective measures such as low price-to-earnings ratios,
low price-to-book ratios, or high dividend yields.
Theoretically speaking, at the opposite end of the
investment philosophy spectrum, is what is labeled by the investment industry journals
as, “growth investing.” Typically some of the same short cut methods of
analysis are used. The idea is to look for high revenue and earnings growth
rate forecasts.
Statistically oriented types are usually pretty quick to
point out that the price-to-earnings and price-to-book ratios of companies that
so-called “growth” managers tend to prefer are usually much higher than those
of the so-called value manager.
At first glance the “growth versus value” debate seems like
an intellectual tug of war wrapped around a decision-making dilemma. Again it
is useful to quote one of the great investment masters on this subject to try
to clear the smoke.
“Growth and value investing are joined at the hip,”
according to Warren Buffett. “Value is the discounted present value of an
investment’s future cash flow and growth is simply a calculation used to
determine value.”
Take Buffett and Munger at their words on the growth versus value
debates. They have delivered results in the real world to prove they know what they
are talking about.
Once you realize growth is merely a component of the value
calculation, it creates much more clarity. Estimating future owner earnings per
share is critical to the valuation calculation, just as the estimating the risk
free return etc.
Naturally, there are never any guarantees of success in
investing. Even when you find a business that is understandable, offers
enduring economic characteristics, a shareholder-oriented management team, and
you feel that the intrinsic value of the shares can be estimated with an
acceptable degree of certainty, a final step remains before success can be
achieved. These kinds of companies still must be purchased at a reasonable
price. This is where some patience will pay off.
Selection mistakes using this method usually come about as one
of three types of errors:
1.
You overpay for a company’s shares
2.
You misjudge management’s ability
3. You misjudge the future economics of the
business.
Miscalculations of the future economics of businesses are
the most common error in judgment.
Ultimately, buying shares of great companies at a discount
to their intrinsic value tends to create a significant margin of safety.
Summary:
Understanding the implications of history being inflationary
and applying these investment principles wisely and consistently regarding
business aspects, management, financials, and valuation can drive success.
--------------------------------
Understanding Exchange Traded Funds
Exchange Traded Funds (ETF’s) are investment funds traded on
stock exchanges.
An ETF is a type of fund that owns assets (bonds, stocks,
gold bars, etc.) and divides ownership of this basket of assets into shares
that are held by shareholders.
The details of the structure (such as a corporation or trust)
can vary by country, and even within one country there may be multiple
structures.
The shareholders indirectly own the assets of the fund, and
they will typically get an annual report. Shareholders are entitled to a share
of the profits, such as interest or dividends, and they may get a residual
value in case the fund is liquidated.
Only authorized participants, which are large broker-dealers
that have entered into agreements with the ETF's distributor, actually buy or
sell shares of an ETF directly from or to the ETF, and then only in creation units, which are large
blocks of tens of thousands of ETF shares, usually exchanged in-kind with
baskets of the underlying securities.
Authorized
participants may wish to invest in the ETF shares for the long-term, but they
usually act as market makers on the open market, using their ability to
exchange creation units with their underlying securities to provide liquidity
of the ETF shares and help ensure that their intraday market price approximates
the net asset value of the underlying assets.
The Evolution of
ETF’s
- In 1989 Index Participation Shares, an S&P 500 proxy began trading on the American Stock Exchange and the Philadelphia Stock Exchange. This product was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in stopping sales in the United States.
- In 1999 a similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange (TSE). These shares, which tracked the TSE 35 and later the TSE 100 indices, proved to be popular. The popularity of these products led the American Stock Exchange to try to develop something that would satisfy SEC regulation in the United States.
- Standard & Poor's Depositary Receipts were introduced in January 1993. These units, known as SPDRs or "Spiders,” became the largest ETF in the world (SPY)
- In May 1995 MidCap SPDRs began trading (MDY).
- Barclays Global Investors, a subsidiary of Barclays PLC, entered the ETF fray in 1996 with World Equity Benchmark Shares (WEBS) subsequently renamed iShares MSCI Index Fund Shares. WEBS tracked MSCI country indices, originally 17, of the funds' index provider, Morgan Stanley. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind.
- In 1998, State Street Global Advisors introduced "Sector Spiders", which follow nine sectors of the S&P 500. Also in 1998, the "Dow Diamonds" (DIA) were introduced, tracking the famous Dow Jones Industrial Average.
- In 1999, the influential "cubes" (NASDAQ: QQQ), were launched attempting to replicate the movement of the NASDAQ-100.
- In 2000, Barclays Global Investors put a significant effort behind the ETF marketplace, with a strong emphasis on education and distribution to reach long-term investors. The iShares line was launched in early 2000. Within five years iShares had surpassed the assets of any other ETF competitor in the U.S. and Europe. Barclays Global Investors was sold to BlackRock in 2009.
- The Vanguard Group entered the market in 2001. The first fund was Vanguard Total Stock Market ETF (VTI), which has become quite popular, and they made the Vanguard Extended Market Index ETF (VXF). Some of Vanguard's ETFs are a share class of an existing mutual fund.
- iShares made the first bond funds in July 2002, based on US Treasury bonds and corporate bonds, such as iShares Invst Grade Crp Bond (LQD). They also created a TIPS fund.
- In 2007, iShares introduced funds based on junk and muni bonds; about the same time SPDR and Vanguard got in gear and created several of their bond funds.
- Since 2007 ETFs have proliferated and are increasingly tailored to specific arrays of regions, sectors, commodities, bonds, futures, and other asset classes.
- In 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively managed ETFs.
- In 2008, the SEC began issuing exemptive orders to fully transparent actively managed ETFs. The first such order was to PowerShares Actively Managed Exchange-Traded Fund Trust, and the first actively managed ETF in the United States was the Bear Stearns Current Yield Fund, a short-term income fund that began trading on the American Stock Exchange under the symbol YYY on March 25, 2008.
- As of January 2014, there were over 1,500 ETFs traded in the U.S., with over $1.7 trillion in assets. In December 2014, U.S ETF assets went above $2 trillion.
Trading behaviors of
ETF’s
ETFs have transparent portfolios, so institutional investors
will know exactly what portfolio assets they must assemble if they wish to
purchase a creation unit. The exchanges disseminate the updated net asset value
of the shares throughout the trading day, usually at 15-second intervals.
If there is strong investor demand for an ETF, its share
price will temporarily rise above its net asset value per share, giving
arbitrageurs an incentive to purchase additional creation units from the ETF
and sell the component ETF shares in the open market. The additional supply of
ETF shares reduces the market price per share, generally eliminating the
premium over net asset value. A similar process applies when there is weak
demand for an ETF: its shares trade at a discount from net asset value.
Investment
Characteristics
ETFs generally provide the easy diversification, low expense
ratios, and tax efficiency of index funds, while still maintaining all the
features of ordinary stock, such as limit orders, short selling, and options.
Because ETFs can be economically acquired, held, and
disposed of, some investors invest in ETF shares as a long-term investment for
asset allocation purposes, while other investors trade ETF shares frequently to
implement market timing investment strategies.
Why Lower costs?
ETFs generally have lower costs than other investment
products because most ETFs are not actively managed.
ETFs are insulated from the costs of having to buy and sell
securities to accommodate shareholder purchases and redemptions.
ETFs typically have lower marketing, distribution and
accounting expenses, and most ETFs do not have 12b-1 fees.
Buying and selling
flexibility
ETFs can be bought and sold at current market prices at any
time during the trading day, unlike mutual funds and unit investment trusts,
which can only be traded at the end of the trading day.
As publicly traded securities, their shares can be:
purchased on margin
sold short (enabling the use of hedging strategies)
traded using stop orders and limit orders, which allow
investors to specify the price points at which they are willing to trade.
Some ETFs have the capability for options (puts and calls)
to be written against them. Covered call strategies allow investors and traders
to potentially increase their returns on their ETF purchases by collecting
premiums (the proceeds of a call sale or write) on calls written against them.
Mutual funds do not offer those features.
Tax efficiency
ETFs generally generate relatively low capital gains,
because they typically have low turnover of their portfolio securities.
While this is an advantage they share with other index
funds, their tax efficiency is further enhanced because they do not have to
sell securities to meet investor redemptions.
Market exposure and
diversification
ETFs provide an economical way to rebalance portfolio
allocations and to "equitize" cash by investing it quickly.
An index ETF inherently provides diversification across an
entire index.
ETFs offer exposure to a diverse variety of markets,
including broad-based indices, broad-based international and country-specific
indices, industry sector-specific indices, bond indices, and commodities.
Transparency
ETFs, whether index funds or actively managed, have
transparent portfolios and are priced at frequent intervals throughout the
trading day.
Styles
Stock ETFs can have different styles, such as large-cap,
small-cap, growth, value. ETFs focusing on dividends have been popular in the
first few years of the 2010s decade, such as iShares Select Dividend.
ETFs can also be sector funds. These can be broad sectors,
like finance and technology, or specific niche areas, like green power. They
can also be for one country or global.
ETFs compared to
mutual funds
ETFs have a reputation for lower costs than traditional
mutual funds. This will be evident as a lower expense ratio. This is mainly
from two factors, the fact that most ETFs are index funds and some advantages
of the ETF structure.
Some index mutual funds also have a very low expense ratio,
and some ETFs' expense ratios are relatively high.
Not only does an ETF have lower shareholder-related
expenses, but because it does not have to invest cash contributions or fund cash
redemptions, an ETF does not have to maintain a cash reserve for redemptions
and saves on brokerage expenses.
Because ETFs trade on an exchange, each transaction is
generally subject to a brokerage commission. Commissions depend on the
brokerage and which plan is chosen by the customer.
Generally, mutual funds obtained directly from the fund
company itself do not charge a brokerage fee. Thus, when low or no-cost
transactions are available, ETFs become very competitive.
The cost difference is more evident when compared with
mutual funds that charge a front-end or back-end load as ETFs do not have loads
at all.
The redemption fee and short-term trading fees are examples
of other fees associated with mutual funds that do not exist with ETFs.
Taxation vs. Mutual
Funds
ETFs are structured for tax efficiency and can be more
attractive than mutual funds. In the U.S., whenever a mutual fund realizes a
capital gain that is not balanced by a realized loss, the mutual fund must
distribute the capital gains to its shareholders.
This can happen whenever the mutual fund sells portfolio
securities, whether to reallocate its investments or to fund shareholder redemptions. These gains are taxable to all
shareholders, even those who reinvest the gains distributions in more shares of
the fund.
***** In contrast, ETFs are not redeemed by holders
(instead, holders simply sell their ETF shares on the stock market, as they
would a stock, or effect a non-taxable redemption of a creation unit for
portfolio securities), so that investors generally
only realize capital gains when they sell their own shares or when the ETF
trades to reflect changes in the underlying index.
In most cases, ETFs are more tax-efficient than conventional
mutual funds in the same asset classes or categories.
**** Because
Vanguard's ETFs are a share-class of their mutual funds, they don't get all the
tax advantages if there are net redemptions on the mutual fund shares.
Although they do not get all the tax advantages, they get an
additional advantage from tax loss harvesting any capital losses from net
redemptions.
Tracking Errors
The ETF tracking error is the difference between the returns
of the ETF and its reference index or asset. A non-zero tracking error
therefore represents a failure to replicate the reference as stated in the ETF
prospectus.
The tracking error is computed based on the prevailing price
of the ETF and its reference. It is different than the premium/discount which
is the difference between the ETF’s NAV (updated only once a day) and its
market price. Tracking errors are more significant when the ETF provider uses
strategies other than full replication of the underlying index. Some of the
most liquid equity ETFs tend to have better tracking performance because the underlying
is also sufficiently liquid, allowing for full replication.
In contrast, some ETFs, such as commodities ETFs and their
leveraged ETFs, do not necessarily employ full replication because the physical
assets cannot be stored easily or used to create a leveraged exposure, or the
reference asset or index is illiquid.
Futures-based ETFs may also suffer from negative roll
yields, as seen in the VIX futures market.
Effects on stability
ETFs that buy and hold commodities or futures of commodities
have become popular. For example, SPDR Gold Shares ETF (GLD) has 41 million
ounces in trust.
The silver ETF, SLV, is also very large. The commodity ETFs
are in effect consumers of their target commodities, thereby affecting the
price in a spurious fashion.
In the words of the IMF, “Some market participants believe
the growing popularity of exchange-traded funds (ETFs) may have contributed to
equity price appreciation in some emerging economies, and warn that leverage
embedded in ETFs could pose financial stability risks if equity prices were to
decline for a protracted period.”
ETFs have a wide range of liquidity. Some funds are
constantly traded, with tens of millions of shares per day changing hands,
while others trade only once in a while, even not trading for some days. There
are many funds that do not trade very often. This just means that most trading
is conducted in the most popular funds. The most active funds (such as SPY,
IWM, QQQ, et cetera) are very liquid, with high volume and tight spreads. In these
cases, the investor is almost sure to get a "reasonable" price, even
in difficult conditions.
With other funds, it is worthwhile to take some care in
execution. This does not mean that less popular funds are not a quality
investment. This is in contrast with traditional mutual funds, where everyone
who trades on the same day gets the same price.
ETFs are dependent on the efficacy of the arbitrage
mechanism in order for their share price to track net asset value. While the
average deviation between the daily closing price and the daily NAV of ETFs
that track domestic indices is generally less than 2%, the deviations may be
more significant for ETFs that track certain foreign indices.
The Wall Street Journal reported in November 2008, during a
period of market turbulence, that some lightly traded ETFs frequently had
deviations of 5% or more, exceeding 10% in a handful of cases, although even
for these niche ETFs, the average deviation was only a little more than 1%. The
trades with the greatest deviations tended to be made immediately after the
market opened.
