Ahead of the Press…Again

In the July 26th issue of Businessweek, the feature article titled “Amber Waves of Pain” attacks the commodity Exchange Traded Fund (ETF) market. They note that investors were “angry” about certain ETF investments that did not perform as expected including the U.S. Oil Fund (symbol: USO). This was mostly due to a condition in commodity futures markets known as “contango,” where longer dated futures contracts are more expensive than near term contracts for the same commodity. USO and other commodity ETFs are constructed to buy contracts that are closest to maturity, and continuously purchase new near term contracts when they are about to expire. This process effectively reduces profits when contango exists, since the ETF is forced to purchase the more expensive future contracts that lose money when they are about to expire, resulting in something called “negative roll yield.”

Additionally, many commodity index funds reinvest their contracts between the fifth and ninth business days of the month. Because this rebalancing is well known by other traders, who are not bound by specific roll dates, they game the system and make it more expensive to conduct these rolls. These traders buy and sell before the expected ETF roll which drives up the price of the next futures contract while driving down the price of the expiring contract. In the end, the purchasers of certain ETFs lose.

However, here at Pinnacle, this is old news. In March, we recognized the inherent problem in many commodity ETF products and pro-actively searched for alternative products. This search led us to the E-TRACS UBS/Bloomberg CMCI Index Exchange Traded Note (symbol: UCI) which we believe is the most attractive commodity index option available at this time. UCI is constructed in a fashion that staggers the purchase of futures contracts at different maturities ranging from 3 months to 5 years, rather than just buying the closest contract to maturity. This helps to reduce the negative roll yield effect when contango exists. Additionally, UCI is constructed to slowly rebalance small percentages of future contracts every day. This helps prevent other traders from manipulating the price of the futures contracts. UCI has outperformed our previous holding by 150 basis points (1.5%) since we purchased it. We expect the marketplace to continue to develop new approaches to manage negative roll yields. This is another instance in which Pinnacle was ahead of the press…again.

For a more in depth look at UCI, please see the following Article of Interest on our website.

http://www.pinnacleadvisory.com/pages/pinnacleArticleDetails.aspx?LinkID=97605&spid=100848

Managing Fixed Income

With the advent of Exchange Traded Funds (ETFs), we have raised the question of how to best manage fixed income on multiple occasions. Since our inception, we have used individual municipal and government bonds when we felt there was value in that asset class. This is very normal in the institutional world, and has served our clients very well. However, I recently informed our Chief Investment Officer (Ken Solow) that the fixed income portfolios for many clients are drifting from our targeted duration due to the use of individual securities. As a reminder, duration is the sensitivity of a bonds price to a change in interest rates. A longer duration bond has greater price moves when interest rates change than shorter duration bonds. When an individual bond gets closer and closer to maturity its duration becomes shorter and drifts away from our intended target.

If we bought bonds to generate income, and just held them to maturity it would be a much simpler world. However, we manage bonds for total return – which is income plus changes in price. And as bonds drift from their duration targets, the total return on the bond also drifts from our expectations, and we are left with a choice. Do we sell the current bonds to purchase longer duration bonds, or do we hold on to them with the realization that our total return expectations would have to change?

Getting back to ETFs, many companies have created products that provide exposure to municipal or government bonds while managing duration. For instance, the iShares 20+ Year Treasury (TLT) invests in U.S. government bonds over 20 years in maturity, while maintaining a fairly constant duration in the vicinity of 15.5. We can purchase this product for every client and have two reassurances: the product will generate the same return for each client and iShares will manage the duration for us. So even though the use of individual securities has many merits, I feel like these two factors allow us to more effectively manage our bond allocations and therefore we may see more ETFs used in Pinnacle portfolios in the future.

A Little Nuance to ETF Trading

ETFs, or Exchange Traded Funds, are similar to a mutual fund because they invest in a basket of stocks. However, one clear advantage of ETFs is that they trade intra-day in a similar manner to stocks. When trading these positions, we can monitor intra-day prices and sell or buy at an exact price whereas mutual funds are only traded at the end of the day. This has been covered in the past and has been repeatedly flogged by Pinnacle as one of many reasons to switch our US Equity holdings to ETFs. But during a recent trade, I strategically ignored this benefit to take advantage of pricing inefficiencies in a specific security.

Like any other stock, ETFs are purchased at the bid (the price a dealer is willing to sell you a stock) and sold at the ask (the price a dealer is willing to pay for your stock). The difference between the two prices is called the spread. If a stock is actively traded then the spread is very small (typically $.01) and if a stock is thinly traded then the spread is very large. When purchasing an ETF with a large spread it is very likely that the purchase price will be way above the ETF Net Asset Value (NAV). The NAV is the weighted price of the basket of stocks being bought. So what is a trader to do?

In order to avoid the large spread difference, and get a better buy price for our clients, I called the creator of the ETF being purchased and asked to buy through a process called ‘creation’. Basically, you tell the creator of the ETF a quantity to purchase, and they create new shares at the NAV. It is a very simple process but it does take away the ability to intra-day trade. The creator will fill the new order but it is for the NAV at the close of the business day very similar to a mutual fund. This was a small price to pay for the thinly traded ETF when the eventual savings to our clients were very large.

The ETF Advantage

At Pinnacle, we have embraced the Exchange Traded Fund (ETF) universe for a variety of reasons, including low expenses, tax efficiency, and trade execution advantages. As their popularity has grown in recent years, ETF product offerings have grown as well, which provides us with a wider array of investment options to choose from. We currently use ETFs for all of our U.S. equity exposure. With diverse offerings in sectors and industries we can efficiently rotate our holdings as better value opportunities arise. Additionally, another big advantage in trading ETFs is that they trade intraday like a common stock, whereas mutual funds only trade at the end of the day. The intraday trading capabilities allow for more precise trading strategies such as stops and limits, and give me (in my role as Pinnacle’s Portfolio Trader) an opportunity to create value for our clients when favorable market conditions arise. Yesterday was a great example of that.

We recently decided to add a couple of new ETF positions in our models, funded by selling mutual funds and cash. We were able to execute all trades on the same day because mutual funds have a 1 day settlement and ETFs have a 3 day settlement. On the open yesterday the market fell 2% as concerns over Greece and the U.S. labor market weighed on investors. However, stocks started to stage a rally just before noon as news of a possible stock split in Apple made the rounds. For Pinnacle clients this presented a great opportunity to purchase the ETFs we had targeted to buy.

The two pictures below show the intraday movement in the Sector SPDR Energy Select ETF and the trade execution details (L: 12,355 @ $55.2531 means we bought 12,355 shares at a price of $55.25). The range of prices in this security was $54.72 to $56.04, and as I just mentioned the execution price for our purchase was $55.25. This was not the exact bottom but at the end of the day our purchases had already gained 1.44%. This is a gain we wouldn’t have been able to earn for our clients if we had used mutual funds instead of ETFs, since those orders would’ve executed at end of day prices.

ETF Methodology in Practice

When deciding on which Exchange Traded Fund to buy, there are different methodologies from which to choose. Carl wrote about the differences in construction in his post called Cap-Weighted vs. Equal Weighted. As he mentioned, there can be important biases built in to the products which could provide benefits or downfalls in different markets. For instance, the equal weighting methodology lowers the market capitalization of the index and may be more beneficial in a bull market. However, it is important to realize that each fund can dramatically drift from the stated construction rules and performance could be affected.

We owned an ETF called the First Trust NYSE Arca Biotechnology ETF (FBT) which is designed to replicate the price and yield of that exact index. The index is an equal weighted, 20 member biotechnology index which includes well known companies such as Genzyme and Amgen. But it was through a lesser known, small cap company called Human Genome Sciences (HGSI) where we experienced the dramatic drift (beneficially) in construction. The company had successful Phase 3 trials for their new Lupus drug called Benlysta and the stock exploded from $3.30 a share on July 17th to $18.80 today.

The explosion in the stock price took the equal weighted index and propelled HGSI to a 22% weight from 5% (20 stocks equal weighted). And the fund had stated in its prospectus that it would only rebalance the stocks every quarter back to a balanced state. With a 22% weight HGSI would dominate the performance of the ETF and it would no longer provide us with the equal weight methodology for which we originally invested. We decided it would be prudent to sell the fund and capture the gains provided by HGSI, and find a better alternative. With the explosion of ETFs over the last few years there are several options for most sectors and we will continue to evaluate them to ensure that we are invested wisely.

Cap-Weighed vs. Equal Weighted

We’ve been using Exchange-Traded Funds (ETFs) to implement many of our investment ideas for several years. ETFs offer the convenience of being diversified across many individual stocks, being highly liquid, and sporting very reasonable fees. They’ve exploded in popularity in recent years, and there are now hundreds of different funds to choose from, ranging from very broad market funds to more focused sector and industry funds. Therefore, we spend a lot of time analyzing the specifics of these funds to make sure we find a vehicle that best fits what we’re trying to do.

ETFs are designed to passively track an index, and many indexes are weighted by the market capitalization of the underlying stocks. All that means is that the largest stocks receive the largest weight in the index, proportional to their size relative to the size of the other companies. One of the downsides of this method that we’ve occasionally come across is that sometimes there might be one or two enormous companies in a particular sector or industry that receive an outsized weight in the index, meaning that the performance of that ETF is largely driven by the performance of a particular stock, basically defeating the purpose of owning a diversified ETF.

So, some ETF providers have solved this problem by offering equal-weighted ETFs. As the name implies, they simply take all of the members of an index give them the same weighting. The biggest difference is that this effectively reduces the weight of larger companies and raises the weight of smaller companies compared to a cap-weighted ETF, meaning that equal-weighted ETFs tend to have a smaller-cap bias. Since the market values of the companies fluctuate from day to day, causing them to drift from their equal weighting, they’re typically rebalanced back to the proper weighting on a quarterly basis.

Ultimately, investors should realize that not all ETFs were created equal, and there can be important biases built in to supposedly passive index products that they should be aware of, since they can have important performance ramifications.