Exchange-Traded Funds (ETFs)

There are two very different types of funds that are traded on the stock exchange(s).  The dominant form is the open-ended exchange-traded fund, commonly called an ETF.  The smaller cousin of the ETF is the closed-end fund commonly called the CEF.

According to a recent Forbe’s article ETFs currently contain $725 billion in assets and could top $1 trillion in the next two years.  According to this site CEF assets totaled $335 billion in 2007.

Closed-End Funds

The weakness of the CEF is that its assets are bound up in a closed financial package.  In a way a CEF is a bit like a financial black hole — the investments inside are not reachable by the rest of the financial universe outside the event horizon.  The only way that the money is accessed is indirectly through the current price of the CEF and through cash distributions.   To take the analogy further a CEF is a bit like a “white hole” in that the internal assets can slowly radiate out in the form of cash distributions.

Because there is no effective mechanism to keep CEF price in line with NAV (net asset value) they hold they frequently trade at a premium or discount to their NAV.  This yahoo finance chart shows the ever-changing relationship between price (red) and NAV (blue) for S&P 500 covered call CEF.

The price versus NAV tracking-error in CEF pricing is a big con to CEF investments.    It does also present a couple opportunities.  1) Buying CEFs at a steep discount to their NAV is sometimes possible and 2) shorting CEFs that are at a steep premium is another opportunity.  Generally, however, I don’t advice speculating or investing in CEFs, largely because of the superior alternate — the ETF, or exchange-traded fund.

Exchange-Traded Funds (ETF)

The ETF is a really great financial innovation.  ETFs excel over CEFs because they build in a financial arbitrage mechanism that minimizes price/NAV tracking error.   The underlying components (stocks, bonds, money, etc) can be be redeemed directly from the ETF issuer in large blocks of ETF shares called creation units.  Typically 50,000 shares of an ETF equals a single creation unit.  If the NAV is greater than the price of the ETF a large investor can buy a creation unit worth of shares and resell the constituent investment pieces for a profit.  This arbitrage mechanism helps to keep ETF prices in very close correlation with the underlying NAV.

The beauty of ETFs is that they incorporate many of the best attributes of stocks, closed-end funds, and mutual funds into an efficient financial package.  ETFs, like CEFs, trade like stocks.  Because they do, they can be bought and sold in virtually any brokerage account just like any other stock.  Additionally, ETFs can do essentially anything a mutual fund can do — provide diversification, passive or active management strategies, invest in foreign or domestic securities, etc.

Often a mutual fund company will offer a particular fund it two different packages– a typical mutual fund or as an ETF.  For example Vanguard offers the Vanguard Total Stock Market fund as a mutual fund under the symbol VTSMX and as an ETF under the ticker VTI.

I have just scratched the surface of the CEF and ETF investment world with this blog article.  Suffice it to say I am a proponent of ETF investing.  Understanding the disadvantages of CEFs helps illustrate the advantages of ETFs.  In fact, I believe ETFs are one the of greatest financial innovations since the index mutual fund.  One passing word of caution.  Please be carefully not to confuse ETFs with the similar-sounding ETN (exchange-traded note).  ETFs are backed by the underlying securities they contain, whereas ETNs are simply senior debt notes that are only as secure the issuer who sells them.  For this reason, I prefer the real McCoy, the EFT.

Investor’s Thanksgiving Thanks

As we reflect on Thanksgiving, here are some personal finance things I am thankful for:

  • Decimal stock pricing. Remember all those pesky fractions?  Decimal pricing is so much easier.  And the spreads are much better too.
  • Online stock trading. I don’t know about you, but I don’t want to talk to a broker.  I want fast quotes and cheap trades without the conversation.
  • Free online financial data. Thank you all you online publishers of stock data.  It’s 2:00 AM and I just have to know the market premium on the BEP closed-end fund — No problem.
  • Index funds. Thanks John Bogle and others for these diversified, tax-efficient, cost-efficient funds.
  • Good financial planning. Thanks, Dad, and others along the way who taught me money management, investing, and financial planning.
  • 401K, IRA, and Roth IRA accounts. These tax advantaged accounts were spectacular ideas, and they work.
  • Good accountants. Thanks for helping me make some sense of the US tax code.
  • Buying opportunities. Every now and again a great investment comes along and a great price.  Doubling my money on PCU comes to mind.  Such opportunities are what make investing fun for me and keep me searching for the next great buy.
  • Dividends. Even when stocks are down, many still pay dividends. A lot of stocks are currently repaying 3% dividend yields. These quarterly dribbles of cash do feel good to receive.

For investors, there is a lot to be thankful for.  Yes, our equity investments are generally down, and our economy is lethargic. Equities have been a wild ride to nowhere in the last decade.  But bonds and, yes, in many places even real estate have fared much better.  And as long-term investor I am excited about the prospects finding buying opportunities.  I wouldn’t say equities are cheap, but I am thankful that they are not all that expensive either.  I am looking forward to the next 10, 20, 30+ years of investing.

Wealth Management Scorecard

One or twice a year I take some time to reflect on my investments and investment decisions.  This time I’m writing up this process for the world to see.  Here goes…

Questions I’m asking myself this time (5 point scale, 1=poor, 5=excellent):

  1. In the last 10 years, how has your personal portfolio performed against the S&P500 in terms of return?
  2. … In terms of volatility?
  3. How have your returns compared against money markets? (softball benchmark usually, but no so much in 1999-2009 period)
  4. Rate your investment tax efficiency.
  5. Rate your diversification.
  6. Rate your objectivity of investing decisions (esp. for big-scale asset allocation changes).
  7. Rate your savings rate. (1=negative, 2=none, 3=up to 10% of gross income, 4=20%, 5 =>30%)
  8. Progress toward retirement goals?
  9. Understanding of  your portfolio and its performance?
  10. Paying reasonable fees and expenses?

And here’s how I score myself:

  1. 5.  I definitely crushed the S&P500 over the last 10 years. (S&P went from 1422 down to 1105 in this period)
  2. 4.  Much less volatile than the S&P500, but still volatile.  Could have made better use of options to dampen volatility.
  3. 3.  My overall returns have, in aggregate, not performed dramatically better than 10-year money market returns.
  4. 4. Good, but not great.  Managed cap gains very well (keeping them long-term and largely unrealized). Still payed lots of tax on interest income. Could have made better use of municipal bonds.
  5. 5. Broadly diversified including international exposure, real estate, bonds of various durations and styles, etc.  Almost completely avoided the tech bubble.
  6. 4.  Steady and disciplined decisions.  Reasonable and contained risk taking.
  7. 5.  At least 30% AGI on average saved.  If anything I saved a bit too much.
  8. 5.  I am on track to “retire” early.  Maybe by age 50 or 55.
  9. 5.  I understand my investments and follow their performance.
  10. 4.  My average expense ratio is approx 0.7% including commissions for trades.

So how did I score?  I gave myself 44 out of a possible 50 points, or 88%.  In my book that’s a B+.

Common Sense Money Management

It is amazing how much simple mistakes can cost a person over the years.  A common example is banking fees.  A single overdraft fee can cost $39!  And bank like to play tricks like computing the withdrawals first in day THEN tabulating the deposits.  This banking trick can cost you.

It is pretty easy to avoid this these pricey fees.   First find a bank/credit union that offers overdraft protection.  One kind will automatically transfer from savings to checking if there is is a potential overdraft.    A second, more powerful kind features an unsecured line of credit that will cover overdrafts but charge and interest rate.   I have had both for years .   If there is not enough money in checking, money is automatically pulled from savings.  If there is not enough money there, it comes out of the line of credit.  I have not paid an overdraft fee since I set this up years ago.

Bottom line: don’t settle for crappy banking.  Read the fine print and shop around.   Personally I’ve tended to have better luck with credit unions than with banks… but everything varies.  There are some good banks out there and some good credit unions.  Just avoid the bad ones.  And if your good one turns bad have the cojones to switch to a better institution.

Another area to avoid pesky expenses is with credit cards.   An important step to avoiding late fees is to set up an automatic monthly payment of your credit card(s).    Doing so can help avoid any late fees.  For example I have my two credit cards set up to be paid $100 every month a day  before the due date.   This does not pay off the full balance, but will pay the minimum balance and avoid a late fee.   Typically I will pay the full balance on line as well.

This advice will help you avoid fees.  Next I will give a few tips about how to make a little profit.

The first tip is to check out “dividend rewards” checking.  This is offered by a lot of banks/credit unions.  Typically an above market interest rate is paid on checking accounts, say 3.51%, if certain actions are followed on a monthly basis.  Usually these actions include one direct deposit into the account each month, one monthly withdrawal (say a credit card payment), and 12 debit card transactions.

This does take some discipline.  Banks make money because people fail to jump through the debit card hoop each month.  But if you are disciplined it is pretty easy.  Use your debit card early in the month for small purchases at say, your favorite latte store.   Use it to buy lunch.  Make your you make the minimum amount of debit purchases each month by tracking you account online.  Then laugh all the way to the bank as you see a nice interest rate.

Finally, find a credit card that pays cash back.  (Do this only if you have the self discipline to pay off the monthly balance in full every month.)  There are cards that pay 1% cash back on every purchase with no limit.  Pay your monthly expenses such as utilities, internet, cell phone, etc. on this card.  Bingo, instant 1% discount.   When you buy a car put the max on this card [often $3000 or $5000] and get some bucks back.  This is small but it will add up.   Just remember, this only works in you favor if you pay off your balance in full every month.

These “tricks” are really pretty simple, but effective.  They require investigation, discipline, and tenacity.  But if you use them correctly they can help keep a few extra twenties in you proverbial wallet every month.  And that will add up over the years.  Be bold, be persistent, and yes a little paranoid and you can profit.

Can we afford national health bureaucracy?

Today the House is voting on the next round of health legislation.   Today I pose a simple question.  Can we afford it?

My belief is that it will be very expensive.  It won’t quite break the bank, but it will result in significantly increased taxes.   This in turn will be another weight dragging on the US economy.  And it will be politically impossible to unload this new burden.

Today, I fear, may be the next step in ensnaring the US economic colossus.  As one person amongst millions who benefits from a powerful but sagging US economy, I am sad to see such a rapid and untested scheme.

Why not a slower more thoughtful path that tests a variety of approaches in a variety of states?

I sigh thinking it is likely too late, perhaps, for such questions.   Pragmatism is a sad casualty of expediency.

So it is with a sad heart that I predict another severe wound will be inflicted on our economy.  Nonetheless I cling onto a faint, faint hope.  I will be watching and hoping as the vote presses on tonight.   Good luck America.