Category Archives: Financial

More about ETF liquidity and the underlying assets’ liquidity

Sorry for the ridiculous title.  Not clickbait.

Noah, from Noahpinion, posted at Bloomberg, which was reposted at wealthmanagement.com:

It’s Smart to Worry About the Risks ETFs Pose

Remember how mortgage-backed securities turned out?
Now *that’s* a clickbait title.
The article is actually a lot more interesting than the title implies.

My own biggest worry about ETFs revolves around liquidity.

There is no single unified definition of liquidity. In general it means the ease with which you can trade an asset, but that depends on conditions in the market — mortgage-backed securities were plenty liquid before the crisis struck, but became incredibly illiquid once people started doubting the quality of their ingredients.

ETFs look very liquid, because as the name implies, you can trade them on exchanges. Take a thousand hard-to-trade bonds and pile them into an ETF, and you suddenly have one bond fund that the lowliest retail investor can buy and sell at will.

But what happens in a crisis? Suppose some bonds turn out to be a lot lower-quality than most investors believed. Without ETFs, those bonds would plunge in price, but other bonds would be fine. But now imagine that both the bad bonds and the good bonds are all bundled into ETFs. Now, when the bad bonds are discovered to be bad, investors who ignored the composition of their funds will suddenly wake up to the fact that they might contain toxic assets. Liquidity in the ETF market might suddenly dry up, as everyone tries to figure out which ETFs have lots of junk and which ones don’t.

With assets like stocks, this isn’t so much of a danger — when stocks go bust, everyone can see which ones are bad. But when the ingredients in an ETF are complex, highly heterogeneous assets, as is the case with many bonds and derivatives, one ETF might be fine while another is worthless, and yet investors may ignore the differences until it’s too late.

Another possibility, pointed out to me by a friend in asset management, is that some of the individual securities in an ETF might start to have their own liquidity problems. If banks or other big broker-dealers suddenly become unwilling to facilitate the trading of certain kinds of bonds, ETFs that include large amounts of those particular bonds might suddenly plunge in price. Investors now buying up ETF shares might not realize that danger, thus leading to general overpricing.

So the more bespoke and exotic markets ETFs expand into, the greater the worry that they could be involved in a 2008-style liquidity crunch. That could pose risks for key financial institutions that hold ETFs, and it could also spell danger for individual investors’ retirement savings.

A few people are already worrying about this possibility, which is good. The more we worry about financial innovations in advance, the less chance we’ll need a crisis to teach us the limits of those innovations.

This is sort of the flip side of my earlier post regarding bond mutual funds vs. ETFs.  My assumption is that traders will quickly price in the illiquidity of the underlying assets.  His assumption is that they will not, or may not.  I think if you are investing in funds of illiquid assets, though, you are still better off in an ETF than a mutual fund if you are a buy and hold investor.  This article gives you even more reason to hold a mutual fund if you plan to sell into a downturn.

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ESG vs. Returns

Great post from Asness regarding ESG.  The bottom line is, if you are trying to encourage good behavior, you should expect that your goals do not come free of charge – there should be a cost to total returns.

Pursuing virtue should hurt expected returns. Some have discussed this fact. But, it’s still not widely understood or broadly accepted. This seems to arise from investment managers selling virtue as a free lunch, and from investors who very much want to believe in that story. In particular, and my focus here, accepting a lower expected return is not just an unfortunate ancillary consequence to ESG investing, it’s precisely the point (though its necessity may indeed be unfortunate). As an ESG investor this lower expected return is exactly what you want to happen and really the only way you can effect the change you seek

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Fed Balance Sheet unwind

Michael Arone at SPDR Blog has added a bunch of global data to the info I posted previously regarding the Fed’s balance sheet.  He includes some information about current and future levels of required reinvestments (maturity dates) but really doesn’t touch on how equity markets might be impacted.

There are a bunch of cool charts (and one really, really dumb one, click on the link and you figure out which one).

Here’s a couple:

growth_in_global_central_bank_assets_1160x760

us_treasuries_and_china_fx_reserves_1160x687

 

Importantly, he noted that the Chinese sale of treasuries was related to their desire to control the level of the yuan, not some general panic over US Treasuries, as that action is often portrayed.

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Fixed Income Investment Options

For fixed income exposure, there are currently 3 ways to own:  Hold the individual bonds, hold a bond fund, or hold a bond ETF.  Each has its advantages and drawbacks.

Depending on the type of bonds to be purchased, it may be difficult to achieve adequate diversification in individual bond holdings without a substantial investment (corporate and muni bond managers typically require at least $250,000).  Both mutual funds and ETFs provide maximum diversification with minimum investment.  ETFs have a slight edge here, as many funds do have investment minimums, and you only need to buy one share of an ETF.

Liquidity is another concern.  Again, individual bonds will have the least appeal for best execution.  ETFs have similar concerns, because the liquidity of an ETF is based on the liquidity of the underlying assets.  Bond funds can always be redeemed at NAV on a daily basis, so if you are interested in bonds that can be quickly bought and sold at NAV, regardless of bond market conditions, bond funds are the best choice.

Expenses and costs also vary greatly.  Individual bond portfolios, again, depending on the types of bonds, may be assembled at minimum cost, or may be managed for ongoing fees.  ETFs and funds have management fees, which vary from just a few basis points for index funds and ETFs to much higher fees for active funds.  It’s important to consider trading costs, including spreads and commissions, for ETFs (related to liquidity).

These basics are simple enough to determine, but they are not enough to make an informed decision.  For that, you need to consider why you own bonds, and when and how you plan to divest.  Is your investment process tactical, with buying and selling of positions?  Or is it more strategic, buy and hold?  Are you holding bonds to maturity in a bond ladder?

Consider the scenario of rising interest rates, forcing bond prices down, or, equivalently, a bond selloff in the type of bonds you own:

  • If you own the individual bonds and plan to hold to maturity, there is no practical impact on your portfolio. The bond values may drop, but the cash flows for your existing bond portfolio do not change.
  • If you own a mutual fund, you can redeem your shares daily at NAV. This option forces the fund company to either raise cash during downturns (a drag on performance), maintain credit for redemptions (an added cost), or sell assets, likely below NAV.  If you are selling tactically, you get the best price immediately.  If you are a buy-and-hold investor, you will bear the added costs of these sales and your investment may be harmed in the long run.
  • If you own an ETF, you can sell intra-day at market prices. The share creation/redemption process will force market prices for the ETF toward actual pricing of the bonds that includes costs of liquidity, so the ETF is likely to sell below NAV.  Investors who hold their shares are not impacted by these price movements.  Any fire sale pricing will be borne by the authorized participant who is redeeming the shares, and the individuals who are selling to the AP.

Bottom line:  If you are a buy and hold investor, an ETF or individual bonds may serve you best.  If you make tactical trades, the mutual fund daily NAV redemption feature is your friend.

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Montier vs. Inker

Here’s the link to James Montier’s post (in pdf form), which essentially rebuts a “this time is different” argument that Ben Inker made in GMO’s 2016 3rd quarter letter.

Both articles contain good points, and I agree with parts of each, although not really the conclusions of either.

IMHO, QE and the resulting balance sheet of the Fed is a major “this time is different” factor that neither of these articles addresses.  It impacts the bond market in continuing purchases to maintain the balance sheet as assets mature, and it has impacted the markets for all other assets as dollars are pushed out into the investment world and stay there.  Neither of these impacts are small or transitory in nature.  And it isn’t just our Fed, but many central banks around the globe. I wonder what these guys think about that.

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Tax Loss Harvesting

James Osborne of Bason Asset Management published a piece about tax loss harvesting on 3/17/17.

Most of the robo-advisors claim that their aggressive TLH strategy will add nearly 1% per year (right now on Wealthfront’s website they are claiming a whopping 1.55% per year!) in additional risk-free return.

Okay, time for some math. I pulled a handful of client account that had been around for at least a few years and looked at what amount of losses were harvested. For the random accounts sampled, in 2015 I harvested between 2% and 4% of the account value, and in 2016 between 1.5% and 4%. The variance depended primarily on asset allocation and inception dates. So in each of 2015 and 2016 you could estimate that we were taking around 3% of account value in harvested losses ($3,000 on every $100,000 in the portfolio). If you want to use some of the ridiculous math supported by certain robo advisors, you can get pretty close to that translating to 1.5% in tax alpha. But I think that’s absurd.

What you really get is a $3,000 current year ordinary income tax deduction, which is valuable. Yay! And then you get to bank any losses over and above that amount to offset future gains. Gains that you might take from rebalancing or from freeing up cash in a portfolio for retirement expenses. Again, this is a very good thing. You’re creating tax deferral in a taxable environment. Big win. But we arrived at these figures without constant daily trading of ETFs to pick up $10-$15 losses, risking bid/ask spreads, portfolio drift, trade execution risks and paying brokerage commissions. These figures were the result of reasonable, intra-year harvesting of substantive losses. No 40 page 1099-Bs required. Tax loss harvesting is great, but the presumed benefits of aggressive daily loss harvesting over a more “traditional” strategy are likely highly overstated.

I have an additional comment on this, and I know it is an easy one to criticize.  None of our client accounts have taxes automatically withdrawn.  To the best of my recollection, once in the last 10 years has a client made a withdrawal from an investment account in order to pay a tax bill, and it was an amount far exceeding the tax bill generated by the investments (the withdrawal was due to a cash flow issue).  Additionally, clients are making contributions that are planned in advance, not based on on their tax bills.  My point is that, while the taxes paid are certainly real, they are not really having any impact at all on returns within the investment accounts.  Yes, this means that taxes impact consumption today, and yes, that is important also.  And I know that money is fungible and the client’s overall financial position is what counts, and that this tax adjustment to returns is the most fair way to look at the impact taxes have on the clients.  But it’s not an trivial point to make, that if no cash flows to the investment account are impacted, then all this churning in the robo accounts will actually incur a loss in the investment accounts compared to accounts that do not generate all these fees and other trading friction.  Even if the total cash flows are net positive to the client.  So clients will actually have less money in the investment accounts in the future when they want to use that money, unless they start contributing their tax savings into their investment accounts.

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On Saving Money

Morgan Housel has a great post dated 3-9-17 about saving money.

I tell the smartwomensecurities ladies at CMU and my class at Thiel that much of your emergency fund, or short term savings, is not for emergencies at all, but for expenses that are random in nature, though certain to occur.  Every car needs repair at some point.  Every person gets sick or injured, and it may be you or it may be someone you want to care for.  Your friends may decide to have a destination wedding.

One point I had not made to the young people was this:

…the best reason to save is to gain control over your time. Everyone knows the tangible stuff money buys. The intangible stuff is harder to wrap your head around, but can be far more valuable and able to increase your happiness. Savings gives you options and flexibility, the ability to wait and the opportunity to pounce. It gives you time to think. Every bit of savings is like taking a point in the future that would have been owned by someone else and giving it back to yourself.

That flexibility and control over your time is an unseen return on wealth. When time isn’t on your side you’re forced to accept whatever bad luck is thrown your way. But if you have flexibility, you have the time to wait for no-brainer opportunities to fall in your lap. This is a hidden return on your savings. Savings in the bank that earns 0% interest might actually generate a meaningful return if it gives you the flexibility to take a job with a lower salary but more purpose, or wait for investment opportunities that come when those without flexibility turn desperate.

This is very true.  Savings is often referred to as a “cushion.”  This is why.  It allows a person to make a soft landing, to defer panic.

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