ETF Prime Archive

Nuclear Energy and Its ETFs

As global populations continue to multiply and manufacturing starts to expand in developing nations, the demand for electricity will likely follow.  With this in mind, it’s important to consider how and where nuclear energy fits in to meet this growing demand.  In fact, in the United States, nuclear energy is the second most common way to generate electricity, closely behind coal.  As for its uses around the world, countries like Lithuania, France, Belgium and Sweden generate more than half of their respective nation’s electricity via nuclear energy. 

In addition to being an excellent source to power an economy, nuclear energy is relatively clean.  Nuclear energy plants produce electricity through the fission of uranium, not the burning of fuels.  Consequently, nuclear power plants do not pollute the air with nitrogen oxides, sulfur oxides, dust or greenhouse gases like carbon dioxide.  Another important benefit that nuclear generated energy has on our environment is that the wastes produced are completely isolated from the environment.

Nuclear energy’s benefits make it not only economically viable, but politically attractive.  Most recently, President Obama announced more than $8 billion in loan guarantees to build the U.S.’s first nuclear power plant in nearly 30 years.  In addition, the President is pushing his energy bill which assigns a cost to the polluting emissions of fossil fuels so that nuclear fuel becomes more affordable.

The benefits of nuclear energy seem to be moving to the forefront in the energy sector and will likely continue to do so.  Investors wishing to make a play on this sub-sector can do so through the following ETFs:

• Market Vectors Nuclear Energy (NLR), which holds 23 different companies that deal with nuclear energy and carries an expense ratio of 0.61%.
• PowerShares Global Nuclear Energy Portfolio (PKN), which holds 64 different companies who are involved with nuclear energy and carries an expense ratio of 0.75%.
• iShares S&P Global Nuclear Energy (NUCL), which holds 23 different companies around the globe who deal with nuclear energy and carries an expense ratio of 0.48%.

Massman Hosting Workshop at ETFs Investing Summit 2010

Joe Massman, President & CEO of The ETF Store, will be hosting a workshop titled “Examining Exchange Traded Vehicle Performance for 2010” on March 10^th at iGlobal Forum’s ETFs Investing Summit 2010 in New York.  ETFs Investing Summit 2010 will take a closer look at the vast pool of investment opportunities in the field of Exchange Traded Funds (ETFs) and will shed light on the latest developments in this growing arena.  ETFs remained resilient during the market crisis of 2008 and are expected to reach $1 trillion in assets by the end of this year.  A number of prominent speakers will discuss the attractiveness of ETFs in today’s economic environment, in addition to exchanging opinions on the latest ETF innovations, risks and strategies.

The workshop Massman is hosting will examine the entire ETF landscape, including ETF construction and composition, advisor usage of ETFs, and the tremendous asset-gathering potential of ETFs.  The discussion will center on actionable recommendations for implementing an ETF strategy in 2010.

Massman founded The ETF Store in 2008 to provide innovative investment solutions to individuals looking for alternatives to the commissions and high fees imbedded in the typical all-mutual fund portfolio.  Massman is also the founder of ETFBuzz.com, an online source for news and commentary about ETFs, and The ETF Institute, the first industry association for investment advisors utilizing ETFs in client portfolios.

Taking MPT to the Next Level

(note:  this article was originally published at indexuniverse.com on 2/9/10)

Equity and bond-friendly secular declines in interest and inflation rates have given the investing masses license to stretch Markowitz’s Modern Portfolio Theory (MPT) beyond its contextual foundations and to extrapolate investment practices bearing little relation.

Serial autocorrelation in prices (i.e., that prices tend to trend) and assumptions regarding perpetually “full-in” capital deployment carry deeply profound implications for the very foundations of portfolio theory and, more importantly, for the construction of practical applications.

The next chapter in the evolution of modern portfolio theory addresses these issues through the disaggregation of capital at risk (DCaR) – an extension of MPT encompassing the heretofore lacking dimension of market participation.

Starting with the forest …

One major problem with the majority of the discussion regarding how to manage portfolios is that it starts with the proverbial “trees,” rather than stepping back to gaze at the big-picture “forest.”

The “active vs. passive” investing debate that has raged in financial media circles over the last decade, for example, is relevant and important, but it is far from the first order of “strategy” business that investors and risk managers should undertake. Likewise for ongoing debates regarding the asset allocation format du jour and the casting of opinions regarding the relative importance, prospectively, of individual asset classes or sub-classes.

Indeed, starting with the “active vs. passive” debate, irrespective of which of the two strategies (or both) is adopted, or with the asset class allocation matter, can lead to patently wrong conclusions regarding where investors need to look first in order to manage risk.

By focusing on these debates first, many investors erroneously conclude that simply engineering a particular active or passive asset allocation strategy will enable customization of risk and return attributes with precision, thereby ensuring (or so they believe) risk characteristics that they both understand and can live with.

But along the way they’ve missed the first and, really, most critical question:  

To what extent is capital placed at risk?

Just what does this question mean?

Reduced to their most basic level, any and all investment strategies can be viewed as residing in one, and only one, of three discrete risk buckets:

Risk Bucket 1:  Fully principal-protected

Risk Bucket 2:  Conditional market participation and capital at risk, with explicit exit protocols

Risk Bucket 3:  Open-ended, uncapped risk to invested capital

In reviewing an existing portfolio of strategies and holdings, investors and risk managers first need to determine the distribution of investment capital across the three macro-level risk buckets. This is also the first level at which an investment strategy prescription must be defined. Starting anywhere else can cause important sources of risk to be under-appreciated or entirely overlooked.

Let’s take a closer look at the three capital-at-risk classifications to see what each includes and what it does not include.

Risk Bucket 1:  Fully principal-protected

This includes FDIC-insured money market holdings, FDIC-insured certificates of deposit and short-term Treasury securities. All other “cash” vehicles lack explicit protocols that would definitively limit risk to invested capital.

Risk Bucket 2:  Conditional market participation and capital at risk, with explicit exit protocols

This includes trend following strategies, and others, which place definitive and explicit exit protocols on holdings in a manner designed to limit participation in negatively trending markets.

Risk Bucket 3:  Open-ended, uncapped risk to invested capital

This includes buy-and-hold strategies of any flavor, whether they employ actively-managed and/or passively-managed components.

The common denominator is found neither in the instruments used nor in the distribution of holdings across asset classes but, rather, in whether definitive and explicit exit protocols are attached to holdings by the investor or investment manager.

Risk to invested capital that lacks definitive and explicit exit protocols is, de facto, open-ended.

So in which risk bucket would an asset allocation covering equities, fixed income and alternatives fall if it is using actively-managed mutual funds to cover each of the asset classes? Such an approach would reside squarely in the third risk bucket if capital allocated to the strategy lacks explicit exit protocols on each of the funds (or if the individual managers, alternatively, lack explicit exit protocols on holdings residing within their respective strategies).

What about the same asset class allocation strategy (across equities, fixed income and alternatives) if index-based ETFs are used instead of active managers? Classification in the third risk bucket still applies since there are no explicit exit protocols in place to limit damage during market declines. For what it’s worth, a mountain of academic and industry research suggests that the strategy using index-based ETFs is highly likely to outperform the same strategy employing active managers. But that topic, a quite important one, would naturally follow the discussion in this paper.

But what if in either of the above (i.e., whether using active mutual fund managers or index-based ETFs), the asset allocation is, instead, very “conservative”: say, 75% bonds with the rest split into equities and other holdings for diversification purposes? Same story. Third risk bucket. If there are no explicit exit protocols then risk is, in fact, still open-ended. Many bond-oriented investors learned that lesson “well” during the two year stretch through March 2009.

Questions surrounding the use of passively-managed index-based ETFs vs. actively-managed traditional mutual funds are quite important but they speak to issues relating to manager risk relative to participation in index-based alternatives, and to fund costs and holdings transparency. They do not, however, relate to questions regarding market participation and exits from market participation.

Likewise, asset class allocation matters are critical determinants of risk and return characteristics for a given strategy residing within one of the capital-at-risk buckets. In and of themselves, however, asset class allocation questions do not relate to questions regarding market participation and exits from market participation.

What about money market fund holdings that are not FDIC-insured? Such assets would reside in the third risk bucket. These funds, with few (if any) exceptions, have no explicit exit protocols regarding their holdings serving to limit risk. Need a reminder? Think of the Reserve Primary Fund (at the time of its collapse in September 2008, one of the oldest and largest money market funds).

The “cash” and money market fund lessons remind us that: a) there are no free lunches on yield and b) what you don’t know most definitely can hurt you (recall that money market funds are required to publish their holdings only quarterly and up to 60 days in arrears – i.e., holdings data can be as much as two to five months stale). Within the third risk bucket such holdings would be regarded as they truly are: actively-managed very short-term fixed income funds, lacking in absolute principal protection or explicit operational constraints to definitively limit risk.

Practical Applications

The question of what constitutes an appropriate distribution of capital across the three risk buckets for a given investor must precede questions regarding the extent to which risk should be “dialed” up or down, via asset class distribution or otherwise, within either of risk buckets 2 or 3.

For an investor nearing retirement and expecting to need only limited asset growth to satisfy retirement income and other financial goals, the following capital allocation would likely be appropriate:

25-50%  Risk Bucket 1:  Fully principal-protected

25-75%  Risk Bucket 2:  Conditional market participation and capital at risk, with explicit exit protocols

0-25%  Risk Bucket 3:  Open-ended, uncapped risk to invested capital

For this investor, capital deployed in Risk Bucket 3, engendering open-ended, uncapped risk, probably should be in a moderate, moderately conservative or conservative allocation such as a 40/40/20, 30/50/20 or 20/60/20 (equities / fixed-income / alternatives), whether ETFs or a slate of active managers is used.

For an investor far from retirement and on the front end of the “accumulation” phase – and needing growth – the following would likely be more appropriate:

0-25%  Risk Bucket 1:  Fully principal-protected

25-75%  Risk Bucket 2:  Conditional market participation and capital at risk, with explicit exit protocols

0-50%  Risk Bucket 3:  Open-ended, uncapped risk to invested capital

Capital deployed in Risk Bucket 3, engendering open-ended, uncapped risk, probably should be in a moderately aggressive or aggressive allocation such as a 50/30/20 or 60/20/20 (equities / fixed-income / alternatives), whether ETFs or a slate of active managers is used.

Decisions made regarding allocations across capital-at-risk buckets are the primary determinants of the extent to which investors participate in market declines associated with negative trends impacting assets in which they invest.

Investors can dial up or down the risk in strategies residing in Risk Bucket 2 by a) altering the level of diversification or concentration of capital allocations across asset classes and subclasses, b) widening or narrowing the “price bands” at which exits are triggered, c) changing  the frequency and scheduling of evaluation of exit trigger parameters, including the use of running “stop-loss” orders, and d) determining the extent to which capital exiting a holding persists is being held in cash instruments (pending reestablishment of a positive price trend in the asset class just exited) or is redeployed to another asset class presently exhibiting a positive price trend.

Once capital allocations are appropriately adjusted on the capital-at-risk macro front, investors and advisors can then clearly and properly focus their attention on important matters relating to the use of passive index-based instruments vs. actively managed funds and asset class allocations associated with those strategies and holdings.

Bond ETFs Have Appeal

Fearing that the global economy is weaker than most expected, some investors have started to pull assets out of equities and turn to bonds.

Disappointing employment numbers in the United States and rising debt levels in Europe have many questioning whether the recent uptrend in equities is sustainable and has made bond exchange traded funds (ETFs) an attractive investment option. 

To further add to their appeal, the Fed is expected to keep short term interest rates close to zero which makes bond yields more appealing than a run-of-the mill money market fund.   Additionally, bonds are generally a good place to stash extra cash in the event of a market correction, which some believe may be occurring sooner rather than later.

When it comes to choosing a bond ETF, there are a number of choices and ETF providers continue to bring new products to market.  Most recently, bond giant, PIMCO, launched the PIMCO Short Term Municipal Bond Strategy Fund (SMMU), enhancing the firm’s line up of actively managed ETFs covering the municipal yield curve.

Some of other more common bond ETFs include:

• iShares Barclays Tips Bond Fund (TIP), which offers protection against inflation.
• iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD), which offers lower risk corporate bonds.
• iShares Aggregate Bond Fund (AGG), which gives diversified exposure to bonds, including Treasuries and corporate bonds.

The Importance of Exit Points

(note:  this article was originally published at indexuniverse.com on 2/3/10)

All of the hand-wringing, all of the second (and triple) guessing and heated debate typically reserved for position entry points and security selection would have us believe that disproportionate shares of return potentials and risk management levers therein reside. But for a significant portion of most people’s investment assets, attention to specification of position exits is at least as important.

Since the spring of 2007 we’ve seen markets express extremes of seemingly boundless euphoria and truly gut-wrenching, gutter-level despair. The ticket for investors to participate in and experience the depths of the negative side of that ride, in a truly up-close and personal way, has been simply to lack an exit strategy – to take to the road in a vehicle having no brakes, no doors, no windows. And many investors – if not most – did just that.

But “everybody” … the “experts” … they were nearly all saying (and are nearly all still saying) …

The shear weight of “buy”-oriented recommendations reflected in reporting, promotion and discussion on all media fronts and pushed by fund sponsor, fund research and brokerage marketing mills, all but buries relevant discussion and advice regarding exits and definitive measures to truly protect capital and to truly preserve wealth. Look to any of the media sources to which you regularly turn and judge for yourself the entry/exit coverage balance – or, rather, lack thereof.

Getting to the real sources of wealth destruction …

During the two most recent recessions, as well as during the intervening bubble-building years, how much personal wealth could most investors figure was destroyed, or even forsaken, on account of poor timing of position entries or poor security selection? How many tears were shed and shared at the water cooler on account of being one or two weeks, or one or two months “late” in establishing a position entry?

Consider, then, the absolutely mind-boggling expanses of wealth that were so thoroughly ravaged, so completely obliterated during the “train wreck” that commenced in May 2007 and hit bottom in March 2009 … simply for lack of a real and operable exit plan.

It was not market entries that, for far too many, killed the goose; that, for far too many, swept away the fruits of decades of personal sweat and labor. Rather, it was lack of exits. It was “cars without brakes”.

The bigger diversification picture: start with the forest before moving on to the trees

Most investors are quite familiar with the long-standing “street” mantra rightly touting the merits of the practice of diversification across holdings within a given investment strategy. As Harry Markowitz clearly illustrated many years ago, diversification across holdings within a given strategy can help moderate risk within that particular strategy.

Diversification among investment strategies having varied performance and risk attributes, likewise, can help reduce risk across an investor’s aggregate portfolio of assets. Few investors, though, are nearly so well-versed in diversification disciplines at the investment strategy level – that is, diversification across investment strategy approaches based on strategies’ market and risk participation characteristics.

For many investors, a single, stand-alone investment approach (especially one which carries truly open-ended downside risk) engenders far too much volatility, far too much poorly-compensated risk. And, of course, that simply isn’t good enough.

The bottom line: maintaining a favorable performance profile while limiting capital losses is the name of the game and is as important to aggressive investors as it is to conservative investors.

To illustrate this perspective, a diversified portfolio of strategies might include the following complementary components, in proportions suited to the investor’s risk appetite and in consideration of market participation and risk attributes of the particular strategies used:

Strategies imparting open-ended or uncapped risk to invested capital:

These buy-and-hold approaches take on either of two primary forms. A rather passive approach to management involves the periodic rebalancing of an asset allocation deployed utilizing index-based ETFs. Alternatively, capital can be committed to active money managers who exercise discretion on matters of asset allocation, entry/exit timing and security selection. Except where managers specify exit protocols, downside risk in these strategies is open-ended.

Strategies engendering conditional market participation, with explicit exit protocols to limit risk:

Strategies having explicit exit protocols seek to systematically limit participation in negative price trends – to cut losses short – thereby limiting downside risk to invested capital.

Strategies providing full principal protection:

Truly principal-protected “cash”-oriented strategies are comprised of short-term Treasury securities, FDIC-insured certificates of deposit or FDIC-insured money market funds (up to applicable coverage limits).

Diversification across investment strategies – that is, across the principal protection, conditional participation and open-ended participation spectrum – is where investors and advisors need to extend their thinking, their learning, and attention. It is here where the bulk of return and risk potentials is defined.

Orthodox “buy-and-hold” strategies … buy it and forget it?… Properly setting expectations …

Diversified buy-and-hold strategies, whether in the form of a “passive” ETF asset allocation or committing capital to an active money manager, tend to do well during periods of relative calm and positive price trends, including those punctuated by minor corrections.

But portfolios comprised of diversified buy-and-hold strategies alone, carrying open-ended downside risk, got pummeled from 4Q 2007 through 1Q 2009. And they suffered significantly in 2000-2002 as well.

Accordingly, investors using a buy-and-hold approach alone ought to expect to incur significant capital losses during market “corrections” as well as during stretches associated with deflationary and inflationary extremes – as we may have opportunity to witness in the years ahead. Investors need to treat with deep skepticism sweeping, generic assertions that buy-and-hold strategies out-perform historically or that, by extension, they surely must outperform in the future. The simple reality: buy-and-hold approaches outperform some strategies in some market environments.

From a purely risk-management perspective, the commitment of capital to active money managers is often approached in the same manner as capital deployed in buy-and-hold strategies utilizing passive, index-based instruments. That is, most investors simply do not explicitly and on an ongoing basis limit losses incurred by active managers in their employ. Downside risk is, accordingly, typically open-ended.

Moderation of concentrated exposure to strategies having open-ended downside risk via relatively irrevocably-invested capital (as is the case in truly orthodox buy-and-hold strategies, whether or not they involve active managers) is the key.

Open-ended downside risk to zero, whatever its form or source, must be coolly and plainly identified as such and, then, consciously and deliberately limited.

Play it again, Sam …

Lessons to be learned from the most recent financial crisis? Precisely the same lessons as from the preceding crisis, and the one before that, and the one before that …

Lesson 1:         It is not market corrections and market crashes that kill investors. Rather, it is full participation in market corrections and market crashes that kills investors.

Lesson 2:         With a bit of proper education, quite fortunately, the “participation” matter to a large degree becomes an object of choice. Unfortunately, it is not and cannot be a matter of choice to the uninformed (investor/advisor education is vitally important!).

Lesson 3:         Aggressive and conservative investors alike need to limit capital destruction; properly-functioning brake systems are no less important to Formula I race cars than they are to family sedans.

Lesson 4:         Strategy diversification is an important defining characteristic of a healthy total portfolio. This reality is overlooked, under-rated, misunderstood and regrettably under-appreciated by most investors.

Lesson 5:         Market “corrections” are not historically infrequent events. Get used to it. Plan for it.

Putting brakes on the car …

We’ve written about tools, such as sell stops (here https://etfstore.com/etf-insights/stop-loss-and-sell-stop-limit-orders/ and here https://etfstore.com/etf-insights/protecting-recent-gains/) that can be employed to limit risk in a declining price environment. And we touched on a price trend perspective that can help to frame thinking regarding an exit strategy (here https://etfstore.com/etf-insights/where-theres-smoke-theres-usually-fire/).

Participating in markets with confidence?

• Consider having an exit strategy for a meaningful portion of your investment assets. Coolly, deliberately, consistently and mechanically cut losses short for those assets while letting winners run.
• If you’re not equipped or not inclined to go it alone, find an informed and capable advisor to assist you. And expect the advisor to also require that you learn and that you understand any strategy employed on your behalf.
• Lack of time is no excuse. If the fruits of decades of your labor are on the line and at risk, then make the time.
• Be aware that no well-reasoned investment strategy is beyond the comprehension of the average investor.

Be standing, financially-fit and winning during rounds 8, 9 and 10 of your 10-round lifetime investing bout. Make sure that you have working brakes on your car!