ETF Prime Archive

What To Look For In Emerging Market ETFs

As the ETF landscape continues to change and new product innovation remains robust, iShares is looking to further expand its offerings of emerging market ETFs.

The leading ETF provider is expected to introduce two new ETFs:  the iShares MSCI Emerging Markets Financials Sector Index Fund and the iShares MSCI Emerging Markets Materials Sector Index Fund.  One reason that iShares has decided to introduce these new ETFs is the appeal of emerging markets.  In October 2009, net inflows into the iShares MSCI Emerging Markets Index (EEM) and the Vanguard MSCI Emerging Markets ETF (VWO), the two most actively traded and largest emerging market ETFs, accounted for 45% of all net inflows into exchange traded funds.

There is no doubt that international ETFs are becoming more popular and can offer great diversification benefits to a portfolio, but before considering adding more than one, it is equally important to consider concentration and overlap.  

On one end of the spectrum are the broad-based ETFs, like EEM, which diversify assets over a vast array of emerging market equities.  EEM’s top three country holdings are Brazil, China and Taiwan, with 16.2%, 15.7% and 10.6% allocations respectively.  On the other end of the spectrum are the concentrated funds which give exposure purely to one country, like the iShares MSCI Turkey ETF (TUR).  These two ETFs enable one to gain exposure to emerging markets, but in completely different ways and with completely different risk profiles.

A second factor to consider is the holdings of the ETF.  In many emerging market ETFs, single companies can dominate performance because of their relative size and the fact that the ETF uses market capitalization or modified market capitalization to allocate assets.  An example of this can be seen through the iPath MSCI India Index ETN (INP), which has 59 holdings and allocates nearly 23.5% to two companies.  A well-diversified ETF will allocate no more than 10% of its assets to its top holding. 

Thirdly, it is equally important to be mindful of the underlying sector allocation of an emerging market ETF.   Take TUR, for example – the ETF holds 80 different stocks, however it allocates more than half of its asset base to the financial sector.  Another example is the Market Vectors Russia (RSX) which holds 36 different stocks but allocates more than 50% of its assets to the oil, gas and energy sector.

It is important to know what an ETF holds and tracks before utilizing it to build a well-balanced portfolio.  You don’t always get what you think you are getting.

Most Popular ETFs in October

In the month of October, it appears that investors became more bearish on U.S. equities and turned to other investments like international markets, fixed income and commodities for their portfolios.

All together, net inflows for international equity long ETFs was $7.47 Billion for the month which accounted for more than half of the gross inflows for the entire ETF industry.  To take it a step further, of international ETFs, the Vanguard MSCI Emerging Markets (VWO) witnessed net inflows of $2.2 Billion and the iShares MSCI Emerging Markets (EEM) witnessed net inflows of $1.76 Billion.  Together, these two ETFs comprised nearly 45% of the net inflows across all exchange traded products.

U.S. bond funds followed the international markets and were led by inflation protected securities like the iShares Barclays TIPS (TIP), an ETF that is constructed to enable investors to gain protection against inflation, which saw net inflows of $589 million.  Another popular fixed income ETF was the iShares Barclays 1-3 Year Credit (CSJ), which indicated that an appetite for the short-end of the yield curve is emerging.  In aggregate, bond ETFs saw inflows of nearly $3.1 Billion indicating that inflation is a concern amongst Wall Street.

The third asset class that investors fled to was commodities.  In general, as investors become fearful of inflation and the U.S. dollar continues to weaken, commodities become more attractive.  The United States Natural Gas (UNG) and the SPDR Gold Shares (GLD) led the commodities markets in net inflows, with $308 million and $272 million, respectively. 

As for outflows, broad based U.S. equities were the culprits in the month of October with the SPDRs (SPY) leading the way logging net outflows of $2.3 billion, while the iShares Russell 2000 (IWM) lost nearly 8.5% of its September 30 AUM by witnessing a net outflow of $1.1 billion.

ETFs Continue to Innovate

The month of October was a busy month for ETFs as numerous providers launched new ETFs or filed registration paperwork with the Securities and Exchange Commission to launch new ETFs.

iShares filed a registration form to launch the first line of ETFs that hold municipal bonds which have maturities that fall within a specified date range.  The funds are designed to work like traditional municipal bonds in that they return tax-exempt distributions and an investor’s principal investment.  The new fixed income funds will be designed to track indexes in the S&P AMT-Free Municipal Bond Index Series and will distribute its assets to shareholders after the last holding of the fund hits maturity, which is expected to be around August 31 of the year in the fund’s name.

To further extend out the line of fixed income ETFs on the market, bond giant, PIMCO, is expected to launch two new ETFs that track the Treasuries market.  The first is the PIMCO 3-7 Year U.S. Treasury Index Fund (FIVZ) which will carry an expense ratio of 0.15%.  The second is the PIMCO 20+ Year Zero Coupon U.S. Treasury Index (ZROZ), which will carry an expense ratio of 0.15% and track the Treasury STRIPS 20-25 Year Equal Par Bond Index which sells Treasuries and securities at a discount and doesn’t offer interest payments because the bonds mature at par.

In the commodities arena, ETF provider Jefferies has launched two ETFs based on agriculture and industrial metals indexes.  The first is the Jeffries/TR/J CRB Global Agriculture Index Fund (CRBA) and the second is the Jeffries/TR/J CRB Industrial Metals Equity Index Fund (CRBI).  Both ETFs are based upon the Thompson Reuters/Jeffries CRB-EQ series of indexes, carry an expense ratio of 0.65% and hold equity securities. 

CRBA holds international companies that are focused on the production and distribution of agricultural products and equipment, whereas CRBI offers investors exposure to companies that engage and specialize in the production and distribution of base and industrial metals and products around the globe.

Additionally, ETF Securities recently announced that it plans to launch the ETFS Palladium Trust (PALL), which will be the first U.S. listed ETF that holds physical palladium. 

To offer further diversity, the ETF landscape broadened with the launch of the first state-focused ETF, the Spade Oklahoma Index (OOK).  OOK focuses on companies that are domiciled in Oklahoma, carries an expense ratio of 0.85% and donates at least 10% of revenue generated from fees to an Oklahoma charity.  The fund tracks an index of 29 companies, each with a market cap of at least $100 million and is heavily concentrated in the energy sector – more specifically, drilling and exploration, pipeline and oil and gas.

Forget Stocks?

The front page headline on CNBC.com today reads “Forget Stocks: Investors Pile Into Exchange-Traded Funds”.  More and more investors are beginning to realize what we at The ETF Store have known for a long time:  ETFs can provide a more convenient, transparent, cost effective, and tax efficient way to invest across a wide range of asset classes.  With ETFs, you can precisely tailor your portfolio with exposure to equities, bonds, commodities, REITs, currencies and even inverse and leveraged vehicles.  As has been well documented in many of our previous blogs, with ETFs, you can choose between specific market segments, sectors and industries such as energy, commodities, basic materials and industrial metals.  You can even invest in agriculture and precious metals such as gold and silver.

ETFs combine the benefits of stocks and mutual funds into one investment.  Because ETFs trade throughout the day, investors can utilize stop loss/limit orders and options – flexibility that mutual funds can’t provide.  And because ETFs are baskets of securities, investors can minimize company specific risk – flexibility that individual stocks and bonds can’t provide.  With this kind of flexibility, investors are realizing that ETFs can be a much better way to deal with the current turbulent market – they need the ability to stay nimble in this highly complex and risky environment.

ETF assets exceeded $700 billing in September on what continues to be a steep upward trajectory for the ETF industry that many expect to exceed $1 trillion in assets by 2011.  As Sean Crawford, a portfolio manager at Barclays, pointed out in the article, “There are a lot more ETFs in different asset classes than (there) had been in the past, and they’re becoming more nuanced.  It’s become a pretty compelling investment idea.”

VRDWhat?

Variable Rate Demand Obligations – that’s right, Variable Rate Demand Obligations, or “VRDOs”.  To most investors, the name is entirely “Greek” as is the nature of how the instruments work.  But VRDOs represent a holdings play generating a hugely important yield component in municipal money market funds as well as for many institutional cash managers.  And, since November of 2007, they’re also available via an ETF structure.

VRDOs are nothing new.  In fact, VRDOs have been around since the early 1980s and presently comprise roughly $500 billion of municipal bond issues (according to PowerShares, April 2009).

So why haven’t most individual investors heard about these long ago?  VRDOs aren’t common kitchen-table talk topics in most homes or, for that matter, in most investment advisory shops.

First, at $100,000 per unit, VRDOs are not “pocket change” to most investors.  Secondly, the fact that liquidity is available only weekly and only via the exercise of a put option makes VRDOs very much a “hands-on” cash management tool requiring more touch and attention than most investors and advisors are accustomed to.  Further, advisors themselves generally just don’t have a good understanding of what VRDO instruments are, how they work or related risks.

So how can VRDOs be of interest to investors using ETFs?  VRDO ETFs can serve as an attractive source of tax-exempt income in a form that has demonstrated a highly stable NAV through some pretty challenging times since the launch of PowerShares’ PVI in November 2007.  And the industry’s second VRDO ETF, State Street’s VRD, came to market just last month.

Let’s take apart a VRDO to get a sense as to how these instruments work and the characteristics they impart to an ETF.

VRDOs are fixed, long-maturity bonds – typically thirty to forty years – and are issued by municipalities.  But VRDOs carry a put-option feature that allows the holder to put the bonds back to the issuer, or a surrogate liquidity provider, at par plus accrued interest.  Most VRDOs have a 7-day put feature, meaning that the instrument can be put back to the issuer or liquidity provider on a weekly basis (with typically up to five business days for settlement following exercise).

The definitive put feature enables classification of VRDOs as short-term debt or cash instruments by their holders.  This important aspect makes VRDOs eligible for holding in most tax-exempt money market funds where, consequently, they represent an important yield component.

Yields for 7-day VRDOs are reset weekly according to indexes maintained by the Bond Marketing Association.

For municipalities, the attraction of VRDOs is that they enable long-term debt to be financed at short-term rates.  The trade-off for municipalities is the taking on of floating-rate risk and the specter of higher interest rates.

As a practical matter, most municipalities are not operationally well-disposed to manage the ebb and flow of VRDO holders’ exercise of puts and the ensuing need to resell the previously put-tendered VRDOs.  Accordingly, most VRDOs are wrapped with a liquidity assurance supported by a bank-issued letter-of-credit to ensure return of principal plus accrued interest for holders following the exercise of VRDO puts.  Many long-term municipal bonds – including many VRDOs – are also insured against default.

As with all debt instruments, there are liquidity and credit risks to holders of VRDOs which, in the end, could compromise a holder’s ability to recoup interest and principal from the issuer or the market.

VRDO provisions typically enable the immediate retraction of the liquidity put feature by the provider of the bank-issued letter of credit when the rating of the issuer (or, if the issuer is insured, the higher rating of the municipality or its insurer) drops below investment grade (BBB-/Baa3).

Declines in issuer (or insurer, if applicable) to levels below (typically) AA/AA2 or AA-/Aa3 can also trigger a retraction of the put feature but typically only after a 30-day notice period during which time holders may put the bonds to the liquidity provider.

Consequently, the greatest liquidity and credit risk to a VRDO holder would tend to be associated with a rapid plunge in rating of the issuer (or insurer, if applicable) to below investment grade – causing the bond to behave as a non-investment grade, long-maturity debt instrument with yields still reset weekly at short-term rates.

Since the spring of 2008 the Federal Reserve and Treasury have taken steps to enable liquidity providers to pledge many VRDO securities as collateral – greatly reducing liquidity risk for banks providing liquidity wrap features to VRDOs.

As of October 2, PowerShares PVI held $1.02 billion in assets spread across 127 holdings.  PowerShares reports that “PVI’s NAV has stayed within a range of $24.97 to $25.10 from its inception through May 2009” while maintaining “an average price spread of $.01, putting it on a par with some of the most liquid securities in the market today.”  The 30-day SEC yield on October 2 was 0.80% (roughly 1.23% taxable equivalent yield for a 35% federal income tax bracket).

PVI’s expense ratio stands at 0.25% while State Street’s VRD clocks in at 0.20%.

Glass half full? … What you see is what you get but what about what you don’t see?

Municipal VRDOs represent a great innovation that has, so far, withstood severe market stresses of the current crisis as well as recessions and market shocks of the past nearly thirty years.  However, the challenges faced by municipal bond markets today are arguably more acute than at anytime during all of our lifetimes.

Full disclosure of ETF holdings on a daily basis provides a clear picture of the VRDO bonds held in PVI or VRD.  This is an important advantage relative to the severely lagged reporting on holdings in money market mutual funds where publishing of holdings is quarterly and up to sixty days in arrears.  What you see, holdings-wise in the ETF, is what you get.  What you see in the money market fund holdings disclosures is what you had at a single point in time, sometime between three months ago and five months ago.

Quite unfortunately, what you won’t currently find in money market fund disclosures or in VRDO ETF literature is a description of holdings by provider of liquidity support or by bond insurer.  Prospectuses do, in their statements of risk, highlight the fact that insurers are relatively large and concentrated such that financial trouble with one or more of these large institutions could have an adverse impact on holdings in the fund.  Disclosures of a similar kind are noted in regards to VRDO liquidity providers.  And yet, in fund descriptions, single bond and VRDO holdings are listed but distribution and concentrations across liquidity providers and credit insurers are not, even though these are acknowledged to exist and to constitute a material source of risk.

In the end, position disclosure by ETFs is significantly better than what is generally provided by municipal money market funds.  And, for that reason, PVI or VRD can make a very solid case, for the sake of clarity and (at least partial) peace of mind, relative to municipal money market mutual funds.  As with other holdings, including money market funds, moderation is the key.