ETF Prime Archive

Stop-Loss and Sell Stop-Limit Orders

As the investment community continues to trumpet the many potential advantages of exchange-traded funds – including lowers costs, tax efficiency, and transparency, one advantage that is often overlooked is the ability to place stop-loss or sell stop-limit orders on ETFs.  Because ETFs trade intra-day on the exchanges like stocks, investors can utilize tools that aren’t available with mutual funds.

A stop-loss order is simply an order placed with a broker to sell a security when it crosses below a certain price threshold.  For example, if an ETF share is purchased for $25.00 and a 10% stop-loss order is immediately placed on the share, the broker will execute the sale of the share at the market price when the ETF trades at $22.50 or lower.  Note that a stop-loss order doesn’t guarantee the trade will be executed at $22.50, only that the sell order will be triggered.  If the price of the security is deteriorating rapidly, the sale could actually be executed at a lower price.

A sell stop-limit order is similar, except that more precise control can be exercised over the sale price.  If a stop is entered at $22.50 with a limit of $22.00, the sale will be triggered once the ETF trades at $22.50 or lower, but the trade will only be executed if the broker can sell at a price of $22.00 or better.  This allows the investor to ensure they receive a certain price or better for the ETF if the sale order is triggered.  It’s important to note that if the price of the ETF quickly gapped down below $22.00 before the sale could be executed, then the sell order would not be filled (versus a stop-loss order where the order would be filled regardless of the price once the ETF hit $22.50 or lower).

While these types of orders are not for everybody and wouldn’t come into play for traditional buy-and-hold investors, these can be useful tools for more active approaches – particularly in the type of market we’re currently operating in.  After a run-up of nearly 50% in the S&P 500 and given the still uncertain economic environment, many experts are concerned that there could be a significant pullback.  While no one knows for sure what will happen, ETF investors can utilize stop-loss and sell stop-limit orders to ensure they lock-in profits and limit severe drawdowns in the event there is a sharp market decline.  In contrast, with mutual funds, sales can only be executed based on the net asset value of the shares of the fund at the end of each day and also require investors to continuously monitor market events.  With ETFs, investors can tend to their busy work and family schedules or go on vacation and have confidence that downside protection is in place.

What is a Unit Investment Trust?

The first exchange traded fund to come to market, and today the most actively traded ETF, the SPDR S&P 500 ETF (SPY), was structured as a unit investment trust (UIT).  In simple terms, a unit investment trust is an investment vehicle which purchases a fixed portfolio of securities, such as municipal or government bonds, mortgage-backed securities, common stock or preferred stock.

The way they work is that the trust purchases the securities and then markets and offers shares of the trust to investors through brokers.  Unit holders of the trust receive an undivided interest in both the principal and the income portion of the portfolio in proportion to the amount of capital they invest.

UITs offer transparency in that their portfolios are selected at the time of deposit and they don’t change until the trust matures.  However, holdings in the trust can be eliminated under extreme circumstances such as deterioration in credit quality, fraud or other irregularities.  They are tax efficient and offer low costs because there is little to no trading activity in the trusts.

To further dissect a UIT, take a look at the above mentioned SPY.  This security represents ownership in a long-term unit investment trust that holds a portfolio of common stocks designed to track the performance of the S&P 500 Index.  In addition to capital appreciation, owning shares of this trust entitles the holder to receive proportionate quarterly cash distributions corresponding to the dividends that accrue to the S&P 500 stocks in the underlying portfolio, less trust expenses. 

To sum it up, a UIT offers many of the same benefits and characteristics of a run-of-the-mill ETF, but one owns shares of the trust and not that of the actual basket of securities.

ETFs Continue to Remain Hot

As the European exchange traded fund (ETF) market continues to glimmer, one of the world’s largest banking and financial services organizations, HSBC, has entered the arena with the introduction of a FTSE 100 Index Fund listed on the London Stock Exchange. 

The HSBC FTSE 100 ETF (HUKX) is designed to track the performance of the FTSE 100 Index, domiciled in Ireland, registered for sale in the United Kingdom and carries an expense ratio of 0.35%.  The newly created ETF will be managed by HSBC Global Asset Management and HSBC Global Markets will ensure liquidity as a market maker.

HSBC is no stranger to the ETF universe, as it is already involved in the ETF markets in Asia through its subsidiary Hang Seng Bank and is a well established provider of services to the global ETF industry as a custodian and market maker. 

To not much surprise, the move into Europe by HSBC was inevitable.  After all, Europe is the leader of the ETF world offering 753 different ETFs of the 1,768 available on the global markets.   Additionally, ETF assets under management in Europe rose 28% in the year to July as compared to 17.2% in the United States. 

As for ETFs in general, total assets globally hit $862 billion in July, 21% above the start of the year and is one reason HSBC plans to leverage its global capabilities and to extend its ETF business across Asia, Latin America and the Middle East.

An Uphill Battle for Commodity ETFs

Over the past few weeks, things have become a bit difficult for commodity-focused exchange traded products (ETPs) as Barclays Capital announced that it is halting the issuance of new shares in the iPath Dow Jones-AIG Natural Gas ETN (GAZ).

GAZ became the third commodity focused exchange traded product to stop issuing shares, joining the United States Natural Gas Fund (UNG) and the PowerShares DB Crude Oil Double Long ETN (DXO).  After the sponsors of UNG announced they were suspending the issuance of new shares, many investors seeking exposure to natural gas fled to GAZ, resulting in significant inflows.  In fact, at the end of July, GAZ held nearly $127 million in assets but closed on August 20^th with $187 million in assets, a jump of 47%. 

With the increasing popularity of these commodity focused ETPs , the Commodity Futures Trading Commission (CFTC) is analyzing these indexes under a microscope and issuers are worried that the CFTC will impose strict position limits on commodity holders, which may make it difficult to track their benchmarks.  Attention to these funds was especially drawn after the commodities market was accused of manipulating futures prices and market fluctuations. 

The issuers of these funds are haltering new shares to cap their size which prevents them from being in a position where they would be forced to redeem shareholder positions to meet new CFTC caps.

To take it a step further, the CFTC increased regulations by ruling that the PowerShares DB Comodity Index Fund (DBC) and the PowerShares DB Agriculture Fund (DBA) are no longer exempt from position limits in wheat and corn.  The CFTC is limiting the funds to 13,500 Chicago Board of Trade corn contracts and 5,000 wheat contracts in any non-spot month, and an all months combined limit of 22,000 corn contracts and 6,500 wheat contracts.

As for the future of these ETPs, Barclays has openly stated that more of its iPath ETNs may join GAZ, and it appears that regulatory agencies will continue to impose stringent limitations on the commodities industry.

ETFs Pressuring the Fund Industry

The exchange traded fund (ETF) world has emerged with full force and continues to put pressure on the mutual fund industry.

ETFs are so attractive because they have opened up a new panorama of investment opportunities for all types of investors.  They enable investors to grab broad exposure to stock markets of different countries, emerging markets, sectors and styles as well as fixed income and commodity indices with relative ease on a real-time basis and at a much lower cost than other forms of investing.  They can be traded intraday while enabling investors to remain diversified and have full transparency.  Additionally, they are so versatile that they can be bought on margin, are lendable, can be bought and sold at market, limit or as stop orders.  They don’t have any sales loads and carry expense ratios in the range of 0.05% to 1.60%. 

From a broad market perspective, these aforementioned low expense ratios make it feasible for investors to remain diversified while grabbing exposure to the three major U.S. indices.   For example the PowerShares QQQ (QQQQ) which has an expense ratio of 0.2% and enables one to grab exposure to the technology heavy Nasdaq.  Additionally, one can grab great exposure to the Dow Jones Industrial Average through the DIAMONDS Trust Series 1 (DIA), which has a low expense ratio of 0.17%.  Lastly, the S&P 500 can be accessed through the SPDRs (SPY), which has an expense ratio of 0.09%.

Another great characteristic of ETFs is that they have a unique daily creation and redemption process which enables them to keep their market price in line with its underlying Net Asset Value.   They can only be redeemed “in-kind” which is beneficial because it doesn’t create a taxable event. 

Just to get an idea of how the ETF world has emerged here is a brief landscape of the industry.  There are over 1,677 global ETFs with over 3,000 listings from 90 providers on 43 exchanges around the globe.  Additionally there have been 109 new ETFs that have came to market this year and plans to launch an additional 756 new ETFs are in the making. 

So why should mutual funds feel threatened?   A study done by New-York based research and consulting firm Novarica indicates the following predictions for the investment industry:

• The number of mutual funds will decline from 8,022 in 2008 to 4,237 in 2015 with assets declining from $9.0 trillion to $6.75 trillion over the same period
• The number of ETFs is expected to increase to 2,618 by 2015, with assets more than doubling to $1.15 trillion
• The number of actively managed ETFs will increase to 325 by 2015, currently there are ahandful of them offered by ProShares and Grail Advisors.

To add to these predictions mutual funds have continuously been seeing outflows of assets while ETFs have been witnessing an inflow of assets.  Additionally, as investors become more educated about the markets and the plethora of investment tools at their disposal, ETFs will continue to grow and remain attractive.  Lastly, ETFs are finally starting to make their way into the 401(k) world, which will just be icing on the cake.

To conclude, as investors become more active in managing their portfolios and seek ways to protect themselves from market downfalls and cut risks, the underlying characteristics of ETFs will continue to enable them to grow and be an attractive tool for investors.