ELF
Capital Management, LLC
(Endowment
Like Fund Management)
April
17, 2009
This is the ELF Capital Management,
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ETF Death Watch: Is This the Next Shoe to Drop?
Have you
heard about the ETF Death Watch? Do you
know what it is? Is this the next big
bearish shoe to drop?
The ETF
Death Watch is a relatively new list comprised of ETF securities that a handful
of analysts and internet bloggers believe could terminate and go into liquidation
over the near term. One web site that I
found, www.investwithanedge.com,
posts a monthly “ETF Deathwatch” describing a list consisting of “U.S. listed
ETFs and ETNs at least six months old with an Average Daily Value Traded for
the most recent calendar month of less than $100,000 per day.” In other words, this site’s editor believes
that any ETF that existed for six months or longer and attracts less than
$100,000 per day in trading volume is destined for the “scrap heap”.
Maybe this
is a fair criteria, and then again, maybe it isn’t. However, my knee jerk reaction is… Who
cares? After specializing in the management
of ETF portfolios for the last six years, I find this kind of information
rather trivial.
Despite my
indifference, the ETF Deathwatch concept has gotten much press in the last several
months. And, I’m happy to say that the
media has done a fair job to alleviate the potential anxiety that the name
conjures up. It is one thing to educate
people and another to foster fear and uncertainty. Haven’t we had enough of the latter?
Yes, the
ETF market is consolidating a little and it is about time. Since I started managing ETF portfolios in
February 2003, the number of funds has grown seven fold. Back then, many of the ETFs that were
available represented the same basket of stocks offered by different fund
sponsors. In other words, competing fund
companies were vying for the same investor dollars. The result was that there were actually less
than 30 index types available and most represented only the broadest market
indices. Oh, how I longed for more
selections to pick from. Then in 2006,
originations of new ETFs types began to explode – creating many new investment
segment opportunities. Now, there are
more types of ETF investment opportunities than the average person might
imagine and it certainly seems as if we have reached a saturation point. In fact, many of the newer ETF innovations have
not seemed to attract enough investor interest to keep them going. Hence, the ETF Deathwatch lists.
So, why
would an ETF terminate? And, what is the
significance of not attracting enough investor interest? Perhaps more relevant than the criteria of
daily trading volume, a more significant measure would be the particular ETF’s
assets under management – the size of the fund.
Given the low cost structure of ETFs, it takes roughly $50 million to
$100 million of underlying assets to cover the cost of maintaining the average
fund – the cost involved to keep it going.
After some period of time, if an ETF is not able to attract enough
investor capital, the fund’s sponsor will have to come to the painful decision
of determining whether to close the fund or continue to subsidize costs. If they believe that the fund size will grow
in the future and have the resources to keep holding on, most sponsors would
rather maintain the fund rather than conceding to a failure. This decision varies from sponsor to sponsor
and the larger fund ones usually have more staying power.
And, what
if you happen to own an ETF that decides to liquidate? Well the worst thing that I could imagine
happening would be to receive a pro-rata distribution of the underlying
shares. Especially if it means receiving
2 or 3 shares each of the stocks that comprised the ETF. Actually, given the cost of liquidating small
numbers of shares, this would be bad!
But, if you liked the fund’s concept to begin with and purchased with a
long term mentality, you could selectively add to those positions and work them
out over time. The more likely scenario
is that the fund sponsor liquidates the portfolio and distributes you back
cash.
But, you
might ask, would the liquidation of an ETF cause the underlying shares to be
sold at depressed prices? Couldn’t I
lose value that way?
Possibly,
but I think the chances are remote. If
an ETF decides to liquidate, it is because the fund is too small to
perpetuate. As such, the liquidation of
the underlying basket of stocks into the market would hardly be expected to
sell at “fire sale” or depressed prices unless they were thinly traded underlying
stocks to begin with. The term “thinly
traded” refers to a stock – or other investment security – that has a limited
amount of interested buyers and sellers and, as a result, transactions occur
infrequently or in small amounts. By the
way, if you are looking at any EFTs comprised of thinly traded securities, you
should be aware that thinly traded securities tend to be much more volatile
than actively traded securities.
Rather than
rely on an ETF Deathwatch list, it always pays to do your homework before
investing. ETF’s are great risk management
tools because they provide diversification from unique events and leave the
investor able to focus more on the “big picture”. I.e., you are less like
to suffer a total loss due to a single company going bankrupt in an otherwise
profitable sector, or some other unique event.
However, there are other risks involved that always need to be
considered: like liquidity risks, leverage risks, or political risks –
just to name a few. To read more about
investment risks, please refer to my earlier article “The Game of Risk” – via
this link.
Market Update
While I
would have liked to report to you that the worst was behind at the end of
February, the global stock markets tested new lows on March 9th. The first 10 weeks of 2009 were among the
worst declines for global stock markets and, quite frankly, the markets had
showed their worst performance since the 1930’s. As I suspected, more hedge fund selling took
the market to levels that were down-right frightening. Thank goodness that the remainder of March
offered greater prospects and April continues to show promise that the worst
may now be behind us. What more could
possibly go wrong?
I don’t
know about you, but with each passing day I am growing more positive that 2009
will end on a very positive note. Many
economic indicators have either begun to stabilize or are actually beginning to
show improvement. This is a darn good
start!
While the
unemployment rate continues to grow, the number of jobs lost each month is
definitely slowing. Historically, this
has been a good signal that the economy is beginning to stabilize. And, as I noted in my November 2008 market
letter, unemployment is the most lagging of economic indicators. Also, other many other economic indicators
are reflecting even more promising results…
The housing
market has begun to show improvement for two months in a row now. This is unusually good and we have yet to
enter the spring selling season for the residential real estate sector. Several of the larger banks have reported
better than expected first quarter results and the markets have begun to
respond in kind. If you remember, it was
the troubles in the banking sector that was a primary factor in this economic
contraction we are now experiencing.
Retails sales have begun to show improvement and the stock market has
begun a significant rally upwards. At
the same time, buying volume in the markets has picked up significantly in this
rally also. These are very good signs.
With
exception to one client who has requested I maintain a specified minimum cash
level in their taxable account, on average, our portfolios are invested
approximately 50% in high yielding bond funds, 40% in US equity funds and 10%
in cash. Over this next quarter, I will
be putting more cash to work, possibly bring cash levels down to 5% by buying
market dips. By the way, we
significantly added to our equity exposure in the middle of March and have been
taken good advantage of this rally. And,
as of this writing, the aggregate value of our portfolios are up better than
15% in April. Let’s just hope this rally
has much more upside to go as more companies report their earnings.
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