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ETFR 4 Natural gas ETF in the works Victoria Bay Asset Management, the folks that brought the $900 million US Oil Fund (AMEX: USO) to market, has filed papers with the SEC for an ETF tied to the price of natural gas. The US Natural Gas will, like other commodity ETFs, buy natural gas futures contracts on the New York Mercantile Exchange and roll them one month to the next, while investing collateral cash in Treasuries. Victoria Bay’s isn’t the first natural gas ETF in development. Barclays Global Investors is also planning such a fund. Claymore adds three quirky and four style ETFs In early April, Claymore Securities added seven ETFs to its ever-expanding lineup. As usual with this ETF provider, three of the products are quirky, four are domestic style boxes. The style ETFs include: BIR Leaders Mid-Cap Value (AMEX: BMV); BIR Leaders Small-Cap Core (AMEX: BES), Q1 Expert Portfolios Amidst much market turmoil, the major indexes were either flat or down slightly as the first quarter closed. The Dow was down 0.9%, while the S&P 500 and the Nasdaq Composite gained 0.2% and 0.3% respectively. (For a fuller picture of first quarter performance, see March Madness, this issue page 7.) The best performing portfolio for March was Saddle River, up 1.98%, and the best performer for the quarter was UPDATES Great Companies Large-Cap Growth (AMEX: XGC), and Zacks Mid-Cap Core (AMEX: CZA). The remaining three ETFs are: • BIR Leaders 50 (AMEX: BST), which tracks the BIR Leaders 50 Index. It holds 50 common stocks and ADRs listed on US exchanges and covered by Best Independent Research, LLC, a consortium of the following five independent research companies: Ativo Research, Channel Trend Inc, Columbine Capital Services, Ford Equity Research, and Thomas White International. • Ocean Tomo Growth 6 PMMA Momentum, up 3.34%. Newcomer Saddle River Capital Management rebalanced its portfolio, as scheduled March 1, and now holds RSP at 17.5%, IWR at 15%, IWM at 10%, EFA at 40%, EEM at 10% and XLB at 7.5%. All the portfolios invested $1 million January 1, 2007 in no more than ten ETFs. Advisor Ret (%) Ret (%) Ret (%) Q1 March 2006 2005 XTF 80 Growth 1.59 2.63 17.96 8.80 PMAA Momentum 1.94 3.34 19.71 9.90 Saddle River 1.98 2.05 16.78 13.16 S&P 500 1.00 0.30 15.80 4.84 Russell 2000 0.63 1.95 18.40 4.59 EAFE 2.90 4.05 26.30 13.34 1 the next day in China. You can see what Tom and Diya are driving at: If the underlying Chinese stocks only dropped 5.2% over two days, how could US investors sell with prices down 9.9%? The argument is wrong in many ways, and this is one case where a picture is definitely worth a thousand words. The chart on page nine shows the performance of three iterations of the FTSE Xinhua 25 Index trading across three different markets: • The underlying index, trading in China • FXC, the UK-based ETF tied to the index • FXI, the US ETF Where to begin? The easiest place is with the assertion that the Chinese market “fell another 3.1% the next day.” Indeed: The underlying index closed down 3.1% the next day in China. But as you can see in the chart on page nine, the market opened down 6% from the previous close, or just 1.77% off of the close of the US market (a full 4 hours and 45 minutes earlier). If you look at that chart, the trend lines are almost comically perfect: a seamless, connectthe-dots painting of shifting investor sentiment. It looks to me like, well, stock market trading in action. The article drove me crazy because I’d spent a long time over two days with Tom and Diya in the days before the article was published patiently explaining some of their misunderstandings of how ETFs work. And after all of that, they ended up posting something that really warrants a retraction. If you’re going to compare today’s US-listed ETF close with something, try tomorrow’s live opening of the Chinese index. It seemed to be a case of the story writing itself, with the facts being lined up behind that initial idea, instead of the other way around. The Facts • On February 27, funds like FXI (and, indeed, much of the market) went into a downward spiral. Here’s that quote again: “One ETF managed by Barclays Global Investors that tracks the Chinese stock market closed the US day on Feb. 27 down 9.9% even though the index it was tracking had fallen just 2.1% during Chinese trading hours. That index fell another 3.1% the next day in China.” • That first line is meaningless. The market crash (and everyone knows international markets have increasingly moved in lockstep) did not start to happen until early afternoon in the US, hours after the Asian markets had closed. • The second line is a fumble at best, and a ham-handed hand at making the data fit the story at worst. Focusing on the close of Chinese trading the next day, rather than the open, is simply a fundamental mistake. Quick quiz: “How do free markets work?” Answer: “They price in the relevant information.” If someone sees what they think is an inefficiency on the sell side, they BUY BUY BUY. It happens every day in every market in various degrees. Only in the wake of a market sell-off and settling is anything clear. Effectively, the sellers of FXI were caught that day in the same place as intraday sellers of DIA, SPY or any one of a thousand individual stocks: the markets hit bottom around 3pm EST, and if you sold then, you lost out. The US equity markets recovered some territory 9 ETFR • May 2007 5
ETFR 5 between 3pm and 4pm that day, and that recovery continued when the Chinese market opened four-and-a-half hours later. You can see that clearly in the trend line of recovery in the chart below. The great irony here is that there is far more defined, gameable risk in a traditional mutual fund that prices its net asset value once a day. Say an ordinary investor sends in money to his fund company to purchase shares of the AA Active China Fund at the close of the Chinese market. He gets those shares priced at the NAV. The next day, the US market trades up 3%. A hedge fund manager can practically be certain that the Chinese market will follow the US market up when it opens four-plus hours later. But because the fund’s price is based on the previous day’s close in China, he can still buy shares at yesterday’s NAV. Essentially, for a fund that does not “fair value price” (and most of them don’t), the odds are very strong that hedge fund managers and other “fast money” can swoop in and steal that return from the rest of the funds shareholders. That, like expenses, is something knowable; the live direction of trading is not. I’ll take my chances in a volatile market to bet on the losing team after the game is over any day. As a result, a long-only investor in a traditional mutual fund is much more likely to get damaged by hedge fund trading around volatility than an ETF investor. The only ETF investors who were damaged in February were those who panicked and bailed out intraday on February 27. Traditional fund investors, on the other hand, could (and probably did) get hit by a bunch of shares being bought on the cheap based on stale pricing (assuming no fair value pricing is in effect). To add insult to injury, traditional mutual fund shareholders will have to pay capital gains on all the fund activity caused by buys and sells based on this late-trading strategy. Pct Change (%) 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% -10.00% -12.00% The Malaysia Example Tom and Diya’s argument, while wrong, is not new. The poster child for “failed ETF pricing” is the iShares MSCI Malaysia ETF (AMEX: EWM). In 1997, during the Asian financial crisis, the Malaysian markets shut down to international investors. Malaysia’s politicians, furious at currency speculators like George Soros, also halted trading in the Malaysian ringgit. For US investors, EWM quickly became the only game in town. If you had bigtime Malaysian exposure, EWM was the only way to hedge it. Effectively, the ETF became the price discovery mechanism not only for the Malaysian market, but also for the Malaysian currency. As might be expected, the ETF traded at wild premiums and discounts to the closed-off Malaysian markets, with discounts reaching 20-30%. But while people decried these differences, the ETF was actually doing its job: it was pricing the market as accurately as possible, given investor sentiment at the time. FTSE China Trading Feb 27 - Feb 28 16:15 21:00 0:30 3:30 7:30 11:30 15:30 19:30 23:30 3:00 6:30 10:30 13:30 Trading Hours (EST) Conclusion It seems to me that the only case Tom and Diya could even try to make about trading on February 27 is that ETFs trading outside the live market for the underlying stocks may have more volatility, due to thinner overall trading. But what’s the suggestion there? Shut down after-hours trading? Don’t allow live trading on foreign markets in the US? It’s lunacy, especially when the obvious alternative (openend funds) has more knowable downside to investors. ETFs are only a reflection of the markets they represent. In effect, you end up blaming the market for its own volatility. The ETF structure didn’t fail, as Tom and Diya seem to suggest. In fact, the opposite is true: ETFs reflected prevailing market sentiment at that time. There happened to have been more sellers than buyers. If you had the guts to take the other side of that trade, instead of selling in panic, you made money. That’s how the market works. That’s arbitrage. That’s capitalism. The truth is that ETFs have brought MORE liquidity, MORE transparency and MORE stability to the markets. You can short ETFs, even in a precipitously falling market (unlike ordinary equities). And if a ton of short volume comes in, the ETF shares theoretically have to be created to cover those loans, necessitating the purchase of the underlying and actually flattening the downward volatility. In short: good intentions, bad execution. The great irony is that, like the general tone of current affairs, the authors have really turned reality on its head to make the very strength of ETFs into their weakness. They’re simply barking up the wrong tree. Take on ETFs for being too narrow? Sure. Do some exchange-traded products have ill-considered structures and active-like costs? Absolutely. Those criticisms you can level. But don’t take on the free markets. FTSE China Local Market FXC China ETF London FXI China ETF US China Market: 21:00pm – 3:00am London Market: 3:00am – 11:30am US Market: 9:30am – 16:15pm ETFR • May 2007 9
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