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Old 12-20-2003, 03:24 PM   #1
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ETFs

Anyone utilizing ETFs (exchange traded funds)? What are pros/cons for this investment vehicle?

Thx,

Doug
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Re: ETFs
Old 12-20-2003, 03:55 PM   #2
 
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Re: ETFs

Right now most of my money is in SPY and QQQ ETFs

Pros:

Cheap! Low expense ratio

Very liquid. I don't "Wheel and deal". I plan to hold them as long as it is feasable and profitable. Hopefully at least a couple years. But when I want to get rid of them I won't be upsetting any mutual fund or the shareholders of said fund.

There is a slight advantage vis a vis funds having to do with year end cap gains distributions but it's not anything worth counting

Cons:

Most of them are rather obscure and technical in nature. Possible arbitrage problems in a market -meldowm situations.(Dont ask me to explain that in laymans terms. I barely undersdtand it myself) But since everything worked just fine in the 9/11 scenario I dont' worry about their survivability. Strictly a <1% situation in my book

Thinly traded ETFs can theorectically be hard to offload in an emergency and can also have a wide dfference between the bid/asked price. SPY, QQQ, DIAs are traded in very large volume so they do not have those problems
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Re: ETFs
Old 12-20-2003, 04:24 PM   #3
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Re: ETFs

I like them! You can trade them in a regular low-fee brokerage account, no loads front or back, buy them on margin if you want, short them, etc. Obviously, you'll get a commission hit when you trade, which funds don't impose if you buy direct, but these days the trade-off is small.

What I like best about them is the associated derivatives. You can hedge your bets with puts, for example.
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Re: ETFs
Old 12-21-2003, 09:29 AM   #4
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Re: ETFs

Quote:


Possible arbitrage problems in a market -meldowm situations.(Dont ask me to explain that in laymans terms. I barely undersdtand it myself) But since everything worked just fine in the 9/11 scenario I dont' worry about their survivability. Strictly a <1% situation in my book
Ok. don't explain it. But I thought that arbitrage was the reason that the prices tracked the NAV so well. If there is a difference, then the arbitrage traders buy the fund, sell the stocks or do the opposite. The arbitrage (or possibility of?) keeps the bid/asked price tracking the underlying basket of stocks.

Wayne
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Re: ETFs
Old 12-21-2003, 01:32 PM   #5
 
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Re: ETFs

Ok. don't explain it. But I thought that arbitrage was the reason that the prices tracked the NAV so well. If there is a difference, then the arbitrage traders buy the fund, sell the stocks or do the opposite. The arbitrage (or possibility of?) keeps the bid/asked price tracking the underlying basket of stocks.

Wayne


Ok, sounds fine with me. I have only heard this "arbitrage problem" thing spoken of as a posibility not a forgone conclusion. And then only in highly non-standard panic type situations. Like I said, I dont look for it to ever be a problem
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Re: ETFs
Old 12-22-2003, 05:22 AM   #6
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Re: ETFs

Since ETFs are essentially closed end funds, it is possible for them to trade at a discount to net asset value, and there is no theoretical limit on this discount. From a practical standpoint, however, at least the larger ETFs are highly liquid and trade very close to NAV. In any case, a discount would probably be very short-lived and would not affect anyone who was simply holding the ETF.

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Re: ETFs
Old 12-22-2003, 07:53 AM   #7
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Re: ETFs

Quote:
Since ETFs are essentially closed end funds, it is possible for them to trade at a discount to net asset value, and there is no theoretical limit on this discount. From a practical standpoint, however, at least the larger ETFs are highly liquid and trade very close to NAV. In any case, a discount would probably be very short-lived and would not affect anyone who was simply holding the ETF.
In some respects, yes. However the ones I am familiar with, like SPY, have share creation/redemption mechanisms that allow exchange of shares and the underlying basket of shares. Now the dollar amounts to do this are very large, but it does provide a way to make money if the price drifts from the NAV.

I think that the creation/redemption mechanisms distinguish them in a very key way from closed end funds. Maybe there are other forces and mechanisms at work also, but that is the one I have read about. This is certainly not a complete or authorative statement, only my understanding.

I would like to understand the possible problems in panic type situations if anyone is familiar with them.

Wayne
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Re: ETFs
Old 12-23-2003, 04:31 PM   #8
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Re: ETFs

I owned some S&P 500 Index Shares (SPY/"Spiders) at one time and wasn't aware of the feature mentioned by Wayne that would apparently allow an owner of SPY shares to convert them to the stock of the 500 underlying companies. A little rough estimating indicates that it would indeed require a huge investment in SPY shares to do this.

Say that the average price per share of the 500 companies in the S&P 500 Index is $30. So, to purchase a round lot of 100 shares of each of these companies would cost on the order of $1.5 million. SPY shares currently trade at about $109, so a person would have to own quite a few shares before conversion became practical.

This does not mean, however, that a conversion provision is worthless. The fact that very large investors could and would convert if a large discount to the net asset value developed, would prevent that from happening.

One way to "play" covered index arbitrage is this. Typically, the price of stock index futures is at a premium to the current value of the index. So you buy, say, 1,000 shares of SPY selling at $109 (cost = $109,000), and enter into a futures contract to sell $100 times the S&P Index, 6 months from now, at a value of, say, 1,150 (as determined by the market for futures contracts). In other words, you are contracting to sell your claim on $100 times the value of the S&P Index -- whatever the index value may actually be 6 months from now -- for $100 x 1,150 = $115,000. Thus, for an investment of $109,000, you have guaranteed yourself a profit of $6,000 in six months, representing a guaranteed annualized return of about 11% on your investment (not counting transaction costs).

Unfortunately (from the standpoint of people searching for a free lunch) and fortunately (from the standpoint of economists interested in maximizing the benefits to society as a whole) market efficiency has now made the premium on stock index futures so low that covered index arbitrage pays about as much return as an investment in Treasury Bills. In summary, my advice to small investors is to not mess with it.
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Re: ETFs
Old 12-23-2003, 07:27 PM   #9
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Re: ETFs

Well, I didn't mean to suggest that us average investors could do it. But from the prospectus, which is at http://www.amex.com/etf/dataDwn/SPY_ad.pdf I quote:
Quote:
The Trust issues and redeems SPDRs only in specified large lots of 50,000 SPDRs
or multiples thereof referred to as "Creation Units." Creation Units are issued by the Trust
to anyone who, after placing a creation order with ALPS Distributors, Inc. ("Distributor"),
deposits with the Trustee a specified portfolio of Index Securities and a cash payment
generally equal to dividends (net of expenses) accumulated up to the time of deposit.
Redemption is also described. But SPDRs currently sell for $109.73, so one creation unit is $5,486,500. Not for the average investor! But as you say, the fact that someone can do it prevents the NAV and trading price from drifting apart.

Wayne
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Re: ETFs
Old 12-24-2003, 04:21 AM   #10
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Re: ETFs

To clarify my previous concluding remark -- I did not mean to imply that small investors should avoid ETF's, just that they shouldn't attempt to use them to make a "guaranteed" return through covered interest arbitrage. (I first learned about it back in the '80s, when it produced a higher return, and used this opportunity to recall the mechanics of how to do it.)

Another ETF to consider is Vanguard's total U.S. stock market index fund, called "VIPERS." This and the other more prominent ETFs have very low expense ratios -- on the order of 0.10% per year. In accordance with the principle of no free lunch, however, it is not true (as somebody posted elsewhere) that they charge no expenses.
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