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Taking ETF Trades To The Next Level

Experienced investors know the theory: ETFs are supposed to trade very close to their net asset value (NAV). And most of the time they do. But this week my PWL Capital colleague Justin Bender and I encountered a glaring exception that could have had expensive consequences. On Monday, Justin and I wanted to sell the iShares U.S. Dividend Growers Index ETF (CUD) in a client’s account. It was a large trade: more than 5,000 shares, which worked out to over $160,000. As we always do before making such a trade, we got a Level 2 quote, which reveals the entire order book. In other words, it tells you how many shares are being offered on the exchange for purchase or sale at various prices. By contrast, a Level 1 quote-the type normally available through discount brokerages-only tells you how many shares are available at the best bid and ask prices. If an ETF’s market maker is doing its job, there should be thousands of shares available at the best price. But we were surprised to find the Level 2 quote looked like this: Source: Thomson ONE Let’s unpack this. As sellers, we looked at the “Bid” column, and the best price (at the top of the column) was $32.61. But we’d be able to sell a mere 200 shares at that price, as revealed in the “Size” column to the left. We could unload another 400 for just a penny less, but after that the prices plummeted. Had we placed a limit order to sell 5,000 shares for $32.60 (one cent below the best bid price), we likely would have seen only 600 shares get sold. But that would have been a minor inconvenience compared to what might have happened if we’d placed a market order. Remember, a market order does not specify a minimum price you’ll accept when selling: it simply tells the exchange you will take whatever is being offered. Assuming a market order for 5,000 shares would have been filled according to the prices above, we would have received as little as $31.65 on the last few hundred shares-almost a full dollar lower than the best bid price. The average price for that market order would have been just $32.23, netting us proceeds of $161,150. Had we been able to sell all 5,000 shares at the best bid price-which is what we’d normally expect-we would have received almost $2,000 more . As you can imagine, we did not place this trade for our client. When market makers take a holiday This lack of depth in an ETF’s order book is very unusual. Even if an ETF is not frequently traded , market makers ensure that thousands of shares are available for purchase or sale at a price very close to NAV. So what was the reason for this anomaly? We can’t be sure, but Justin suspected it was because U.S. markets were closed on Monday (it was Martin Luther King, Jr. Day) while the TSX remained open. CUD is a Canadian-listed ETF, but its underlying holdings are U.S. stocks that were not trading that day: this would have made it more difficult for the market makers to determine the NAV of the fund. Indeed, the lot sizes were so small it’s unlikely they were posted by market makers at all: they may simply have been from individual investors. To test that idea, we got a Level 2 quote for another Canadian ETF that holds U.S. stocks: the Vanguard U.S. Total Market (VUN) . Sure enough, this one showed little market depth as well. Had you tried to sell more than 400 shares (or buy more than about 1,300) you may have seen your order filled at a surprising price. I checked the Level 2 orders for both ETFs again on Tuesday and the situation was completely different. Both funds had 20,000 to 30,000 shares available within a penny of the best bid and ask prices. Lessons learned This was a big trade that most retail investors would never make. But there important lessons from our little adventure that apply to anyone who uses ETFs. First, it’s the most dramatic example I’ve seen for why you should never use market orders . In this situation, a market order would have got you into trouble had you tried to trade as little as $20,000. On a very large trade like ours, it might have been a disaster. Second, avoid trading foreign equity ETFs when the underlying markets are closed. There are several American holidays when the Canadian market remains open, and these are not the days to be making large trades in ETFs that hold U.S. stocks. If you’re making a significant trade in an international equity ETF, it’s also a good idea to pay attention to time zone differences . Finally, if you have a large portfolio, consider subscribing to a service that provides Level 2 quotes. Check with your brokerage to see what is available, because practices vary a lot. Scotia iTRADE provides these free upon request, for example, while RBC Direct Investing and TD Direct Investing offer them as part of their Active Trader programs, and others such as Questrade charge a fee.

Finally A New Airline ETF Prepares To Take Off

The U.S. aviation industry has been on cloud nine since the oil price succumbed to gravity. Moreover, a pickup in the domestic economy, rising cargo demand, a boost to tourism and the subsiding Ebola scare put the industry in the top-performing category. The sentiment around the sector was so bullish that Airlines rocketed to the highest level since 2001 in late December, per Bloomberg . Investors should note that the ETF industry was largely unable to reap the return out of this booming industry as Guggenheim closed the last airline ETF Guggenheim Arca Airline ETF (NYSEARCA: FAA ) in 2013. Prior to that, Direxion Airline Shares ETF (NYSE: FLYX ) had also faced the same fate in 2011. However, to fill the void, a new airline ETF has been filed lately. The fund looks to trade under the name of U.S. Global Jets ETF (JETS) . The Proposed Fund in Detail The passively managed product intends to track the U.S. global Jets Index that considers worldwide airline companies, per the prospectus. The index attaches weight to the companies on the basis of the square root of their average daily volume seen in the trailing three months. The index looks to consider 25 to 40 airline stocks across the market. The product will charge 60 bps in fees. How Does it Fit in a Portfolio? The global aviation industry holds a steady outlook for 2015. The outlook is especially positive for the U.S. economy, with GDP growth gaining momentum. Consolidation benefits, growing travel demand and enhanced ancillary revenues also provide an impetus for growth. Other regions including the Middle East, Latin America & Africa and Asia-Pacific also hold promise. Several Gulf-based airlines continue to build up their positions within the global airline industry. Fleet development should improve over the coming years. Apart from the high demand from the oil rich Gulf nations, a major part of the fleet demand will be driven by China and India, and continuous expansion of low budget carriers around the world. If this was not enough, an unexpected plunge in oil prices turned out to be the real catalyst in propelling the industry. Airline profit outlook depends on fuel prices, the major variable component in the industry. The oil price drop of about 50% seen in 2014 is yet to turn around in 2015. In such a bullish backdrop, the upcoming airline ETF has every reason to be successful, if it gets approval. ETF Competition The road ahead for the proposed ETF is nothing but clear skies. The industry has long been waiting for such a product after the shutdown of the Guggenheim fund. While there are no direct competitors to the product, investors should note that two transportation ETFs, namely the iShares Transportation Average ETF (NYSEARCA: IYT ) and the SPDR S&P Transportation ETF (NYSEARCA: XTN ) have weight in the airlines industry. While IYT puts about 45% of its weight in the airlines, air freight & logistics sectors, XTN places about one-fourth of the fund in them. We expect the newly filed product to cash in on the underlying sector’s allure and find a solid following among investors. Nonetheless, the two transportation ETFs could eat into the proposed fund’s asset base because of the formers’ diversified approach to the transportation sector. Still, investors solely eyeing the global aviation industry would be satisfied by the proposed JETS ETF.

How To Build A ‘Lifetime’ Portfolio (Step 1)

Why obsess about what will happen this coming week? That’s the job of people who get paid by the word. Why not take the road less traveled and ignore 90% of the hullabaloo?!! This is the time of year when most investment writers predict what will happen in 2015. What I’d rather offer, however, is what is “most” likely to happen this year, next year, or the next 10, 20 or 50 years. The short and glib answer is the one proffered by J.P. Morgan when asked what the market would do next. “It will fluctuate,” he replied. That may sound offhandedly dismissive of the question, but in fact there is much truth, and the beginnings of what we now call Modern Portfolio Theory (MPT) in his pithy response! Modern Portfolio has much to recommend it and much to eschew. The basic idea is solid: MPT is a way to optimize your returns based on your acceptable level of market risk. You accomplish this by diversification among various asset classes. If you can remember as far back as January 2014, almost every pundit was predicting a disastrous year for bonds, a so-so year for US stocks to digest the gains of 2013, and sector bets all over the place. I don’t know of a single analyst who predicted that the best-performing sector in the USA would be utilities, yet there they are, proudly atop all markets. The matrix below shows what asset class performed best over the past few years. (These are asset classes, not business sectors, so you won’t see utilities there, but you will see “REITs” and both “High Grade” and “High Yield” bonds, both of which are equally-interest-rate-sensitive.) If you look carefully at every year, you will note the results vary considerably. The same holds true over all other, even more extended, periods. Diversification works! Yes, you will sometimes fail to beat the market, “market” being shorthand to most investors for the “Large Caps” represented by the S&P 500, but over most periods other than an out-and-out bull romp in US stocks that means you are likely to do much better. (click to enlarge) You’ll note, for instance, that in 2000, the large caps, as measured by the S&P 500, were the 3rd- worst performing asset class. In 2002, they were “dead last.” In fact, if you look closely, you’ll note that not once was the S&P 500 the top-performing asset class – including the past 6 remarkable years! Being open to other asset classes is the heart of Modern portfolio Theory, but also the heart of Asset Allocation theory, and the heart and soul of our approach to building a Lifetime Portfolio. In a period of low and declining or stable interest rates, the aforementioned utilities, bonds and REITs often outperform stocks, and with considerably less volatility and heartburn. MPT has also become associated with the notion that, since no one can predict what will happen on any given market day (or week, month, year, etc.) why bother? Why not instead select the asset classes that give you a level of risk you are comfortable with and then get reasonable returns year in and year out? Rigorous academic research shows that you will typically come out ahead after even a few years of doing this than you will if you try to “beat the market.” To oversimplify: if your risk tolerance is low, you might create a portfolio of 40% high grade bonds, 20% REITs, 20% high yield bonds and 20% large cap stocks. If you are comfortable seeking greater returns with greater risk, you might select 10% each of high grade and high yield bonds and REITs, with the other 70% of your portfolio split among US Large and Small Caps, International Large and Small Caps, and Emerging Markets. In any scenario you construct, you want to let your profits grow while feeding the areas you have selected that aren’t doing as well. The usual way this is done is to rebalance at some defined period every year (or less). A variation of this is to pick a certain percentage, say 20%, and if one asset class gets “out of whack” by that amount you add to it if it is down, or sell off some of it if it exceeds the 20% higher than your chosen percentage allocation. If you wanted to hold 20% of your portfolio in large caps, for instance, if that asset class appreciates 20% and is now therefore 24% of your total portfolio (20% of 20 is 4), you would “re-balance” to bring that part of the portfolio back to your risk comfort level, using the proceeds to buy, at lower cost, some of the other asset classes that are “currently” lagging. Does this sound boring? It may be, but which sounds better: a 7.4% annual return over 14 years or a 4.3% return? The bottom line on the above chart is that the simplest asset allocation plan imaginable, 40% high grade bonds, 15% each U.S. large caps and international stocks, and 10% each of small caps, emerging markets and REITs, rebalanced annually, still beat the currently-in-vogue “just buy an S&P 500 index fund; active management doesn’t work” mantra. This “just buy an S&P 500 index fund; active management doesn’t work” fable becomes popular once we are well ensconced in a bull market – and dies just as quickly when the market plummets. As the data above shows, the drawdown for the S&P 500 was -37% in 2008. The biggest drawdown for the asset allocation model (AA) was -22.4%. For comparison, our Growth and Value portfolio, in which we used our own variations on asset allocation described below, was down 18.7% that year. On a million dollar portfolio, the S&P would have declined in value to $670,000; our G&V to $813,000, with less position risk and less volatility. How We Diverge From the Standard Model There are scores of ways you might select an asset allocation model that works for you, from changing the percentage allocations to increasing the asset classes to adding a little sentiment, fundamental, historic or technical analysis. We try not to sway too far from the basic principles of asset allocation. We like to think we are merely adding a dollop of common sense and placing history on our side. We believe: Rebalancing based on the calendar is folly. In the chart above, the results tabulated are for a rebalance once a year at the beginning of each year. Macro-trends evidence themselves any time of the year; both black and white swans swoop and dive based upon events, not calendars. We take action when our asset allocation percentages diverge from our intended allocation. Underlying the concept of asset class investing is the assumption that markets are efficient and that investors act rationally. We might give some credence to the first assumption, but the second is patently false! We believe we can benefit from investor emotions. An example today might be early nibbling at the huge integrated oil companies that can slash CapEx and make a profit on their current properties if the price of oil falls even another 50%. Buy them when they’re cheap; don’t obsess if something you buy for 10 times forward earnings and a 5.9% yield falls so that you “might have” bought it at 8 times forward earnings and a 6.4% yield. At times when interest rates are rising, we might be as little as 0-20% in bonds and REITs combined. When falling, we might be at 60-70%. We are dynamic, not static. [This is a very big divergence from the academics’ idea of asset allocation. That’s their way; this is our way.] “To every thing there is a season.” We augment our asset class investing to take advantage of the fact that small caps tend to enjoy the bulk of their outperformance in the first two quarters of the year, that pre-presidential election years are often excellent market years as both parties crank up the PR machines, etc. We don’t chase any single asset class like S&P 500 large caps, REITs, small caps or any other. Nor do we obsess if we fall behind in comparison to any one asset class for an extended period. We maintain our discipline and do our best to grow our portfolios steadily. Sometimes we have setbacks, sometimes we are out of sync, but we’ve always bounced back. In Part II, I will discuss the asset classes that are historically most and least correlated with the S&P 500 (U.S. large caps) and with each other, so you can begin to consider how you might construct a Lifetime Portfolio that works for you. I’ll also discuss the types of mutual funds and ETFs our research and analysis leads us to, including examples and some of our specific current holdings. As Registered Investment Advisors, we believe it is our responsibility to advise that we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice. Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund one year only to watch it plummet the following year. We encourage you to do your own due diligence on issues we discuss to see if they might be of value in your own investing. We take our responsibility to offer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.