“Do you know what you’re investing in?” – I ask this question of people all the time and what I find most often is that the answer (in the end) is “No”. Understanding specific financial instruments and how they work can be considered pretty boring, but it is crucial to your portfolio’s success. If we don’t understand how a financial instrument, like a “stock” is constructed, we cannot know the risks of owning that instrument.
So, I am always on the lookout for useful tools for our members that explain financial instruments and how they work. And this week, Bloomberg.com has published some “must see TV” on ETF’s.
The ETF Files: How the U.S. government inadvertently launched a $3 trillion industry
The ETF Files: Interactive Creation / Redemption Animated Tool
ETF’s or Exchange Traded Funds have become ubiquitous in our members’ portfolios over the years, particularly since the financial crisis. There are all kinds of good things about this “financial democratization” – lower fees (these funds are managed by a computer and are most often tied to an index already in place), a clear price (unlike a mutual fund, shares are traded like a “stock” and are priced continuously) and high liquidity (lots and lots of people trade/invest in some of these funds and so the markets for them are very “deep”, meaning that if you want to sell, on most days, there’s high likelihood of a willing buyer at a fair price.).
One important reason for Framework Investings as “ETF owners” to understand exactly what’s in an ETF is so that we can understand the risks that come to us from holding this instrument. Once we understand that, we can effectively manage that risk or at least be aware of it when trouble shows up.
Let’s take a quick example of what happens when we don’t know what’s really in our portfolios. Consumers believed, quite wrongly in the end, that Money Market Funds were a safe “cash-like” asset. They found out otherwise in September 2008 when a few of these “safe” funds “broke the buck” – meaning that their asset values fell below $1 / share. Redemption pressures were so strong that, until the U.S. Treasury Department stepped into backstop all money market funds, some investors realized a loss when they redeemed from funds that had broken the buck, and one fund was forced to liquidate — meaning that all its shareholders had to realize a loss.
Investors saw money market mutual funds as riskless deposit instruments, when in fact, nearly all of them held bonds of some sort (that’s how owners received higher interest rates than a conventional bank deposit), and an unlucky few held bonds of Lehman Brothers. These funds had losses that were borne by their investors.
Another important reason to understand exactly what’s in an ETF is so that we can use them more effectively for hedging. As we discuss in IOI 103 when talking about hedging strategies, ETFs can provide less expensive, albeit imperfect hedges for individual stock positions.
When I was working for a hedge fund with a large Energy sector exposure, I did a lot of hedging using options on the Energy Sector SPDR, XLE. The Energy stocks the fund owned were not all components of XLE, but their movements had a high enough correlation with the XLE to make options on the ETF a good hedge.
The two articles above provide good facts on how ETF’s are structured and, as a result, how they actually work. What you may realize while reading through is that ETFs are actually derivatives; they are financial instruments whose value is derived from the value of an underlying asset — the textbook definition of a derivative. At investment banks, ETFs are termed “Delta 1” derivatives because unlike options, their prices change in a 1:1 relationship to the price change of the underlying asset(s).*
While it may seem like a stretch, I also think of stocks as derivative instruments. Of course, stocks represent an ownership claim on a company, but in a sense, they are a financial instrument whose value is derived from the value of the cash flows generated by a business. In the same way that an intelligent investor understands the components driving value for an ETF, an intelligent investor should understand the drivers of cash flow at a business. The ability to understand cash flow drivers at a company is precisely what the IOI 102 course on Valuation and our Valuation master class are both all about. An investor can never shield themselves from market price fluctuations, but they can decrease their investing risk by simply understanding the values of the assets they hold.
NOTES:
* Alumni of IOI training programs and others who have read about options know that options are financial instruments whose “delta” is not equal to 1.
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