Hennion and Walsh President, Bill Walsh, tells CNBC viewers that while tax free municipal bonds may not be a sexy investment, they can be an appropriate investment, along with the reasons why.
Parsippany, NJ – Hennion and Walsh Asset Management President Bill Walsh spoke with CNBC host Mark Haines and his viewers about the benefits tax free municipal bonds can offer the individual investor looking for a steady income stream. Walsh joined Haines as part of CNBC’s Financial Advisor Network with information on what to look for when thinking about tax free municipal bonds, especially when there is so much bad economic news about city and state government tax revenues being off.
“I think you have to take a look at what the underlying security is before buying tax free municipal bonds. Grouping all tax free municipal bonds into one class is not advisable. You have to look at what you’re buying and what’s paying it. Normally, there are two or three types of bonds that are more secure than possibly others and looking at the underlying security helps to determine their safety,” says Bill Walsh, President and co-founder of Hennion and Walsh, a passionate advocate for individual investors.
Walsh goes on to explain the three types of tax free municipal bonds that can offer the most safety. The full segment can be viewed on the Hennion and Walsh blog, Portfolio Strategies News, at http://www.portfoliostrategynews.com/?p=424 .
Hennion and Walsh, a full service brokerage firm specializing in municipal bonds, was founded in 1990 by Richard Hennion and Bill Walsh. Their mission is to be the individual investor’s fiercest and most passionate advocate. Investment guides, webinars, seminars and online content are just some of the ways they help investors become better informed and make better investment decisions. The firm has built its reputation on developing strong, mutually beneficial relationships designed to last a lifetime, serving over 15,000 clients with brokerage accounts and managed portfolios. They are committed to providing individual investors with the institutional-quality service and guidance they believe they are entitled to.
The firm also developed and manages the SmartGrowth Mutual Funds, three risk-target-based mutual funds. All three funds have been named to the Category Kings list in October 2008 and January 2009 in the all cap core category as reported in the Wall Street Journal (October 2, 2008 and January 5, 2009 editions). Hennion & Walsh’s Chief Investment Officer, Kevin Mahn, manages the portfolios of SmartGrowth Mutual funds which utilize ETFs (Exchange Traded Funds) as a core part of their investing strategy. For more information, read the ETF Insights Newsletter (link) or visit http://www.smartgrowthfunds.com.
Mutual fund investing involves risk, including loss of principal. There is no guarantee that a Fund will meet its objective.
Please carefully consider a Fund's investment objectives, risk factors, charges and expenses before investing. This and other information can be found in the Fund's prospectus, which may be obtained by calling 1-888-465-5722. Read carefully before investing.
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Do you know where the cash in your brokerage account goes each night? If not, start asking. Every brokerage firm offers some sort of cash-management account, or CMA, which generally allows you to trade securities, write checks, and use a credit or debit card -- all via a single account.
Minimum balances can be high, running well into the thousands of dollars, but many investors find the convenience of combining several types of account features in one place worth it. A CMA is also typically the default destination for dividend payments and the proceeds from securities sales.
To provide a modest return on funds you don't need immediately, any cash left over in a CMA is automatically 'swept,' or transferred, overnight into another account that pays interest. This is where you need to pay close attention. Some brokerages sweep into traditional bank-deposit accounts, which are federally insured up to certain limits . But others sweep into money-market mutual funds, which may or may not be insured, and even then are insured temporarily and only for funds already in accounts as of Sept. 19. (See chart below.)
Let's say, for example, you had a CMA with Ameriprise Financial (AMP). It's possible some of your cash was swept into the Reserve Primary fund, a money-market mutual fund that rattled investors when it 'broke the buck' three months ago. The result? A potential loss of three cents on the dollar and uncertain access to cash you thought was available on demand.
Ameriprise is now suing The Reserve and putting up its own money to cover clients' losses.
Also, some brokerages sweep into their own interest-bearing accounts that have no federal insurance at all. For instance, at Fidelity, cash that clients plan to reinvest in the near term -- including proceeds from the sale of securities -- are by default swept into what the company calls 'FCASH' accounts. These accounts only have some protections via the Securities Investor Protection Corp., which tries to recover assets when brokerages fail.
In theory, all this was explained to you when you opened your account, and you can find details in the fine print of your brokerage agreement. You might have even been offered various sweep options. But in reality many investors don't have a full grasp on where their cash ends up each night.
'With any brokerage firm you have to pay attention to what the sweep is going into,' says Bill Walsh, president of money-management firm Hennion & Walsh Asset Management.
On the bright side, to date just about every major mutual fund company with money-market funds has signed up for the Treasury Department's temporary insurance program and has signed up for the extended guarantee through April 2009. And low returns notwithstanding -- yields on money-market mutual funds have tumbled below 1% -- total assets in money-market funds are at a hefty $3.78 trillion, according to the Investment Company Institute.
But keep in mind the Treasury's insurance program is completely voluntary. Mutual fund providers must choose to sign up and pay a fee; brokerages and individual investors can't request the insurance themselves. So if your brokerage CMA sweeps into a money-market mutual fund, find out who the underlying fund company is and whether they've sign on for the extended Treasury insurance. The deadline for funds to re-enroll was Dec. 5; otherwise the insurance expired on Thursday, Dec. 18.
Does all this mean you should dump your CMA? Not necessarily. If you're planning to reinvest the cash in the near future, these types of accounts still make sense. The key is understanding where your cash goes and what, if any, protections are available in worst-case scenarios. If you're not looking to reinvest the cash soon and are more interested in earning a better yield, you might check into money-market deposit accounts at commercial banks instead. They're liquid, transparent and above all FDIC-insured.
Melinda Peer, 11.18.08, 03:52 AM EST Monday's gloomy economic data drove safe-haven seekers into Treasuries. Recession fears mounted on Monday, pushing down yields on long- and short-term Treasuries, as investors fled the uncertain equity market in favor of the U.S. government bond market.
American investors worried about the outlook fortheir own country after economic data released Monday showed that Japan, the second-largest economy, slipped into a recession as its economy shrank 0.1% in the third quarter, for an annualized contraction of 0.4%. (See "G20 Speeches Fail To Convince Asian Investors.")
Meanwhile, data from the Federal Reserve Bank of Philadelphia indicated the United States may be headed in the same direction. According to the Philly Fed's Survey of Professional Forecasters, the U.S. economy has been in a recession since last spring, and the downturn is expected to last 14 months, economists surveyed said. The survey forecast a sharp contraction in the fourth quarter, with gross domestic product expected to shrink by 2.9%, compared with previous projections for growth of 0.7%.
Adding to Monday's gloom was the Empire State Manufacturing Survey, conducted by the Federal Reserve Bank of New York, showing that business conditions in the state fell the lowest level--negative 25.43--since the index started in 2001.
Also spurring investors' flight to safe-haven investments was an announcement from Chief Executive Vikram Pandit of Citigroup that 53,000 jobs would be cut by the end of 2009's first quarter. (See "Another Ax Swings At Citi.") The company has been reducing its workforce to cut costs amid a global credit crisis that has forced Citi to post four consecutive quarterly losses with a combined deficit of more than $20.0 billion. (See "The Global Financial Crisis.")
Yields fell across the maturity spectrum as money tumbled into the market, some of it apparently fleeing declining stocks. (See "Red Finish For Sagging Street.") The yield on the bellwether 10- year note was down to 3.65% at Monday's close, from 3.75% late on Friday, and the 30-year bond's yield slipped to 4.18%, from 4.23%. Among shorter-dated maturities, the two-year note was returning 1.20%, down from 1.24%, and the three-month bill offered just 0.10%, down from 0.14%.
At the exchange-traded funds that track the bond market, the iShares Lehman 1-3 Year Treasury fund (nyse: SHY - news - people ) gained 15 cents, or 0.2%, to close Monday's trading session at $84.40 and the longer-term iShares Lehman 10-20 Year Treasury fund (nyse: TLH - news - people ) rose by 48 cents, or 0.5%, to close at $106.55.
Comment On This Story "You still have a yield curve that makes sense," said Bill Walsh, chief executive of the investment services firm Hennion & Walsh, since the shortest maturity still has the lowest yield.
From a historical perspective, however, Walsh said the yield curve was pretty steep as a result of the usual pressures such as supply and demand and the flight to quality--bond markets are considered a safe place to park money. "The two-year note at 1.20% is really indicative that people are afraid of the equity market," he remarked. "People are still buying quality, but they like the short-term maturity because they're worried about all the uncertainty."
Investment-grade corporate bonds found favor as well. The iShares IBoxx $ Investment Grade Corporate Bond Fund (nyse: LQD - news - people ) added 0.7%, or 65 cents, to close Monday at $90.55. But an aversion to risk kept investors away from junk bonds: the SPDR Lehman High Yield Bond (nyse: JNK - news - people ) fund fell 1.2%, or 37 cents, to $30.43.
By Kenneth Rapoza Of DOW JONES NEWSWIRES 14 November 2008 8:00 PM GMT Dow Jones News Service English (c) 2008 Dow Jones & Company, Inc.
SAO PAULO (Dow Jones)--A U.S. recession isn't pretty for most companies, but portfolio managers at Hennion & Walsh Asset Management are betting on a universe of roughly 240 exchange traded funds to beat the worst bear market since the Great Depression.
The strategy seems to be working. Although Hennion & Walsh's three new mutual funds are losing money, they're losing much less than investors tied to the Standard & Poor's 500 Index by a country mile.
Hennion & Walsh, a Parsippany, N.J.-based firm with around $170 million under management, created three target-risk mutual funds known as the SmartGrowth funds in 2006 together with Lipper Inc., a mutual fund industry ranking and analytical company.
Lipper was hired to develop three proprietary indexes as a benchmark for Hennion's asset-allocation services. The deal with Lipper gave them exclusive rights to the indexes. Lipper tested a slew of world indexes as far back as 2000 and this time included ETFs in the mix to come up with the new SmartGrowth indexes.
ETFs are like mutual funds, only they are actively traded like stocks instead of once daily like mutual funds.
The SmartGrowth funds that track those indexes are the SmartGrowth Lipper Optimal Conservative Index Fund (LPCAX), the SmartGrowth Lipper Optimal Moderate Index Fund (LPMAX) and its more aggressive sibling, the SmartGrowth Lipper Optimal Growth Index Fund (LPGAX).
Just before a long selloff in U.S. and global stocks began around July, all three funds outperformed their peers in their Lipper classifications. Each fund was up by as much as 7.4% to as little as 5.5%, compared to S&P 500 returns of negative 13.12% over the same period.
But, as every investor knows, past performance doesn't guarantee future results.
Nevertheless, the conservative fund was down 6% to a net asset value of just $9.68 per share, as of the close on Nov. 13. It's still beating the S&P 500, which was down nearly 40% to 911 points Thursday and falling again Friday.
SmarthGrowth's LPMAX fund, for the moderately risky investor, was down around 7% to $9.63 per share, and the aggressive LPGAX was down nearly 12% to $9.20 per share, as of Thursday's close.
All three funds are still outperforming the S&P 500, and that's important in a market where the equity funds that lose less are best.
Kevin Mahn, who manages the SmartGrowth funds, attributes the success of the funds year to date to a healthy blend of around 240 ETFs.
"We can go short currency, or long on the bond curve. We don't sell during the quarter, only at the end. We are of the mind that ETFs are the saving grace for any portfolio manager," Mahn said.
"If you don't have ETFs in your portfolio, you're getting left behind," he said.
The fund has been gaining ground from its positions in the UltraShort S&P500 ProShares (SDS) ETF. The fund was up 6% on Nov. 12 alone, while the rest of the market was plunging. In fact, the UltraShort ETF is up nearly 70% from January to Nov. 13.
"We are riding the short side of the S&P, so when it's down a hundred points, we're up 200," Mahn said. That's because the $2.6 billion ProShares ETF invests 80% of its assets in financial instruments with economic characteristics that should be the inverse to those in the S&P 500. So when the S&P was down 9% in October, SmartGrowth funds were up by 18% because of the UltraShort's downside protection strategy.
These days, the three SmartGrowth funds are investing heavily in biotech and small-capitalization ETFs, and shorting consumer goods.
"Our allocation is heavy on biotech and small cap because these are the markets that are going to lead into a bull rally," he said. Small caps and biotech stocks tend to rally first in a bull market because they are a sign that investors have regained confidence and are now willing to assume buying riskier assets like that of smaller firms and heavily indebted biotechs.
"Whenever the market starts its correction, these are the sectors that will rally highest," Mahn said.
The SmartGrowth Optimal Growth Fund's four biggest ETFs are ProShares UltraShort Consumer Goods (SZK), which corresponds to twice the inverse of the daily performance of the Dow Jones U.S. Consumer Goods index; iShares S&P SmallCap 600 Index (IJR); Vanguard Consumer Staples (VDC) and the Biotech HOLDRs ETF (BBH).
All four ETFs are outperforming the S&P 500 year to date, including IRJ shares, which are holding their own slightly. Biotech HOLDRs and UltraShort ProShares Consumer Goods are actually up on the month. Biotech is up around 6% and UltraShort ProShares is up around 3%, compared to the S&P, which is down around 8% over the last four weeks.
BBH is up nearly 10% year to date, as of Nov. 13, with SZK up nearly 50%. The moderate and conservative SmartGrowth funds are more heavily invested in the SPDR Lehman 1-3 Month T-Bill (BIL) ETF. The fund is up 1.5%, as of Nov. 13.
For now, SmartGrowth funds are U.S. focused. The funds sold out of their emerging market holdings in the second and third quarters of this year, namely positions in Russia and Taiwan.
"We have no allocations at all in emerging markets," Mahn said about the worst performing asset class so far this year.
Investors have been dumping emerging market stocks since July - and aggressively so in early September - after Lehman Brothers Holdings Inc. investment bank folded and it became apparent that more banks would follow suit.
For example, Brazil's Ibovespa stock index bubble has burst. It has gone from a May high of more than 73,000 points to under 40,000 points in November.
Mahn is also taking his time dabbling in the U.S. housing market. The funds have a slight allocation to iShares Dow Jones U.S. Home Construction (ITB) ETF. But with the U.S. housing market crashing, and unemployment increasing nationwide, the ITB fund is down over 40% year to date. It's one of the only ETFs SmartGrowth has that makes the S&P look pretty good.
"We are not fully on board the housing and construction market yet and don't know when you will see a recovery," he said. "Housing prices will probably end up falling again."
(Kenneth Rapoza covers markets for Dow Jones Newswires from Sao Paulo, Brazil. He can be reached at 5511-2847-4541, or at kenneth.rapoza@dowjones.com)
They're for the risk-averse. And who wouldn't want a little steadiness in this wind-blown market?
They're for the quiet, steady side of your portfolio, the portion that lets you sleep well at night.
They're bonds -- and they usually don't give you much bang for the buck. But lately -- low-priced and with decent yields -- they have been returning far more than their riskier cousins: stocks.
"You can get equity-like returns in the corporate bond market for the first time in decades," said Gary Cloud, portfolio manager of the AFBA 5Star Balanced Fund in Kansas City, Mo.
Lately, bond prices have dropped so much and their yields, or expected returns, have spiked so high that bonds are looking attractive as something other than a safe haven. Some municipal and corporate bonds are yielding substantially more than U.S. Treasurys.
So what's behind this state of affairs? On one level, it's the bond market rule of thumb at work: As prices fall, bond yields rise. Prices have tumbled for municipal bonds as stressed hedge funds have unloaded lots of debt. Prices of corporate bonds have sunk along with companies' weakening earnings and the economy's dim prospects.
The higher yields, while attractive, do signal a higher degree of risk. Munis and corporates will never be as safe as Treasurys, which are backed by the U.S. government. With munis and corporates, there is always the chance of default as city budgets stumble or companies collapse.
Nonetheless, bonds' risks are traditionally considered far lower than those of stocks. Look no further than the vicious volatility and staggering declines of stocks this year. The recent gains in bond yields are eye-popping. Over the past decade, the yields of 10-year, highly rated corporate bonds have averaged about 1.25 percent above 10-year Treasurys. As of Thursday, corporate yields were averaging 4.98 percent above Treasurys, according to Barclays Capital (formerly Lehman Brothers) investment grade corporate credit yield index.
The same has been true, though not to the same degree, of municipal bonds, which state and local governments issue to pay for projects such as school construction. Municipal bonds tend to have lower yields than Treasurys because they are exempt from federal and sometimes even local taxes. But lately, some have had higher yields than Treasurys.
In recent days, the yields on municipal and corporate bonds have come down a little, narrowing the gap with Treasurys, suggesting that investors see risks declining. Still, the yields remain high by historic standards, analysts said. "We're seeing yields we haven't seen in nine or 10 years," said Philip G. Condon, head of municipal bond portfolio management for retail and tax-exempt advisory clients at DWS Investments.
Richard Bernstein, chief investment strategist for Merrill Lynch, points out that Treasurys are this year's best performing asset class. "I think there comes a point when people will begin to realize that the certainty of the return, even though it's low, may be worthwhile," he said. For individual investors, bonds can provide diversification for a portfolio.
But beware: Buying individual bonds can be more difficult than buying stocks. You need to go through a broker. A better option, some strategists said, is to buy a bond fund. "It's a tremendous opportunity," Cloud said, "but it's also not an area that individual investors should go into on their own."
Moreover, remember the long-term performance of most bonds. You will be hard-pressed to find an analyst or strategist who advises you to dump your stocks in favor of bonds. The recommended portfolio has a mix of stocks and bonds. "Bonds will normally not give you a big amount of growth over time," said Bill Walsh, president of Hennion & Walsh, a Parsippany, N.J., securities firm specializing in municipal bonds. "I know the last few weeks have scared people and made them nervous [about stocks], but over time, history has proven the equities market will give you growth."
If you're looking for more of a return on your bond investment, then munis or corporates may be for you, analysts said. But stick with high-quality ones. The credit quality of governments and companies is monitored by the ratings agencies: Standard & Poor's, Moody's and Fitch Ratings.
Keep in mind that the lower the credit quality, the higher the interest rate you will get for buying that bond. But analysts said you don't have to take a chance on so-called "junk bonds" and all the risks they come with because the yields on high-quality bonds are high enough to make them worthwhile. "Err on the side of caution from the credit perspective," said Bob Nelson, managing analyst for Thomson Reuters. "For the individual, the real concern in this market environment should be on credit quality."
Cold, hard cash would seem to be the ideal refuge for investors unwilling to put up with the uncertainty of today’s stock and bond markets. But it may come as a surprise to many that cash has its own safety issues. Bank failures could imperil savings accounts in certain situations, and some money market accounts are being threatened by upheaval in the global credit markets.
Cash investors also face a third threat that may be less dramatic but is just as real: The likelihood that taxes and inflation will, over time, eat away not only the investment earnings of a cash savings account but a portion of the principal as well.
Careful investors can take steps, which we’ll detail below, to minimize the possibility that bank failures or credit-market events will destroy their savings. Investors who just want to avoid catastrophic losses probably aren’t too worried about inflation, at least in the short term.
“Right now, capital preservation is the name of the game,” says Will Hepburn, president of Hepburn Capital Management in Prescott, Ariz., which manages $20 million for clients. But understanding how inflation affects your long-term savings is the first step toward taming its impact.
Banks practice safe saving Sixteen U.S. banks have failed so far this year, compared with three in all of 2007, but thanks to the Federal Deposit Insurance Corp., depositors haven’t lost a dime. The government agency, created during the Great Depression, has a $45 billion war chest to shield small savers from the impact of bank failures.
FDIC protection applies to any checking, savings or money market account or certificate of deposit held in an insured bank or savings association. Up to $100,000 in each account is insured, though in early October Congress temporarily raised the coverage limit to $250,000 through Dec. 31, 2009. This protection, however, does not cover non-deposit products -- for example stocks, mutual funds or annuities – even if they were sold by an FDIC-insured bank.
Savers with more than $250,000 in cash can split the accounts among multiple FDIC-insured banks or among multiple account holders to increase their protection. Spouses, for example, could have as much as $500,000 in protected savings in a joint account, or $250,000 each in separate individual accounts. The FDIC provides an online tool, the Electronic Deposit Insurance Estimator, http://www.fdic.gov/EDIE/, that can help you determine to what extent your existing accounts are covered.
In terms of safety, an FDIC-insured account is hard to beat, but the safety comes with a price. The average bank savings and money market account was recently yielding just 2.45% on an annual basis, according to Bankrate.com. Investors willing to shop around and invest in an out- of-town (but FDIC-insured) bank could find rates up to 3.75% with no minimum deposit. But be sure to ask about fees before investing.
Average FDIC-insured CD rates range from 3.06% for six months to 3.59% for 12 months, according to Bankrate.com. Savers looking for a little extra yield without having to lock up all of their money for six months or a year could “ladder” 3-, 6-, 9- and 12-month CDs, and roll over the proceeds of each CD into a new one as it expires.
Non-bank money market funds Many mutual fund companies, such as Fidelity and Vanguard, offer money market mutual funds that typically offer a higher return than bank money market accounts. These money market mutual funds are not FDIC-insured, but historically they have been very safe.
These funds typically invest their assets in low-risk, short-term commercial loans, a market that, like many others, has seen turmoil lately. In September, however, one of the nation’s oldest money market mutual funds, the Reserve Primary fund (Get Prospectus), hit by losses on its investments, “broke the buck” and fell below $1 a share. Some six weeks later, with investors unable to access their cash, the fund announced late Thursday that it would start mailing checks to shareholders on Friday -- for half their original investment.
The fund also said in a statement on its Web site that it was “committed to making future distributions when more cash becomes available.”
To help stem investor fears, the Treasury Department recently announced a temporary program that would guarantee for three months the safety of all money held in participating firms’ money market mutual funds as of Sept. 19.
Fifteen of the largest mutual fund companies have signed on to the program, which could be extended when the three-month period expires. Any money deposited after Sept. 19 is not covered, though. Still, experts say investors will generally be safe if they stick to funds offered by large fund companies that are willing to cover any potential investment losses in these funds’ portfolios.
Investors in money market mutual funds can further protect themselves by opting for those that invest only in ultra-safe U.S. Treasury securities. But again, there is a cost for this extra margin of safety. The Fidelity Government Money Market fund (SPAXX | Get Prospectus), for example, is currently paying a seven-day yield of just 1.86% compared with a 3.08% seven-day yield for the Fidelity Money Market fund (SPRXX | Get Prospectus), which invests in corporate, as well as government, loans. The same holds true at Vanguard. The Vanguard Treasury Money Market fund (VMPXX | Get Prospectus) is yielding 1.35% compared with the Vanguard Prime Money Market fund ( VMMXX | Get Prospectus) yield of 2.78%.
Don’t forget about taxes and inflation While bank savings accounts, CDs and money markets can help you sleep better at night, “they are terrible long-term assets because they are certain to depreciate in value over time,” says Bill Walsh, president of Hennion & Walsh Asset Management in Parsippany, N.J.
The twin forces of taxes (interest income is taxed at your marginal rate, which can be as high as 35% on federal returns) and inflation will combine to make it virtually certain that the purchasing power of savings will decline over time.
But for many consumers, the prospect of a slight erosion of value due to inflation seems like a reasonable tradeoff given the drastic losses suffered recently by virtually every stock market around the world. Ultimately, the only way to beat inflation is to accept some degree of risk in exchange for an inflation-beating return.
“If your goal is to be a long-term investor, being out of the market is riskier in the long term,” says Walsh.
Advisors’ use of ETFs in client portfolios is growing more sophisticated as their options increase
• James J. Green
11/1/2008
Advisor Mike Patton of Integrity Wealth Management in Baton Rouge, Louisiana, thinks highly of exchange traded funds in building client portfolios since they are relatively low-cost, tax-efficient ways to capture the entire market or slices of the market—a cheap, tax-sensitive, liquid alternative to index mutual funds. Advisor Gene Balliett of Balliett Financial Services in Winter Haven, Florida, likes ETFs for different reasons. He believes that certain ETFs can help him in his continuous quest for absolute return vehicles, including inverse ETFs that capture double the beta of major market indexes—one of the only ways in the current market atmosphere to produce alpha in a market where everything, including most fixed-income investments, is in the red. These two advisors represent the two ends of the spectrum when it comes to advisor use of ETFs in client portfolios, and both are appropriate approaches, according to product manufacturers, money managers, consultants, and other advisors interviewed on the subject.
Sue Thompson, who runs the RIA channel of Barclays Global’s U.S. iShares business, says it’s been "an amazing journey to see the variety of ways that advisors use ETFs in their portfolios." She cites the core/satellite approach to portfolio building as an example. Normally, she says "we think of that as indexing the core and doing active management in the satellites. But many clients take the opposite approach. Their core is a group of stocks on which they’ve done fundamental analysis, and their satellite is the ETFs. They may not have expertise in emerging markets, for example, so they decide to index that. It’s almost a reverse core/satellite."
Like those Thompson cites, more and more advisors are incorporating ETFs into client portfolios, helping to increase the pace at which money is being invested into ETFs since their introduction almost 16 years ago (the SPDR was introduced January 29, 1993). Even this year, when the assets in United States-listed ETFs fell 6.6% through the end of the third quarter, they held up much better than the value of, say, the MSCI U.S. index, which fell 20.52%, according to Barclays Global Investors, the largest manager of ETFs in the U.S.
In 2008 alone, another 103 ETFs were launched in the U.S., bringing the total up to 681 holding $542 billion in assets, including the first actively traded equity ETFs, which must disclose their portfolio holdings (see chart on following page displaying the growth of ETFs over the years). Moreover, there are an additional 486 ETFs planned for launch in the U.S., Barclays reports, though some of those may be postponed indefinitely due to the current market freefall.
In fact, the growth of ETFs, and the flexibility that they offer in constructing portfolios, is leading some experts to suggest that ETFs might challenge mutual funds’ hegemony in the near future.
A Threat to Mutual Funds? Cerulli Associates’ Director Cindy Zarker wrote starkly in an August 2008 report, Product Development in an Evolving Portfolio Construction Environment, that "ETFs are a potential threat to mutual funds," reporting that advisors are using ETFs in both "core and satellite allocations, as well as in the active and passive slices of investors’ portfolios." Zarker notes that advisors who are strategic asset allocators are "likely more interested in ETFs for their lower fees and long-term investment themes," while advisors who employ a tactical asset allocation approach may use ETFs "because they offer continuous liquidity and access to commodities and other markets where they want to make a concentrated bet."
While Balliett argues that "ETFs will drive a lot of mutual funds out of business," the vehicles have a long way to go to challenge mutual funds over all, of course.
As of the end of August 2008, the most recent month for which we had data as of press time, there was $11.578 trillion resting, uncomfortably these days, in 8,081 U.S. mutual funds, according to the Investment Company Institute. The woes of September and early October would have put a big dent in that amount, particularly in the money market funds, which had $3.520 trillion in 800 funds as of August, and which had seen $343 billion in net new inflows for the year-to-date through August. But as is the case with advisors who use a range of alternative investments to capture alpha and diversify client portfolios, advisors who are heavy users of ETFs are often among the leaders of the profession.
Plain Vanilla and Tutti Frutti Natalie Lera, vice president for product management at Schwab Institutional, acknowledges that ETFs are a "large part of how our advisors round out portfolios, and they’re growing."
She recalls that a few categories of ETFs have been tried where people said at the end of the day, ‘You know, this is not a great application for an ETF,’" citing in particular the attempt earlier in 2008 that "tried to track the price of oil, and they didn’t do too well. Do I think we’ll have more ETFs that track oil? Yes. Will they do so in the same way? Probably not."
"ETFs have become a more popular tool," says Ed Lopez, director of ETF strategies for Rydex Investments. "As mutual fund providers, we know ETF usage has outpaced individual stock usage in 2008." Research conducted by Rydex AdvisorBenchmarking among RIAs found that almost three-quarters of advisors now use ETFs in building client portfolios, and that 37% of advisors surveyed by Rydex AdvisorBenchmarking chose ETFs "as the number one investment vehicle that has helped them increase business since 2001." (Disclosure: Rydex AdvisorBenchmarking and Investment Advisor have a content sharing relationship under which Rydex provides research data monthly for the IA "Practice Edge" electronic newsletter.)
What accounts for the attraction of ETFs? Lopez ticks off the standard ones: cost, ease of use, access to specific market segments, and diversification, noting the popularity this year among advisors of Rydex’s eight CurrencyShares ETFs and commodity ETFs. Sector ETFs, Lopex says, allows advisors to be more "flexible and dynamic with client portfolios." Speaking on October 6, Lopez said Rydex was seeing good inflows lately to consumer staples ETFs, and outflows from oil funds. He noted that energy ETFs had posted 30% positive gains by mid-year 2008, but that the trend then reversed.
Another growing use of ETFs among advisors is to hedge client portfolios, which is why Lopez has seen more interest in leveraged and inverse products—a specialty of Rydex and ProFunds—particularly in inverse financials ETFs. He’s also seen good flows to the bond ETFs during the recent market turmoil. It’s been a big focus of Rydex to educate advisors, says Lopez, mentioning in particular a Rydex publication called ETF Essentials. Balliett is one of those advisors who doesn’t need convincing. He uses Rydex because of their "long list of mutual funds and ETFs that are no-load, many are inverse, and with no transaction fees." It gives him a "way to diversify within a sector," being able to buy 12 stocks in a sector, for instance, and only pay one commission rather than 12. He notes that it’s "easier to pick a sector that will bloom, rather than the one leader in that sector." Moreover, amid the current market strife, the inverse funds in particular provide "opportunities to soften the down side," Balliett says (he also recommends www.ETFConnect.com for advisors looking for more education on exchange traded funds).
Tactical and Practical While Lera of Schwab Institutional warns that "ETFs are not all things to all people," advisors are certainly using them in multiple ways to meet the needs of clients. Thompson of Barclays recalls the "huge demand last October for the first municipal bond ETF. People were looking for more fixed-income alternatives." Another appealing introduction, she says, is when iShares "expanded our fixed-income suite with a very, very short-term Treasury (SHV).
Especially in this environment that has been massively popular as a place to park [assets] as people were figuring out what to do—it’s not a cash fund, but it’s a very liquid, safe alternative."
Thompson says she’s seen a "huge difference" on how advisors use ETFs on the fixed-income side. "Five years ago, very few advisors were using fixed-income ETFs," she says, "and frankly there weren’t that many out. The suite of products has broadened tremendously, as have the tools. We see people completely moving into ETFs for the entire part of their fixed-income allocation, or they’re still laddering bonds for the first five years, and then, to reduce callability risk, for instance, they’ll push the balance of the fixed income portfolio out into an ETF that has a longer duration, since you’re not looking for the current coupon amount."
Thompson says she knows of at least 30 RIAs who run all-ETF portfolios. "For some, it’s strategic, but many are using them much more tactically, doing global sector rotation strategies, for instance; using a beta product to create alpha." Those advisors cite the classic Brinson, Beebower study "on how more than 90% of the variability of returns comes from asset allocation and a very small amount from security selection. So if they choose the right asset classes to be in at the right time, why not implement that using a very inexpensive product like an ETF? That’s the registered investment advisor as alpha generator."
Dan O’Neill, chief investment strategist for Direxion Funds, reported that as of early October, short ETFs and ETNs were doing well. "Initial ETFs were broad-based indexes for long-term investors," but now, you’re seeing the creation of vehicles that are more tactical," mentioning in particular ProShares as "the great success story" in tactical ETF investing. But the original purposes of low-cost index funds are "still good ideas," says O’Neill, though the newer varieties of leveraged and inverse ETFs allow "investors to become more athletic."
Direxion was first to market in May with a family of 36 funds that will provide triple the performance, or inverse, of the major U.S. and many foreign indexes, and while "leverage" is a dirty word these days and O’Neill admits that "people will say these products are crazy," he argues that isn’t the case if you "use them in a sober, measured way" and if the leveraged ETFs are seen "in the context of the overall portfolio."
ETFs With Training Wheels
So if you’re not crazy about leverage, and more comfortable with a ’40 Act fund, maybe you’d like to explore a mutual fund of ETFs, like that provided by Jim Porter at Aston/New Century Absolute Return ETF Fund (ANENX), which launched in March of this year, though he has been running the all-ETF portfolio since 2004. "Maybe an advisor starts with us," says Porter, "and gets comfortable with the idea of having ETFs in their clients’ portfolios."
In speaking to advisors around the country, Porter says they are receptive to the idea that, "ETFs give you a fabulous opportunity to strive for absolute returns, because you have all the asset classes—you can even buy 90-day T-Bills."
Porter says his fund’s holdings this year have had "as much as 40% cash and 20% inverse and 17% bonds, some commodities, and some currency. How alternative can you get!"
Regarding the active/passive debate, Porter says he "can’t even imagine managing a portfolio in these kinds of markets without using active management. I can’t stand the thought of being a passenger. The ETFs are very conducive to active management: the executions are instantaneous, and many of them are to four places." He’s quick to admit there are "a lot of caveats you have to put on them—especially the thinly traded ones, and the inverse ones, and warns that "you don’t use market orders." But he says ETFs are a great way to do "style and market cap rotation during an economic cycle while doing a sector rotation; it’s a great place to get alpha."
Another manager with a similar idea is Kevin Mahn, chief investment strategist for SmartGrowth Funds, which launched in June 2007 three funds that combine "asset allocation with ETFs in a ’40 Act fund using Lipper’s Optimal indexes on January 1, 2007; we launched our SmartGrowth funds in June 2007 which tracked those indexes.
Mahn says SmartGrowth’s approach reflects what "many advisors and individual investors are starting to realize: that the depth of ETFs that are in the marketplace, with the ability to go long and short certain asset classes and sectors, and the ability to access foreign currency markets and commodities, in such an easy and convenient manner of an ETF, is affording an ability to build really cost-efficient portfolios. We obviously think investors and advisors would be best served by picking our funds and letting Lipper and us do all the work, but a lot of advisors now, if you look at their own portfolios, are including ETFs for the same reasons I pointed out."
Advisors are using the funds in wraps, Mahn says, and reports that others are using them as their alternatives asset class allocation, "since we offer a lot of downside protection." Others are using them in their IRA accounts for clients, he says, since they "are a great tool to build diversified growth, rebalanced on a quarterly basis. I get my load up front, I get my 12(b)-1 in perpetuity and my clients are happy."
Mahn says ETFs have had difficulty penetrating the "Holy Grail of asset gatherers, the 401(k) marketplace," partly because the plan "recordkeepers’ systems don’t have the ability to process ETFs that trade throughout the day instead of capturing NAV at the end of the day like a ’40 Act fund (for more on the role of ETFs in retirement plans, see sidebar on page 82).
The Future Lopez of Rydex believes that more assets will move to ETFs, especially if the "industry can crack the retirement space," and that active ETFs "may spur growth" as well. Lera of Schwab Institutional notes that since there is an "an overabundance of ETFs in some areas, it’s likely there will be some culling as a natural part of the product development lifecycle." While she doesn’t see too much demand for or adoption of mutual funds of ETFs, she thinks advisors are increasingly adopting ETF wraps, which first had their debut in the wirehouses but are finding wider acceptance for their cost-efficiency and transparency.
Thompson of Barclays argues that "Coming out with me-too products doesn’t do anybody any good, but there are aspects of the market where you can get true diversification where there are currently not any products." Some could be easy to do; others would be more difficult. "I can’t tell you how many times advisors have asked for an ETF," she says, "on the VIX [the CBOE’s volatility measure].
To the question of whether there are too many ETFs Porter of the Aston/New Century ETF fund responds, "There are too many, and there aren’t enough. We have some things we don’t need, and we don’t have some things we do."
Among the "not enough" are those in "subsectors like technology and infrastructure, and alternative energy like wind—we just need more companies to make an ETF." Thompson uses 2008 as a timely example of another feature of ETFs. "What’s going to happen is that you’re going to have an awful lot of mutual funds that, come December, will be distributing cap gains that clients will need to pay tax on," she predicts. "If you can have a structure that minimizes that—and keep in mind that ETFs are not immune from cap gains, but they do tend to be minimal compared to their mutual fund counterpart, so it becomes a viable option." If, she says, you expect returns to be lower, "the things that you can control are cost and taxes, and advisors are going to seize on those kinds of solutions."
SIDEBAR The Retirement Angle
Editorial Director James J. Green can be reached at jgreen@investmentadvisor.com.
Conditions are improving for the increased use of exchange-traded funds in 401(k) plans, according to their proponents in the third-party administrator and investment fields. Before then, however, acceptance both psychologically and technically must occur.
First, the provisions of the Pension Protection Act that go into effect in January demanding uniform fee disclosure and transparency make ETFs suitable, as they lend themselves to reporting transparency, according to Alvin Rapp, founding partner of RPG Consultants, a retirement plan consultant and TPA.
RPG uses an open-architecture, daily valuation recordkeeping platform that allows the use of ETF’s as an investment choice.
"Financial advisors in their fiduciary duty should be evaluating the cost and transparency requirements in the PPA," Rapp says.
New Department of Labor rules will lead to "more efficient investing in retirement platforms, sending an increasing percentage of dollars to ETF-intensive plans," Rapp said in a recent white paper he wrote.
"I think ETFs will represent 10% to 20% of retirement portfolios minimally over the next five years—or that is where it should be," Rapp says. He encourages advisors who use his firm to build lifestyle strategies solely using ETFs .
Darwin Abrahamson, founder and CEO of Invest n Retire, a 401(k) recordkeeper and technology company in Portland, a believer in incorporating ETFs into 401(k) plans, is seeing rapid growth in both the number of plans his company has signed up as well as the size of those plans, and he says most of the assets in those plans are in ETFs. He attributes the growth to the impending DOL fee disclosure rules and the ability to fulfill fiduciary duties.
Moreover, the Investment Company Institute has asked his company to start reporting the ETF percentage in 401(k) plans starting at the end of the year, a sign that it is on the ICI radar and that more growth is expected.
"[Those] who have invested in creating platforms that allow the inclusion of ETFs will inevitably be joined by others wanting to capitalize on the unavoidable movement," Rapp writes.
He is right that platforms need to be created, according to Kevin Mahn, a portfolio manager of SmartGrowth Funds, three open-ended mutual funds composed solely of ETFs.
One of the four difficulties faced by those who would like greater inclusion of ETFs in 401(k)s is the fact that most recordkeepers and TPAs cannot process ETFs as they stand right now through their own platforms, says Mahn, who is also chief investment strategist at Hennion & Walsh Asset Management in Parsippany, New Jersey.
The other difficulties plan sponsors face are having fiduciaries accept an investment vehicle that some still see as cutting-edge and risky. After all, ETFs have been around only for a little more than a decade, and ETFs can’t trade in fractional shares like mutual funds can, Mahn notes.
With regard to costs, Rapp argues that ETFs are highly economical, pointing out that it is not the participant who eats the cost of trading, as is the case with mutual funds. The financial institutions that use RPG’s platform incorporate all the trading costs into their custodial fee. Because the cost savings of ETFs are so significant when compared to the average investment expenses of mutual funds, the plan will still pass along substantial savings to plan participants, Rapp says.
"I really think they are going to gain broad acceptance. It is a question of when, not if," Mahn says. "Fiduciaries have to get comfortable and recordkeepers and TPAs have to invest in the technology to process them."
NEW YORK, Oct 30 (Reuters) - U.S. Treasury debt prices fell on Thursday, as stock index futures pointed to a higher start on Wall Street after the economy contracted less than expected in the third quarter, curbing government debt's safe-haven allure.
Bond investors continued to mull the prospects for more Federal Reserve interest rate cuts and initiatives to pump unprecedented extra amounts of liquidity into the global banking system, following Wednesday's 50 basis points cut in the target rate.
With the key U.S. short-term lending rate now at 1 percent, matching a low in 2004, the Fed now has less potential to ease policy. Bond yields have already fallen a long way and may not have room to go much lower, analysts said.
The benchmark 10-year Treasury note's price, which moves inversely to its yield, traded down 23/32 for a yield of 3.95 percent, versus 3.86 percent late Wednesday, within its ranges for the past three weeks.
U.S. gross domestic product shrank 0.3 percent in the third quarter, less than economists' median forecast for a 0.5 percent contraction.
Economists said details within the report suggested a poor economic performance going forward.
"Consumer spending is about 70 percent of the GDP and this looks like the lowest it has been in two decades, which goes to show that in the fourth quarter we are going into the recession," said Bill Walsh, president of Hennion & Walsh in Parsippany, New Jersey.
However, "Treasuries (prices) seem to be off a little bit on both the short end and the long end. The Fed cut yesterday was priced in. We seem to be trading in the same range," said Walsh.
The 2-year Treasury note's price was down 4/32 for a yield of 1.61 percent, versus 1.55 percent late Wednesday. The 30-year Treasury bond was down 8/32 in price for a yield of 4.25 percent, versus 4.24 percent late Wednesday.
The US economy shrank at an annualised rate of 0.3% between July and September, according to figures from the Commerce Department.
The gross domestic product (GDP) figures were better than expected, although they show the sharpest contraction of the economy since 2001.
Consumer spending, which makes up two-thirds of the US economy, shrank by 3.1%, the first contraction since 1991. The 0.3% fall followed 2.8% growth in the previous three-month period.
Company results The growth data came on the same day that some of the US's biggest companies reported their results for the July to September period: • Broadcaster CBS made a loss of $12.46bn (£7.59bn) in the quarter. This included a write- down of $14.12bn-worth of media assets • Electronics giant Motorola reported a loss of $397m for the quarter, compared with a profit of $60m a year ago, largely due to falling mobile phone sales • Paper and packaging company International Paper reported a 31% fall in profits to $149m and warned demand for its products had fallen • American Express, the credit card issuer, announced plans to cut 7,000 jobs as part of a plan to save $1.8bn by the end of 2009 • On the positive side, photographic company Eastman Kodak's profits jumped to $96m for the quarter, compared with a $37m profit in the same three months last year • Personal care product maker Colgate-Palmolive reported profits of $499.9m for the quarter, up 19% on the same period last year Recession judgement
The GDP figures showed that spending on non-durable goods, which are smaller purchases such as food and paper, dropped at its sharpest rate since 1950.
The economic shrinkage means that the US economy is halfway to the standard definition of a recession, which is two consecutive quarters of negative growth. But the official definition in the US is different, meaning that the US economy is never officially in recession until the National Bureau of Economic Research decides it is.
Nevertheless, the Federal Reserve is clearly concerned about the US economy and cut its key interest rate from 1.5% to 1% on Wednesday.
"Consumer spending is about 70% of GDP and this looks like the lowest it has been in two decades, which goes to show that in the fourth quarter, we are going into recession," said Bill Walsh, president of Hennion and Walsh in New Jersey.
The GDP figures were accompanied by Labor Department figures showing the number of new claims for jobless benefits last week.
There were 479,000 new claims in the week ending 25 October, which was the same number as the previous week, but still a high number, suggesting that the problems in the economy are feeding through to the job market.
