Americans have a very different experience in the credit markets than international borrowers and investors. During the 2008 financial crisis –a US “export” to the rest of the world – credit simply disappeared. As Americans tend to borrow long and at fixed-rates, the crisis was far less detrimental to Americans than international investors and borrowers.

This is what a credit crunch looks like for the rest of the world:

As the US Dollar is a major reserve currency, investors flock to it in times of fear. This movement is absolutely devastating for borrowers in other countries who repay foreign investors with local currencies. It’s even more devastating when foreign investors were the sole source of consumer and business credit.

Emerging Market Yields without Currency Risk

Emerging markets are price takers, not price makers. Naturally, they have to accept that global investors in particular want to avoid exchange-rate risk. Thus, many emerging market governments and businesses issue debt securities denominated in US dollars to attract international interest.

Here are a two bond funds that invest in international, dollar-denominated debt:

1. JP Morgan Emerging Markets Bond Fund (EMB) – A product of iShares, this ETF tracks a major global index of US-dollar denominated debt securities. The fund holds investments in the hottest of emerging markets including the Philippines, Russia, Peru, Brazil, Mexico and others. With a weighted average maturity date of just over 12 years, and a 12-month yield of 4.75%, it’s safe to say that this may be one of the best bond funds for high-yield investors. The fund passes on a .60% annual expense.
2. Emerging Markets Sovereign Debt Portfolio (PCY) – Invesco PowerShares is behind this broad-based fund, which holds positions in debt securities issued by 22 emerging market nations. Selections are made annually, and rebalanced quarterly to limit fund expenses, which are a modest .50% annually. This fund provides a larger yield than EMB with a 5.27% 12-month yield. However, investors do accept more rate-risk; the fund has a weighted average maturity date of 14.86 years, nearly 3 years longer than the EMB ETF.

Why Buy Emerging Market Funds?

Emerging markets offer a few lucrative attributes to investors:

1. Higher yields – You should expect that greater emerging market risk provides larger rewards in the form of yields. Few superpowers (with the exception of select European nations) have bond yields that come close to the yields in international sovereign debt. The 20-year US Treasury, for example, yields only 2.4% while the 10-year provides only 1.71% annually and some corporate bond yields are even lower!
2. Short-term improvement – In the bond markets, debt upgrades are everything. A majority (92% for ECB, and 87% PCY) of these funds are invested in bonds with a rating lower than A. This allows for immediate upside should the bonds earn an improved credit rating from the three major credit rating agencies. As with any upgrade, yields go down and bond values go up, creating immediate capital appreciation. As both funds are rebalanced to the index, profits can be reinvested in other bonds on the verge of credit improvement for a very powerful compounding effect.
3. Smart indexing – Realistically, emerging market debt denominated in dollars is a financial novelty – a way for emerging markets to price the real risk of foreign direct investment. When institutional investors and businesses have a proxy for gauging risk (the spread between US Treasuries and emerging market debt denominated in dollars is the effective price for emerging market risk) nations can solicit more foreign direct investment in the form of factories, call centers, or whatever capital investment necessary to offshore operations. It is only logical that emerging markets which open themselves to foreign investment will see the best fiscal outcomes. Foreign direct investment is a major growth driver in emerging markets like Brazil, India, and China.
4. Liquidity – The US dollar is the most liquid currency in the world. Naturally, emerging market debt priced in dollars is more liquid in the event of a second credit crunch. This liquidity keeps volatility in foreign debt issues lower than that of debt issues denominated in local currencies.

Final Word on High-Yield Emerging Market ETFs

Emerging market investments are absolutely not without their risks. However, as risk-free yields are driven to lows by institutional investors, retail investors have an opportunity to up returns with a step up the risk-curve. A future bond upgrade for one or many emerging markets could provide incredible returns in either intermediate bond fund. The opposite is also true, however, a downgrade could substantially affect short-term fund performance.

Investors usually snub emerging market debt securities due to exchange-rate risk, as well as inflation risk. As these bonds are priced in dollars, however, exchange-rate risk is effectively removed. Inflation risk is limited to that in the US dollar, not foreign currencies and smaller central banks. As two major, mostly-unpredictable risks are removed, these funds are demonstrably more predictable than a fund invested in debt denominated in a local currency.

Disclosure: the author holds no positions in any of the above ETFs.

©2012 ETF Base. All Rights Reserved.

.

The rise in gas prices has been tremendous over the past 4 years. Below is a 10 year chart of US Regular Gasoline Prices documenting the rise with data sourced from the Energy Information Administration. For US consumers and businesses, this isn’t good news. While there was a slight tick down this month, the secular trend is up and we are now approaching 10-year highs set in 2008. Higher gas prices mean less discretionary income for consumers and less money to invest for business and even the possibility of inflation as businesses are forced to raise prices.

Fortunately, high gas prices also present opportunity for fuel saving technologies which means that Great Wall Builders’ (OTCBB: GWBU) shareholders stand to benefit immensely. The company, operating as “Start Technologies Europe I.G, owns the exclusive manufacturing and distribution rights to the Start Fuel Efficiency and Emission Device (FEED), an aftermarket device for internal combustion engines that enhances performance by causing fuel to combust more efficiently and completely. The technology uses a high-voltage electric current to break long-chain hydrocarbon molecules into shorter, lighter more volatile molecules. The patent-pending device produces a number of important benefits, including; lower emissions; reduced fuel consumption; and improved engine performance. The technology can be applied to a variety of different types of engines; diesel and gasoline powered, heavy equipment as well as consumer vehicles.

What’s the upside on a clean tech company like Great Wall Builders? The answer to that question can be put in two words, pretty significant. Looking at Westport Innovations (Nasdaq: WPRT), a publicly traded clean energy company such as GWBU, can give us a hint of what’s to come. The company, which started trading on the public exchanges in 2008, is leading global supplier of proprietary solutions that allow engines to operate on clean-burning fuels to help reduce greenhouse gas emissions. After trading around the $5 price during the credit crisis, WPRT staged a staggering rally, reaching nearly $50 a share earlier this year – a 10 bagger! A similar rise in Great Wall Builders would make it a $15.00 stock.

The company has been busy recently making bolt-on acquisitions, strengthening its management team, and signing new distribution deals. On April 20, Great Wall Builders made an aggressive move, strengthening its reduced fuel consumption platform while stepping into the green energy arena. GWBU acquired all of the assets of dPollution International in exchange for 27,306,793 shares of restricted common stock of Great Wall. dPollution has been undertaking the commercialization of the Start Device, an innovative automotive aftermarket device that utilizes high-voltage electric current to break long-chain hydrocarbon molecules into shorter, lighter, and more volatile molecules. The patent-pending device produces a number of important benefits to combustion engines, including: lower emissions, reduced fuel consumption, and improved engine performance.

On May 9, the company announced a new name for its company to more accurately represent the company transformation. GWBU said that it will be conducting all business operations under the name Start Technologies Europe I.G., a wholly-owned subsidiary of the company. The company’s CEO also made his first public statement as an executive of the company, expressing confidence in the company and laying out his strategic plan.

“We are very excited to have completed our corporate transformation and operating under the new Start Technologies Corp. banner will better reflect the direction that we are taking as a technology development company,” stated Mr. Daniele Brazzi, President and CEO of Great Wall. “In the coming months, as we move forward with our business plan to commercialize the Start FEED technology, we also intend to intensify our marketing and public relations efforts to raise awareness of our company and patent pending technology within the global investment community. The entire team is eager to move forward with our growth strategy and intends to build the company for the long-term benefit of all our shareholders.”

On May 16, the company announced strong test results for its proprietary clean energy device. GWBU said that tests conducted by THESI s.r.l. di Imola of Italy, measured significant improvements in mileage and reduction in exhaust emissions through use of the Start Fuel Efficiency and Emission Device (FEED).

THESI s.r.l. di Imola is an Italian ISO 9001 certified company, authorized to perform vehicle testing. The diesel powered vehicles tested included the Lancia Lybra 1.9 JTD and the Alfa Romeo 159 1.9 TDI. Both vehicle engines tested employed common rail fuel injection.

The significant improvements in fuel consumption were calculated as follows: the Lancia Lybra demonstrated an increase from14.8 to 19.0 kilometers per liter (km/L) while the Alfa Romeo demonstrated an increase from 16.0 to 19.0 kilometers per liter (km/L). This represents a fuel improvement of 28.4% and 18.8% respectively.

The significant improvements in particulate matter reduction were calculated using a partial flow opacimeter. This device continuously draws samples of the exhaust from the tailpipe of the vehicle, passing the exhaust through the device to measure particulate matter in the exhaust gas, which is expressed by its “K” value (the “coefficient of light absorption”). The opacimeter test results from the Lybra indicated an average reduction of opacity from K=0.35 to K=0.12, a reduction of nearly 66% of exhaust particulates. The Alfa Romeo, which had an advanced anti-particulate filter, and thus runs significantly cleaner than the Lybra, initially had a K=0.90, which improved to K=0.0 after installation of the Start FEED unit.

The technology and strong management are starting to pay off in a big way. On Friday, the company announced its first sizeable distribution deal. Great Wall Builders announced the appointment of NESS Tech GmbH as its exclusive agent for the European Union and other select European markets. The 5 year agreement calls for a minimum wholesale purchase of EUR8,000,000 in Start Fuel Efficiency and Emission Device (FEED) units in the first year, with the requirement to increase the minimum purchase by 10% per annum in successive years. The contract territory includes all the countries of the European Union with the exclusion of Italy, United Kingdom and Ireland. The contract also includes the territories of Norway, Ukraine, Turkey, Croatia, Serbia, Bosnia Herzegovina, Montenegro, Macedonia, Albania and Kosovo.

Disclosure: Author has no position in any stocks mentioned within, nor any intent to invest within the next 72 hours.

©2012 ETF Base. All Rights Reserved.

.

Investors everywhere have a dilemma: take a risky bet for higher-returns or accept bond yields that barely keep pace with implied inflation. Historically, investors swap stocks for bonds for higher returns in exchange for a riskier portfolio.

The choice is no longer so binary, as safer high yield investments evolve. New senior loan ETFs make it possible for investors to chase high-yield bonds with floating rates that rise and fall with the market.

What are Senior Loans?

Senior loans are variable rate bank loans to businesses that are senior to bonds. Being senior, the loan is repaid first (even before bondholders) in the case of bankruptcy. Also, as senior notes are short-term financing products, senior notes carry a floating interest rate.

Senior loans are key to buyout and private equity transactions. In a buyout, companies accept variable rate, short-term loans to reduce their debt servicing costs. Senior loans are also known as leveraged loans as they are used primarily for the purposes of increasing cash returns for investors with the use of low-interest, short-term debt.

Two Choices in Senior Loan ETFs

Senior loan ETFs are still few and far between. Here is a list of ETFs available (or soon to be available) to investors:

1. PowerShares Senior Loan Portfolio (BKLN) – PowerShares launched a senior loan ETF to eager investors ready to snap up shares. The ETF took in some $358 million in assets, indicative of massive interest in high-yield debt. The fund has a 12-month yield of 4.62%, much higher than other bond funds sporting similar maturity dates. A 55-45% split in assets between loans maturing in 1-5 and 5-10 years puts it squarely in the intermediate bond fund category. Finally, net expense ratios tally to .76% after a .10% fee waiver.
2. SPDR Blackstone/GSO Senior Loan ETF (SRLN) – Recently approved by the SEC, Blackstone will partner with State Street to launch this new ETF tracking the performance of senior loans. The fund will seek outperformance by active management, looking to best the benchmark U.S. 100 Leveraged Loan index. Invested domestically and abroad, it will carry a .9% annual expense. As it tracks the same benchmark as the BKLN ETF, we should expect a very similar average maturity date.

The choice in funds is interesting: both the PowerShares and Blackstone funds intend to use the U.S. 100 Leveraged Loan index as a benchmark to their respective funds; however, Blackstone will look for outperformance by selection rather than passive tracking. The PowerShares ETF seeks only to mirror the index, rebalancing semi-annually in June and December to maintain a market-weighting consistent with the underlying index.

Can Leveraged Loans Win Out?

Leveraged loans are essentially a bet that inflation will run higher than expected by the market, but not high enough to significantly affect business operations. Since senior loans carry a floating-rate tethered to a market index, higher rates reward investors with fatter yields. However, if rates run too high due to inflation, firms borrowing with floating-rate loans risk default as debt servicing costs rise precipitously.

One would expect that both funds will hedge their bets to black swan-style inflation risk. Some leveraged and senior loans are issued with interest rate ceilings, but the ceiling exists only on a case-by-case basis. As leveraged loans are a specialty product, each contract and funding offer is written to suit the borrower – no two loans are exactly the same. The prospectus available for either fund allows for the use of credit default swaps and derivatives to mitigate some risks to investors.

Yield Comparisons between Bond ETFs

A good comparison for senior loan ETFs might be the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), which yields only 3.21% annually. It carries a similar maturity profile; however it also has significant short-term risks to the principal amount in the event that interest rates rise. Also, the fund has a slightly-higher quality bond selection, though the bonds are not senior to other bonds in the event of bankruptcy and of course, the yields don’t approach those of junk bond ETFs.

Net of fees, the 12-month yield on PowerShares Senior Loan Portfolio ETF (BLKN) is 3.86%. Vanguard’s ETF of corporate bonds yields only 3.07%. Keep in mind that PowerShares’ holdings are floating-rate, whereas Vanguard’s are fixed-rate. Investors are compensated nicely for leveraged loan risk while enjoying higher-returns as rates inevitably rise from historic lows.

Investors in “risk-free” US Treasuries at historic lows would have to extend out 30 years to get a return of 3.11%, a yield still lower than the yield in the above funds.

Senior Loans: The Bottomline Difference

The bottom line is this: floating-rates have excellent advantages. Investors with capital in senior loan funds can extend capital further down the yield curve for higher returns without the concern of loss stemming from bond convexity should rates push higher. Traditional bond ETFs would be expected to decline in value as rates rise.

One could reasonably expect to use a senior loan ETF to draw an income with strong principal protection. All in all, in a market where banks have only recently returned to issue new leveraged loans, investors are poised to pick up the slack and achieve returns greater than a similar maturity mix of corporate bonds with less intermediate risk. I find these new products extraordinary attractive as an alternative for yield-chasing investors.

Disclosure: The author has no positions in any of the above ETFs.

©2012 ETF Base. All Rights Reserved.

.

Macro Update and Commentary:

If you haven’t noticed, the yield on the 10 Year Treasury has remained firmly below 2%, which has mortgage and refi rates at record lows as well.  Most people that had the capability to refinance in recent years probably have already, but for those that haven’t, it probably won’t get any better than this.  What’s driving the Treasury yields so low?

Greece – Comments out of the new Greek candidate and a new election looming make one wonder if Greece’s situation will ever be sustainable or if the EU will continually kick the can down the road, hoping to indefinitely stave off recognition of losses by banks holding Greek debt.  If put to the people, they won’t vote for austerity, yet they want to remain in the Euro.  They can’t have it both ways.

France – Hollande’s win in France is viewed as a step in the wrong direction as well in terms of the business environment and austerity measures.  Many are now proclaiming that austerity measures have doomed Europe into permanent recession since they can’t grow while cutting spending, but what is the alternative?  To continue to spend and send interest rates to an unsustainable level where no countries (save for Germany and other northern Europe economies) can roll their debt?  It will take a mix of reigning in spending and smart policy moves (in a coordinated fashion) to save Europe, but it remains to be seen if the currency can remain intact with all the current member states.

These fears are all pushing capital into the US dollar, further driving rates down.  How long it can last is anyone’s guess.  If stock and bond volatility is too much to handle, then, there’s the mattress or you could apply for a current account.  Gold is no longer performing well, especially in dollar terms (as it appreciates in USD denomination).  In the US, it’s an election year, so on one hand, there will likely be all kinds of giveaways from a lame duck session of Congress which may be good for stocks, but conversely, an Obama win and the onset of onerous healthcare reform provisions would probably not be a positive for equities in 2013 which may precipitate a late-year selloff.  I make no predictions, but just warn to manage your risk and consider your time horizon when setting your asset allocation!

©2012 ETF Base. All Rights Reserved.

.

Can you make a perfect, permanent portfolio out of four asset classes? One issuer, Global X, wants to do just that by turning Harry Brown’s 1980s permanent portfolio into the Permanent Portfolio ETF (PERM).

Permanent Portfolio in Practice

The permanent portfolio is made up of only four asset classes – gold, silver, equities, and US Treasury securities. The ideal permanent portfolio has an nearly equal-weighting of investments, with each asset class making up one-fourth of the portfolio.

The Permanent Portfolio is accentuated with annual rebalancing. In a year where stocks outperform and gold lags, assets would be removed from stocks to be placed in gold. This rebalancing element is the key to the Permanent Portfolio’s impressive historical performance.

Here’s a 10-year chart of the Permanent Portfolio’s performance as a mutual fund (PRPFX). MorningStar also includes the performance of benchmarks most relatable to the Permanent Portfolio mutual fund:

Keep in mind that this mutual fund, though it operates much like the exchange-traded fund, has a higher expense ratio and some differences in investment methodology.

Permanent Portfolio ETF vs. Mutual Fund

The ETF is not a perfect match of the Permanent Portfolio mutual fund. In particular, the ETF deviates from the mutual fund to purchase individual US securities rather than whole market indexes.

Below I’ve listed the asset classes and to what weight each is given in the Permanent Portfolio ETF as outlined in the prospectus:

• U.S. Large Cap Stocks – 9 percent
• U.S. Small Cap Stocks – 3 percent
• International Stocks – 3 percent
• U.S. Real Estate Stocks – 5 percent
• U.S. and Foreign Natural Resource Stocks – 5 percent
• U.S. Treasury Securities with 20+ years to maturity – 25 percent
• U.S. Treasury Securities with less than 3 years to maturity – 25 percent
• Gold – 20 percent
• Silver – 5 percent

Stock allocations will be decided on by the manager, and active selection is to be assumed. The fund disclosed in its prospectus that it will follow through with the original plan of the Permanent Portfolio to rebalance annually. However, the fund does retain the right to rebalance in the event of unusually large performance for a particular asset class, an event not well defined. I find it highly unlikely the fund would rebalance more than once per year in direct contradiction to the strategy of the original Permanent Portfolio.

Here’s how the mutual fund divides funds between asset classes:

• Stocks (aggressive growth companies) – 15 percent
• Natural resources and foreign real estate – 15 percent
• Swiss Francs – 10 percent
• Gold – 20 percent
• Silver – 5 percent
• Treasuries – 35 percent

Should You Buy the ETF or the Mutual Fund?

Either the ETF or the mutual fund will outperform the other at various times in the future. The funds have an equal preference for gold and silver, so neither gold nor silver will be a driver of differing investment performance.

The mutual fund’s insistence on Swiss Francs is a bit of an odd-ball. The Swiss Franc may have been a differentiated currency before the Swiss joined the International Monetary Fund, a period in which the Swiss National Bank held substantial gold and silver holdings relative to its money supply. Today, however, the Swiss National Bank is very different, having initiated actions to sell unlimited quantities of the Swiss Franc for Euros to moderate the EURCHF exchange rate.

Investors would be wise to see the Swiss Franc holdings as dead-weight, low-yielding assets that are likely to drag down performance. The Swiss National Bank has every incentive to halt the Franc’s impressive rally against global currencies in the past 5 years.

All things considered, the mutual fund is perhaps more resistant to US dollar inflation, given the smaller positions in Treasury securities. However, the 23 basis point differential in fees between the ETF (48 bp annually) and the mutual fund (71bp annually) is likely to erode any tactical advantage ingrained in the Permanent Portfolio mutual fund. Additionally, currency risk from the Swiss Franc is a poor risk-to-reward gamble, one which is likely to reduce returns in the short-run while offering no substantial upside.

Permanent Portfolio Pros and Cons

Obviously the permanent portfolio is a very unique concept. Let’s run through a few of the benefits of using the permanent portfolio as an alternative investment ETF and a long-term savings vehicle:

1. Heavy Holdings of Alternative Asset Classes – Very few asset managers would keep 25% of a portfolio in precious metals, but in the last 10-year period, both silver and gold have vastly outperformed any other asset class. This is both an advantage in that investors have significant exposure to alternative asset classes, but a downfall in that precious metals are an “on-or-off” play, where they’re hot when they’re hot, and very cold for years when they’re cold.
2. Rebalancing – The rebalancing characteristic of the Permanent Portfolio ETF is what sets it apart. By rebalancing annually to reset each asset class to 25% (stocks and precious metals) or 50% (fixed-income) of the portfolio, winners are cut to double-down on losing assets. This allows the fund to capture profits in secular bull markets (bonds and gold in the last decade, for example) while protecting investors from serious downside by taking profits out of runaway asset classes each year. I would say the rebalancing element is more of an advantage than a disadvantage.
3. Simplicity – The permanent portfolio is designed for simplicity by balancing risks among very differentiated asset classes. In the long-run, a permanent portfolio would be an excellent wager; however, whenever the strategy outperforms or underperforms typical stock and bond portfolios, it is likely to do so for extended periods of time. The mutual fund lagged typical allocations in the 1980s and 1990s, only to outperform similar benchmarks during the 2000s for a larger total return.
4. Inflation loss – The Permanent Portfolio is hardly a perfect hedge to inflation. An increase in expected inflation and US government default risk could substantially affect investment returns in US Treasuries. It’s impossible to say whether the deficit will be immediately hedged by stocks (which have their own rate risks as businesses finance themselves on dollar-denominated debt markets) or silver and gold (which can be both inflation hedges, but also popular “fear” trades.)

All in all, the Permanent Portfolio is nothing short of unique. Designed for the ultimate balance between equities, income, and alternative asset classes, it’s a product without any close comparison. The decision to invest in such a blend of assets is your own; however, it should be said that investors should pay close attention to the costs of employing this strategy. The ETF is less expensive, but any ETF trade creates a flat-rate commission charge. The mutual fund has a higher long-run cost of carrying, but is free to purchase with most online discount brokers.

Disclosure: The author has no position in any of the tickers listed above.

©2012 ETF Base. All Rights Reserved.

.

In various facets of the business world, I’m still often surprised to see some businesses that do accept credit cards and others that don’t.  As technology has progressed, we’re seeing mobile swipe capability for smartphones while some businesses still don’t accept credit cards at all.  Just the other day, I was picking up a pizza at a new Italian restaurant and I was surprised to see the “cash only” sign at the register.  While it wasn’t a problem for me, as I always carry cash, I was watching frustrated customer after customer being directed to the nearby ATM to get cash out.  My presumption is that the establishment either a) gets a cut of those ATM fees (LOL) or b) perhaps the costs they’re realizing for credit card transactions are just too high.  Sometimes fees can eat into sales by 3-5%.

Thinking about why their costs are too high, they could easily account for this by either just having those costs reflected in their pricing or doing a more in-depth review of the top merchant accounts out there.  In the Italian restaurant example above, I wonder if they’ve performed the calculations (with many assumptions needed of course) as to how much in lost sales this no credit card policy has cost them.  I know some people, as a matter of practice will not come back because they only carry plastic and are probably annoyed at the hassle and cost in having to withdraw cash.  As a fledgling startup, the small business my partner and I run on the side started accepting credit cards right off that bat.  It’s an online business of course, but it wasn’t difficult or expensive to set up at all.  The speed and assurance of instant payments is worth the nominal transaction fee to us.

Anyway, just some thoughts on credit cards in the business world, back to ETFs next post!

©2012 ETF Base. All Rights Reserved.

.

State Street Global Advisors, arguably the most influential player in the ETF space, announced the launch of three new actively-managed exchange-traded funds. Before the announcement, State Street sponsored only passive portfolio products.

Actively-Managed SPDRs

The actively-managed products rolled out this week are more than your average plain-vanilla ETF. The products are unique, touching on inflation protection, income, and global allocation.

Here are the three funds as announced:

1. SPDR Global Allocation ETF (GAL) – The fund will look for immediate income and capital preservation before capital appreciation. A lower-risk fund, the Global Allocation ETF will invest in American and international stock and bond holdings, while actively-managing the portfolio to seek the highest possible yields on a risk-adjusted basis. This fund is very inexpensive for an international balanced ETF, charging management fees of only .35% per year.
2. SPDR Multi-Asset Real Return ETF (RLY) – This fund will seek capital appreciation while protecting investors from inflation with income securities including real estate and commodities. The real return ETF follows other real return ETFs such as those from IndexIQ (IQ CPI Inflation Hedged ETF CPI) and WisdomTree (WisdomTree Global Real Return Fund RRF). The fund sells with an annual expense ratio of .7% per year, an amount higher than most index ETFs, but lower than actively-managed mutual funds.
3. SPDR Income Allocation ETF (INKM) – This ETF will focus on a total return strategy from positive carry assets and income products including stocks, bonds, and preferred shares. The fund will also hold real estate investments in its portfolio. The fund differs from RLY in that it is primarily a global fund. This fund will also carry a .7% expense ratio.

The three funds will seek to find “value dislocations” in the market, where short-term trading events misprice the long-term fundamentals for any given security. The goal is to beat respective benchmarks by 2% per year, while keeping tracking error to 2-4% at any given time, according to executives at State Street.

Retirement Planning with ETFs

Exchange-traded fund assets are primarily from the institutional sector of the market, which finds the convenience of ETF products to be excellent for basic trading strategies. So far, retirement planning with exchange-traded funds is a concept that has yet to hit the mainstream – mutual fund assets tally to a sum worth more than $19 trillion, while ETF assets remain stagnant at just over $1 trillion of invested interest.

New actively-managed funds could allow institutional players like State Street to develop an edge in the retirement planning industry. So far, active ETF issues have been few – only 26 actively-managed ETFs existed before State Street’s announcement. Both iShares and PIMCO are both working on their own lines of active funds.

The difficulty for issuers is two-fold: institutional investors typically want index ETFs to implement their own management strategies, and the general public (retirement investors) still have limited access to active ETFs. Retirement plans, such as 401ks, 403bs and other similarly structured vehicles typically limit investors to a few mutual fund choices often all sponsored by the same company managing the 401k account, although the 401k annuity is gaining prominent attention of late. Those who have a broker window into ETFs (estimated to be 25% of people invested in 401ks) typically face higher transaction costs to buy and sell ETFs through a retirement account compared to an online discount broker.

ETFs Are the Future

Despite roadblocks, actively-managed funds like State Street’s newest funds are, in my view, the future for traditional retirement planning. Exchange-traded funds have much lower operating costs as “deposits” and “withdrawals” are handled by the open market, not the fund company. Additionally, the general trend in investment thinking tends to favor lower costs for investors. An actively-managed exchange-traded fund capable of accumulating large amounts of invested interest could easily compete with passive portfolio indexes on price.

Can improved strategies and falling management fees from exchange-traded fund operators make active investing attractive again?

Disclosure: No positions now or planned for the next 72 hours in any ETFs covered in this article.

©2012 ETF Base. All Rights Reserved.

.

For those that aren’t familiar, a blog carnival is a place to show off the best articles in a particular niche.  Publishers submit articles they think would be a great fit for a carnival and the site running it that week determines what articles make the cut.  It’s a great way for a site to show off their best stuff and a great way for readers to learn about a subject and get introduced to new sites.

This particular carnival deals with Passive Investing (hence the name). The purpose of the carnival is to get knowledge out about passive investing and to have a place where those interested in passive investing can learn more and share articles.

If you have a site with an article that would be a great fit for the Carnival of Passive Investing then make sure to submit your article via the carnival submission form.  So, without further ado…

Editor’s Picks

Philip Taylor presents 10 Quick Questions about the Roth IRA posted at PT Money Personal Finance.

Ken Faulkenberry presents Who Should, and Should Not, Convert a Traditional IRA to a Roth IRA? posted at AAAMP Blog.

And the Rest…

Stephen Vanderpool presents NerdWallet’s Top 5 Most Common Investing Mistakes posted at NerdWallet.

Dividend Growth Investor presents MLP’s deliver consistent distribution increases posted at Dividend Growth Investor.

Jim presents What is a Mutual Fund? posted at Bargaineering.

Zach Tripp presents Two-Year Performance of the Vanguard 529 Index Fund Portfolio posted at FOLLOW MY 529.

Paul presents Why Invest For Dividends posted at Make Money Make Cents.

Bob presents What should I do with my old 401k? posted at ChristianPF.

Darrow Kirkpatrick presents Passive vs. Active Investing: Will We Ever Learn? posted at Can I Retire Yet?.

Dividend Growth Investor presents AT&T (T) Dividend Stock Analysis posted at Dividend Growth Investor.

Geoffrey @ Financial Highway presents Fixed Income ETFs posted at Financial Highway.

©2012 ETF Base. All Rights Reserved.

.

Exchange-traded funds might not be as transparent as you think. The industry of exchange-traded fund issuers has already come under fire from FINRA for disclosures on leveraged ETFs, but new complaints say the transparency rules favor larger investors over smaller, retail investors saving for goals like retirement.

How Transparent are ETFs, Anyway?

Exchange-traded funds are required to publish their daily holdings and net asset values at the end of the trading day. Industry insiders have previously noted that such transparency is unprecedented – and it is. Mutual funds do not have the same disclosure rules, which is one of the many reasons why actively-managed funds often form as a traditional mutual fund rather than an exchange-traded fund.

All this transparency does not seem to be benefitting individual investors. While exchange-traded fund companies do report their NAVs and individual holdings to the market, this required reporting is limited to authorized participants – major investment banks, hedge funds, and portfolio managers. Data given to authorized participants rarely flows into public information available to individual investors.

Public sites like Yahoo Finance, for example, list the most recent NAVs for any given ETF as of October 6, 2011. That data is already several months old – virtually worthless to any public onlooker.

On fund issuers’ websites, the data is more recent. iShares and State Street Global Advisors both show NAV values from the previous trading day. Both companies also provide a downloadable database of the holdings.

However, indexing favorite Vanguard offers no such information to investors. The company releases data publicly only once per quarter.

Slowing the Niche ETF Boom

Limited NAV and holding information for smaller niche ETFs is the true problem with disclosure. Lesser-known issuers selling exotic ETFs often launch funds with small total asset sizes. The funds are so small that authorized participants have little incentive to use to the creation and redemption process to keep the price of the fund close to its immediate net asset value – the profit potential is simply too small for institutional investors.

Disclosure may ultimately slow the growth for niche ETFs in smaller and smaller spaces. Financial advisors, for example, cannot reasonably recommend an ETF to a client if the financial advisor has no baseline understanding of the fund’s value relative to its holdings. Is the fund trading for a premium or discount? Can you even know?

And let’s not forget that the creation and redemption process, if largely unused, threatens the awesome tax efficiency of exchange-traded funds.

As an investor, knowing what I own and what it’s really worth is very important. As someone who eagerly looks for new ETF products, I find it ridiculous to invest in a fund that might not provide enough liquidity for me to exit a position without paying a large bid-ask spread. So long as there is not enough public information to bring in long-term retirement investors, there will never be enough investment interest for short-term hedge strategists to keep the fund close to its NAV. The information provided to authorized participants fails to have any value if it cannot be priced into the market.

The fund will just go on the death list for later liquidation after failing to find sufficient assets to warrant another annual exchange fee to keep the ETF listed on the market.

Big Deal!

Vanguard responded to a press inquiry to say the disclosure rules were really no big deal at all; funds are supposed to track an index, and those indexes can usually be found elsewhere. That would be a great explanation if tracking error did not exist. Most funds do not adhere to the rules of the underlying index perfectly, so the performance of the underlying index is irrelevant.

Shame on you, Mr. Bogle!

©2012 ETF Base. All Rights Reserved.

.

Exchange-traded fund investors know better than to ignore the cost of a particular investment in a portfolio. Most gravitate to ETFs for tax efficiency and low annual management fees relative to mutual funds. Let’s explore one natural benefit to the ETF structure that makes it tax efficient.

ETF Structure Affect Tax Liabilities

Exchange-traded funds are designed as trusts, most commonly under the Investment Company Act of 1940, which allows this particular structure of a fund. As a grantor trust, the exchange-traded fund is essentially its own being – an investment company. Buying and selling the ETF, then, is just like buying or selling any other company.

But what makes this open-ended structure unique is the creation and redemption process. Open-ended funds allow for “authorized participants” (mostly major investment banks or hedge funds) to trade assets for new shares, or shares for part of the portfolio’s assets. For example, a hedge fund could offer up a portfolio of S&P500 companies in exchange for shares in the SPDR S&P500 Index ETF (SPY). The hedge fund gives the ETF the appropriate amounts of stock for SPY shares, and the ETF company gives the hedge fund an appropriate amount of SPY shares for their stock.

The opposite of this transaction is the redemption process, whereby investors can trade SPY shares for a large block of all the shares in the S&P500 index.

The Awesome Tax Efficiency of ETFs

This system of creation and redemption allows investors to skip on a majority of their capital gains tax. By virtue of the creation and redemption process, exchange-traded fund administrators can “hide” capital gains that would otherwise be passed on to investors.

Let’s use an example to demonstrate how this works. Suppose State Street Global Advisors, which is the issuer of the popular SPY ETF, has holdings in every stock in the S&P500 index to back its fund. The fund naturally holds some shares at a gain, some at a loss, and from top to bottom the fund has shares acquired at a different cost.

In the S&P500 index is Apple, which SSGA naturally owns in the ETF portfolio. State Street did not acquire all these shares at the same time. It might have two different blocks with a cost basis of $650, and $500, while the current share price might be $600.

In the redemption process, State Street can make redemptions in which it delivers stock in exchange for SPY shares. State Street can deliver the shares with a cost basis of $650 to the investor asking for redemption. This transaction essentially provides for a capital loss of $50 per share, since the current share price is $600, neutering some of the unrealized gains on the stock acquired at a cost basis of $500. Paying out the redemption with shares at a $500 cost basis would create a capital gain of $100, given that the current value of Apple shares is $600 each.

ETFs vs. Mutual Funds on Tax Efficiency

Mutual funds cannot compete with ETFs when it comes to tax efficiency (over virtually anything else – see the data showing Mutual Funds are Dead). Just look to all the stories of mutual funds falling in value yet passing on large capital gains tax bills to investors.

It is tax law that makes ETFs more efficient than mutual funds. Note the difference in tax treatment between the two funds:

• When mutual funds redeem investors’ capital, the transaction is done in cash – shares are sold and the cash is delivered to an investor.
• When ETFs make redemptions, the ETF delivers shares as an exchange. (This is known as an exchange in-kind, where stock in an ETF is exchanged for stock in the underlying assets making up the index.) Exchanging assets is not a taxable event.

The result is that ETFs can essentially “hide” most of their capital gains tax burden. Mutual funds largely have to pass on this tax burden due to the difference between selling securities and exchanging securities.

ETFs Are Not Perfect!

Exchange-traded funds are not entirely tax-free. Not all of the capital gains in any given ETF can be disposed of via the creation and redemption process. However, because the creation and redemption process is integral to the operation of an open-ended exchange-traded fund, high volumes of creation and redemption do allow for the fund to operate without passing on any capital gains tax directly.

A Bloomberg study made obvious the extreme differences in capital gains taxation between exchange-traded fund structures and mutual fund structures. The study found that in the period of August 2000-2001, exchange-traded funds based on popular indexes passed on an average capital gains tax burden of 0.31% of the ETF’s value compared to 5.87% for mutual funds.

Remember, these are the exact same funds tracking the exact same indexes. The only difference is the structure and tax consequences of selling stock compared to exchanging stock.

In this case, a $100,000 investment spread evenly in every index would result in only $310 in capital gains distributions for the year 2000-2001. Mutual funds, by contrast, passed on capital gains distributions of $5,870.

There are many misconceptions about what ETFs are designed to do and what they deliver.  For instance, all leveraged ETFs go to zero and investors are perennially frustrated when they think a 3X ETF should actually triple the return of an index (which they don’t over time!).

Disclosure: the author does not hold any of the securities listed in the article above.

©2012 ETF Base. All Rights Reserved.

.