At the turn of the New Year, V Ramesh, CEO, Prabhudas Lilladher Financial Services Pvt Ltd, has a cheerful message for investors. He talks about why he thinks the market fall presents an opportunity rather than a challenge.
The market is in turmoil. No doubt about that. Many investors who entered it at about 15,000 Sensex levels are really ruing the current situation. I, for one, am happy about the current situation. Every one of us know that this mad rush for selling stock has happened due to the lack of control measures in the US and Europe where decade-old institutions have crumbled like a pack of cards.
When investments were flooding into the emerging markets (India being one of the favoured destinations) in 2007-08, markets were zooming from one milestone to another. This was true not just for the BRIC region (Brazil, Russia, India and China) but also for countries such as the Philippines and Vietnam. With high dollar inflows into India, the rupee grew stronger. Subsequently, we saw oil prices going through the roof. The rest, as they say, is history.
Why do I say that I am happy about the steep fall in the market? Let us analyse the situation. Most of us who have any kind of exposure in the market are sitting on a loss of portfolio value, in the 40-90 per cent range depending on when we invested.
There could be someone who entered stocks five years ago, but still has seen erosion in value. What does this mean? It simply means the erosion is only in the ‘books’. Now the dilemma that all of us go through is whether or not we should now sell.
As long as you do not sell, the loss is only notional and not actual. If you actually buy, there are some amazing bargains on Dalal Street. This calls to mind an SMS doing the rounds some time ago, which termed it a ‘Diwali sale’ on Dalal Street.
One aspect of the fall we must understand is that the FIIs and Hedge Funds are simply selling to take care of redemption demands in their home country. In simple words, they are desperate... desperate to take their cash back to their country. When they are in the sell mode, who is the buyer? It has to be locals, the Indian institutions, individuals and so on.
This is a bargain hunting time for all of us. Our institutions should surely bargain hard to get the best price when the FIIs and Hedge Funds resort to distress sales. In any case, the rule of thumb is that in any distress sale, it is always the seller who is the loser. So why make an exception in the stock market?
If FIIs and Hedge Funds continue to sell, we will get to buy shares at even cheaper prices. This would be a good investment for the future. Though temporarily there can be erosion in value, in the long term, a lower price can only help returns.
With this background, I am a little perplexed on the demand to create the ‘Market Stabilisation Fund’. Such a fund, under such circumstances, will only be shooting ourselves in the foot. Such a move will also not allow discovery of price based on demand and supply. It would mean that FIIs and Hedge Funds would get better prices than they deserve to get.
As long as FIIs and Hedge Funds continue to sell, I do not mind even if the Sensex were to plunge to 3,000 and Nifty to 1,000! After all, that only means we have a better future ahead!
So let the Mutual Funds, Insurance Companies and other domestic institutional investors bargain hard to get better prices from foreign institutions, even if that means some erosion in my current investment value. To do this, it is we, the investors, who need to continue pumping money into Mutual Funds so that they can flex their muscles. Go invest!
Wednesday, December 31, 2008
WHAT WAS SAFE IN 2008 FOR INVESTORS
No place to hide. That’s the expression that best captures what investors went through in 2008, easily the most traumatic year in recent memory for active investing!
If you held Indian stocks, they fell by 54 per cent this year. If you bought foreign stocks to ‘diversify’, your portfolio would still be down by a hefty 44 per cent (return on the MSCI World Index). Commodities, which saw a breathless rally until July, then proceeded to decimate wealth even more rapidly than stocks.
The CRB Spot Index is down 55 per cent from its July peak and 25 per cent for 2008. Gold, that ultimate safe haven, didn’t lose value; global gold pr ices gained 1 per cent. But that meagre return is disappointing for a year which had all the makings of financial Armageddon — an oil ‘crisis’, runaway inflation, an implosion of the world financial system and a sudden about-turn from global growth into recession.
But Indian investors who didn’t have stocks or equity funds in their portfolio, would be surprised at all this fuss! For, rising interest rates for most of the year pushed returns on bank deposits to 10-11 per cent, after a long hiatus.
Fixed maturity plans delivered yields of 10-11 per cent, at least until their credit quality came into question.
Gold ETFs shine
If gold didn’t shine in dollar terms, gold ETFs still did, as a depreciating rupee helped them deliver a 25 per cent return.
The sudden about-turn in interest rates also triggered a sharp rally in gilt and bond prices in the final quarter of 2008. While gilt funds closed the year with a 22 per cent gain, long term debt funds too managed 13 per cent.
Which asset classes should investors lay their bets on, for 2009? As we step into 2009, we’d suggest investors keep money handy in liquid funds, as a bottoming out of the stock markets may offer a once-in-a-lifetime opportunity to buy bluechip stocks cheap. 2009 may be a year of poor earnings growth for India Inc, leaving stocks exposed to further downside during the year.
But with valuations already at historic lows, that may be a great opportunity to buy stocks or the index itself with a 5 or 10-year view. Shying away from stocks because you may lose another 10 or 15 per cent over the next year would be extremely short-sighted. Entering stocks this year will do your long-term financial goals a world of good.
As banks chop their deposit rates, debt investors who have a risk appetite can switch a portion of their money from fixed deposits and fixed maturity plans, into market-linked options such as debt mutual funds and gilt funds, which can reap gains from falling interest rates.
Remember though, that these are subject to credit and interest rate risk. Within bond funds, sticking to those with triple-A rated exposures may be the safe course, with Corporate India hitting a difficult patch.
A portion of your portfolio (say, 10 per cent) should remain invested in Gold ETFs, as gold prices may appreciate if the dollar weakens. Gold is your insurance against equity or debt investments doing badly over the next couple of years.
Finally, one lesson from 2008 is that no forecast is sacrosanct. Therefore, do not take focussed bets on any one asset or investment, no matter how strong your conviction. Start with and stick to a fixed allocation plan between equity, debt and gold investments
MUTUAL FUND INDUSTRY AND INVESTOR CONFIDENCE IN 2009
If 2008 was daunting for the mutual fund industry, the new year is unlikely to be any better.
The outlook for the industry, which was in news for a multitude of reasons, does not appear to be too positive as the buzz word for investors seems to be “caution”.
The slowdown will play out in six months and the quarter-to-quarter results of corporates will be quite disheartening, said a fund manager. Investors should go for bargain picking, he said. It would be difficult to bring investors back in such a slowdown scenario. This could be a subdued year, he added.
Days of debt funds?
Many feel that it will be debt funds that will be the preferred investment avenue, compared to equity funds, which might take time to make a comeback.
While this year will be more of debt funds rather than equity, the challenge for mutual funds would be to build portfolios in an environment where corporate defaults are on the rise, said Mr Kenneth Andrade, Vice President-Equity, IDFC Asset Management.
Investors’ confidence
There will be a lot of play on the fixed income side in the coming year as several investors will go in for short-term use of money as a way of capital protection, said Mr Jaideep Bhattacharya, Chief Marketing Officer, UTI Mutual Fund.
Confidence levels, as far as equity investments are concerned, are shaken up, but they cannot be totally ignored as an asset class, said Mr Andrade.
Equity class will come back as an asset class over a period of time, said fund managers.
Equity funds will take about a year to return to fashion, said Mr Waqar Naqvi, CEO of Taurus Mutual Fund.
Diversification and disciplined investments should be the key to investing next year, said Mr Andrade of IDFC.
Restoring investor confidence seems to be top of mind for many fund managers.
The challenge will be to fight sentiments as retail investors are essentially driven by sentiments, which seem to be very weak, said Mr Bhattacharya of UTI Mutual Fund.
There is basically shortage of cash with retail investors concerned about investing in equity, he said.
Mr Bhattacharya added that 2009 will have to be a year of innovation as mutual fund industry will have to capture the investors’ interest with innovative but simple products (“unlike the structured products we saw this year”) on the equity side.
Mr Sameer Kamdar, CEO and Managing Partner of the proposed AMC ASK Investment Holdings, said: “While the systemic challenges, like liquidity crisis lead by global credit unwinding, are not of the industry’s doing, the restoration of investor confidence in the aftermath is the prime challenge for the industry.”
The challenge for mutual fund industry in the next year will be to make retail investors understand that there is cost attached to good investment advice, said Mr Krishnamurthy Vijayan, Whole-time Director & Chief Executive Officer of JPMorgan Asset Management.
While there are numerous challenges ahead, the future is not without some positives.
It is hoped that the mutual fund advisory committee to SEBI, headed by Mr S.A. Dave, which is looking at the working of the mutual fund industry, will address key concerns and restore investor confidence. Also, with the Pension Fund Regulatory and Development Authority planning to rope in the unorganised sector in the New Pension Scheme, there would be increased availability of funds in the mutual fund space, said fund managers.
The outlook for the industry, which was in news for a multitude of reasons, does not appear to be too positive as the buzz word for investors seems to be “caution”.
The slowdown will play out in six months and the quarter-to-quarter results of corporates will be quite disheartening, said a fund manager. Investors should go for bargain picking, he said. It would be difficult to bring investors back in such a slowdown scenario. This could be a subdued year, he added.
Days of debt funds?
Many feel that it will be debt funds that will be the preferred investment avenue, compared to equity funds, which might take time to make a comeback.
While this year will be more of debt funds rather than equity, the challenge for mutual funds would be to build portfolios in an environment where corporate defaults are on the rise, said Mr Kenneth Andrade, Vice President-Equity, IDFC Asset Management.
Investors’ confidence
There will be a lot of play on the fixed income side in the coming year as several investors will go in for short-term use of money as a way of capital protection, said Mr Jaideep Bhattacharya, Chief Marketing Officer, UTI Mutual Fund.
Confidence levels, as far as equity investments are concerned, are shaken up, but they cannot be totally ignored as an asset class, said Mr Andrade.
Equity class will come back as an asset class over a period of time, said fund managers.
Equity funds will take about a year to return to fashion, said Mr Waqar Naqvi, CEO of Taurus Mutual Fund.
Diversification and disciplined investments should be the key to investing next year, said Mr Andrade of IDFC.
Restoring investor confidence seems to be top of mind for many fund managers.
The challenge will be to fight sentiments as retail investors are essentially driven by sentiments, which seem to be very weak, said Mr Bhattacharya of UTI Mutual Fund.
There is basically shortage of cash with retail investors concerned about investing in equity, he said.
Mr Bhattacharya added that 2009 will have to be a year of innovation as mutual fund industry will have to capture the investors’ interest with innovative but simple products (“unlike the structured products we saw this year”) on the equity side.
Mr Sameer Kamdar, CEO and Managing Partner of the proposed AMC ASK Investment Holdings, said: “While the systemic challenges, like liquidity crisis lead by global credit unwinding, are not of the industry’s doing, the restoration of investor confidence in the aftermath is the prime challenge for the industry.”
The challenge for mutual fund industry in the next year will be to make retail investors understand that there is cost attached to good investment advice, said Mr Krishnamurthy Vijayan, Whole-time Director & Chief Executive Officer of JPMorgan Asset Management.
While there are numerous challenges ahead, the future is not without some positives.
It is hoped that the mutual fund advisory committee to SEBI, headed by Mr S.A. Dave, which is looking at the working of the mutual fund industry, will address key concerns and restore investor confidence. Also, with the Pension Fund Regulatory and Development Authority planning to rope in the unorganised sector in the New Pension Scheme, there would be increased availability of funds in the mutual fund space, said fund managers.
Monday, December 22, 2008
Building Your Own ETF Portfolio
Building Your Own ETF Portfolio
The best way to take advantage of the benefits of ETFs is to trade them
and build a portfolio yourself. Hiring an investment adviser automatically
adds a layer of fees. And sometimes, it can be very hard to determine what value or service you’re getting for your money. If you’ve gotten through this much of the book, you can definitely build a portfolio by yourself.
You’ve learned the difference between an ETF and a mutual fund. You
know that investing in ETFs is better than investing in single stocks because
you get broad-based diversification with the flexibility and tax efficiency of
equities, but without the single-stock risk. Diversification in one trade makes
ETFs less expensive than buying individual stocks, and usually cheaper
and more tax efficient than mutual funds. You also know you can invest
in alternative asset classes with the same ease as investing in stock or
bond ETFs.
Now it’s time to put that information to good use and build your own investment portfolio. While I can recommend a certain investment strategy, readers will bring their own knowledge and preferences to how long they will hold ETFs and in what manner. You have to determine for yourself the amount of risk with which you feel comfortable. Like the title says, this book is about ETFs for the long run. The long run means buy and hold. Buy your investments, put them away, and let them grow; don’t watch the daily machinations of the stock market. The main benefit of a buy-and-hold strategy is that you don’t incur a lot of trading costs and you never have to worry about being out of the market during an up move. Since the U.S. market over the past century has been in a steady upward progression, betting on the market going up is a calculated bet.
When successful companies grow, so do their stocks. By holding and reinvesting the dividends given off by the stocks in your index, you increase the number of shares you own that can see their value grow. This compounds their value.
A buy-and-hold strategy does not mean buy and forget. Always remem-
ber: past results don’t guarantee future returns. This means that even though
the stock market has advanced over the past century, there’s no guarantee it will in the future.
All investments experience down times. Sometimes these down periods last only months, sometimes they stretch out for years. I’m not recommend-
ing market timing, but it’s good to be aware of the market and the outside world and see how they are affecting each other. Sometimes it’s a very good idea to take profits off the table. If the economic mood is changing, you should reassess your asset allocation and possibly lower your exposure to stocks. The nice thing about ETFs is that they offer many products and op-
portunities that let investors take advantage of both an up and down market.
This chapter will offer concrete suggestions on how to build a portfolio as well as some complicated, more sophisticated strategies. Because I’m not a professional asset manager, I decided to ask some professionals for suggestions on how they put together ETF-only portfolios. It’s rare for financial professionals to offer their portfolios for widespread public consumption like this. It’s what they get paid to do—produce—so I greatly appreciate their contributions. Some are well-respected portfolio managers; others are people and firms I’ve used as sources of information for my articles. They all have a lot of ETF experience. I don’t endorse any one strategy over another, but these are all people I respect.
James Kelly of Kelly Capital Management gives a very detailed road map to determine risk tolerance. I will then outline basic strategic asset allocations for conservative, moderate, and aggressive portfolios. These are precision allocations in that they break down the asset allocations into smaller categories in both the stock and bond allocations.
J. D. Steinhilber of Agile Investments created three easy-to-build strategic asset allocations—conservative, moderate, and aggressive—for the buyand-hold investor saving for retirement. The portfolios take advantage of some strategic ETFs to grab a more diverse market exposure. These creative models provide a nice comparison to the first set of portfolios and show that even two similar strategies, with similar stock and bond ratios, can be constructed in very different ways.
Afterward, I provide two examples of portfolios that depart from the classic format of U.S. stocks and bonds. Ron DeLegge of ETF Guide.com provided his Contrarian Fox portfolio. This provides a good example of a tactical asset allocation and how to construct a portfolio that goes against conventional wisdom. Finally, Burton Malkiel offers a portfolio that is focused entirely on investing in the Chinese economy. Both of these portfolios are riskier than a classic strategic asset allocation.
Altogether, these examples show how ETFs offer investors a lot of
opportunities to be creative in a wide range of portfolio construction possi-
bilities.
The Simplest Portfolio
The easiest and most straightforward portfolio consists of two investments, maybe three.
The first would be an ETF of the entire stock market, such as the SPDR DJ Wilshire Total Market ETF (symbol: TMW) from State Street Global Ad-
visors. This ETF follows the Dow Jones Wilshire 5000 Index. The second investment is an ETF that tracks 10-year U.S. Treasury bonds—for instance, the Vanguard Total Bond Market ETF (symbol: BND). It tracks the Lehman
U.S. Aggregate Bond Index, which measures a wide spectrum of public,
investment-grade U.S. government and corporate bonds. They all have ma-
turities of more than one year, and an average maturity between five and
10 years.
This portfolio is fairly low risk. You adjust the percentages according to
your age. The amount of fixed income you hold is equal to how old you are.
A ten-year-old has the most time to recover from a financial disaster. He can
afford to take on the most risk. So, his portfolio would be 10 percent bonds
and 90 percent stock. A 40-year-old with a house, kids, and looming bills
for college and retirement should put 40 percent in bonds and 60 percent
in stocks. You’re still young enough to take on risk in more than half your
portfolio, but you’re conservative enough so that while a financial disaster
will hurt—a lot—it won’t wipe you out. Then when you’re seventy, you
don’t know if you might live to 90 years old. You still need to take some
risk to grow your money, but you’re not working any more and you need
to make sure you have enough to live. This calls for at least 70 percent in
bonds and 30 percent in stocks.
If you like it simple, stop reading. This portfolio will probably suffice.
Assessing Your Risk
James Kelly is the president of Kelly Capital Management in Philadelphia.
In 2001 he became one of the first, if not the first, asset manager to make
ETF-only portfolios for his clients. Kelly has an excellent track record and is
always accepting new clients. He was kind enough to offer his insights on
creating a portfolio. These are the questions he makes investors answer to
determine their risk profile and what the most suitable investments would
be for them.
These are the questions that a professional money manager asks when
creating a portfolio. If you decide to create a portfolio on your own, these
will be instrumental in preventing you from making disastrous investing
decisions.
How Much Can I Invest, and Will It Be Held in a Taxable Account?
It’s best to put securities that will be taxed the most in tax-exempt accounts such as individual retirement accounts (IRAs), 401(k) plans, or tax shelters. This would include taxable bonds and higher income securities. Securities expected to be sold in less than 12 months and one day should be in tax-
sheltered accounts. If held in a taxable account, the capital gains from these investments would be charged at your base tax rate as ordinary income.
Taxable accounts should hold tax-free debt, unless your tax bracket is so low that the after-tax income is at least as good as the tax-free income from your home-state municipal bonds. Assets with a low turnover, those that won’t be sold for a long time, should be in a taxable portfolio. When they are sold they will be taxed at the lower capital gains tax rate. Currently, this rate is 15 percent.
What Is My Risk Tolerance?
In order for a portfolio to return a profit, one must take on risk. The first variable of risk tolerance is the investment time horizon. How long will it be before you need this money? Can you lock up this money? Can you stay invested a long time if the investment goes through a rough patch?
Can you invest for at least three years?
If the answer is no, don’t invest in securities with a fluctuating market value, such as stock or bonds. Kelly recommends keeping these assets in money-market accounts and certificates of deposit (CDs).
If the answer is yes, then investing in securities with a fluctuating market value is acceptable.
What is the goal for investing this money? Will it be for retirement, a child’s education, a house, or another major purchase?
The longer the time horizon, the more “risky” assets you can use, such as stock ETFs instead of bond ETFs.
What Are My Liquidity Needs?
The second variable of risk tolerance is liquidity. Consider not only how
long before you need the money, but your cash flow needs. How often
do you expect to draw money from your investments? Will you need to
access it immediately or on a regular basis? Liquidity is the ability to access
your money quickly. Stocks are more liquid than a certificate of deposit.
However, your stocks could be trading at a loss on the day you need to
sell. Your liquidity needs will play an important part in determining what
to invest in.
Do you need to spend all or most of your money within the next three years?
If the answer is yes, then don’t invest in “risky” assets.
If the answer is no, then you can invest in “risky” assets.
When you begin to take the money out from your investments, how will you take it?
As needed, such as small lump sums on an ad hoc basis.
On a regular basis, such as an annual required distribution from an IRA account.
Like a pension, on a monthly basis. If so, fixed-income oriented ETFs may help smooth the cash-flow generation processes.
Are there legal restrictions on what you can take, such as trusts paying out only income and a limited amount of principal?
How Do I Feel about Losses?
Obviously, no one likes losing money. As described earlier, risk is the measurement of the likelihood of losing money. Risk is also the degree of volatility that the portfolio can be expected to experience. For only through volatility can a portfolio see great growth. The greater the volatility, the greater the moves up and down. A very risky investment is one that has high volatility. For taking on a large risk the investor has the potential to be compensated with huge returns. However, the large risk also means there is a great potential for a huge decline in the asset’s value.
The best way to determine your tolerance of risk is the sleep factor. In
short, how well can you sleep at night when your portfolio is experiencing
large losses? Are you willing to tolerate fluctuations of 5 percent, 10 percent,
15 percent, 20 percent or more in the portfolio’s value in a single year? Can
you stay the course through a market downturn without becoming a nervous
wreck? The greater the tolerance for risk, then the more stock ETFs you
can use.
Are you looking for a long-term inflation hedge? In this case, stock and real-estate ETFs are the best inflation hedges.
Do you tend to look at your investments daily or less frequently? Curiosity is fine, but if you’re a Nervous Nellie then don’t invest much in stock, commodity, or real-estate oriented ETFs.
Are you influenced by the talking heads on financial programs you see on television? These people are entertainers. Take what they say accordingly.
What Is My Tax Sensitivity?
Obviously, no one likes to pay taxes. But some people go absolutely crazy about paying taxes on investment income. If you’ve held long-term investments for many years, you’ve probably accumulated a lot of gains. And once they become realized, the government will want its share. So, the taxes that must be paid after selling assets must be factored into any strategy.
Do you have substantial unrealized gains in low cost-basis securities?
Do you have company stock acquired over many years of employment?
If so, then set up a tax budget to limit the realized gains each year as
you convert your low cost-basis stock into your ETF-based portfolio
strategy.
Did you inherit a security to which you are emotionally attached? For example, a parent or spouse may have left you some stock and you are reluctant to part with it.
Is there an annual limit on how much tax you are willing to pay on capital gains? Generally 10 percent of your portfolio’s market value is a reasonable limit for realized gains.
From where will the funds come to pay the taxes on gains? The portfolio should pay its own taxes. It needs to keep enough liquidity to pay quarterly estimates to the IRS and your state revenue department.
Do Your Homework
ETF providers supply a lot of free information to investors, so look at their websites.
Some sites give you the means to assess your risk tolerance and create mock portfolios to match. In general, one should seek as much risk as one can tolerate and invest for the long term. Set up a tolerance band of about plus 5 percent and minus 5 percent around your long-term target asset mix. Rebalance this mix quarterly if it falls outside your tolerance band.
In general, unless you have a low risk tolerance, Kelly recommends that you place at least 70 percent of your assets in stocks, regardless of your age. Generally a limit of 30 percent foreign stock ETFs is comfortable for most investors with 10 percent being the minimum. The emerging-market stock ETFs give the greatest return, but are more volatile than developed market stock ETFs.
Real estate via ETFs, or specific REITS, should be limited to 10 percent of assets, which reduces the stock target by five percentage points and the fixed income target, if any, by five percentage points.
Commodities are a volatile asset class and a limit of 10 percent in commodities ETFs is tolerable for most individuals. This weighting further reduces the stock target by 10 percentage points.
A sample stock-only, aggressive portfolio might be 70 percent domestic stock ETFs and 30 percent emerging-market stock ETFs.
A sample balanced-aggressive account could be 60 percent domestic
stock ETFs, 15 percent emerging-market stock ETFs, 10 percent real-estate ETFs and 15 percent fixed income ETFs
Be Disciplined
Discipline is the ability to stick to your strategy in the face of strong head winds. Anybody can have a good strategy; it’s the ability to stick with it even as the market goes against you that determines how disciplined you are. People who are not disciplined will take their money out of the market and then invest it back in at exactly the wrong times.
Most people don’t sell at the beginning of a downturn. Instead, they typically suffer through months of declining asset values, hoping that the market will turn around and they will break even. Eventually, the pain of the losses becomes so overwhelming that the investor finally sells. Typically, this is near the bottom of the market, when he or she should be buying. He will get out at the bottom, and not be invested for the eventual upswing. Not believing the rally to be sustainable, the investor sits on his cash until the market proves to him the rally is real. If he invests at that time, he has to pay a higher price to enter the market. This increases the potential for buying just as the market is peaking.
Develop a thick skin; don’t overreact to short-term swings in market value.
Control risk by rebalancing across the ETFs you have selected and across the asset classes they represent.
Assess why things are going right and why they are going wrong. Don’t change the asset mix target frequently.
Strategic and Tactical Asset Allocation
Two common strategies for creating portfolios are Strategic Asset Alloca-
tion (SAA) and Tactical Asset Allocation (TAA). According to Investopedia, strategic asset allocation is a method that establishes and adheres to what is a “base policy mix.” This is a proportional combination of assets based on expected rates of return for each asset class. “Because the value of the assets can change given market conditions, the portfolio constantly needs to be re-adjusted to meet the policy. For example, if stocks have historically returned 10 percent per year and bonds have returned 5 percent per year, a mix of 50 percent stocks and 50 percent bonds would be expected to return
7.5 percent per year.”1
Putting 60 percent of the portfolio in equities and 40 percent in bonds is your strategic asset allocation. This can be broken down further into many different stock and bond ETFs. Once you’ve researched the funds and created the asset allocation, you buy them. Then you hold them. This is a passive strategy.
Over the course of the year the weighting of each ETF in the portfolio
changes depending on how the markets perform. At the end of the specified
time period, usually the calendar year, the investor rebalances the portfolio
to get back to the strategic asset allocation’s original weightings. Most people
wait until the end of the year to rebalance the portfolio and bring it back
to its original allocations. For example, let’s say your portfolio is 75 percent
stocks and 25 percent bonds. Over the next year, you invest more into the
fund and stock market rallies. The stock allocation grows to 85 percent
of the portfolio, while bonds fall to 15 percent. To bring the allocation
back into its proper weighting of 75 percent, you would sell some equity
ETF shares. Then you take the money from selling stock ETF shares and
buy enough shares in the bond ETFs to bring their allocation back up the
model’s desired 25 percent.
Rebalancing is a way of keeping your model at the appropriate risk level. In addition, it is a disciplined way to take profits in the investments that have been doing well and buy shares in the investments that are out of favor. Typically, these investments have been beaten down and trade at much cheaper prices. This is a systematic, disciplined way to force you to buy low and sell high.
The strategy is relatively rigid, but for many people that works. They want to set up their investments, then go about their daily lives. However, economic conditions often favor one asset class over another, creating un-
usual investment opportunities. In tactical asset allocation, the portfolios aren’t passive. The investor, or asset manager, makes short-term, tactical deviations from the strategic mix to take advantage of these opportunities.
Tactical asset allocation, according to Investopedia, can be described as a moderately active strategy, since this flexibility adds a component of market timing to the portfolio. Tactical movements allow you to then make precise shifts in and out of the asset classes. This allows the asset manager to add value and reduce risk by taking advantage of “security misevaluations across the asset classes.”TAA requires much more work and discipline than regular strategic
asset allocation, because the portfolio must be rebalanced to the original
long-term SAA when the short-term opportunities disappear. Such a strategy
can be difficult for the individual investor. It will also add to your transac-
tion costs.
A big problem with creating asset allocations with mutual funds is that you never really know what a mutual fund holds, so you never really know what your exposures are. ETFs bypass all that. The ETF’s transparency allows for incredible risk management because ETFs offer the ability to create strategic allocations with great precision.
You can model these portfolios exactly or use them as a launching point. Feel free to add other ETFs in allocations appropriate to the model’s benchmark ratio of stocks to bonds
Classic Conservative Portfolio
A portfolio is considered conservative if it has an equity allocation of less than 50 percent. In this case conservative isn’t a political philosophy, but an investing one. Conservative investors shy away from risk and are very concerned with not losing any of their principal investment. Many live off the income produced by their holdings.
In this portfolio, the strategic asset allocation is 40 percent equities, not including real estate trusts. This is a reasonable amount for a person with a fairly low risk tolerance. Most of the portfolio sits in bonds, about 51 percent. Unless you’re nearing retirement, this is probably too little to be holding in stocks. But it’s worthwhile to look at a conservative portfolio to give a base line for more aggressive portfolios.
The final 9 percent could be held in real-estate ETFs or commodity ETFs. For this example it won’t hold commodities, because with expense ratios around 0.5 percent to 0.6 percent, these remain too high for the portfolio.
EQUITIES The first thing to determine is how much of your stock portfo-
lio will go to domestic stocks and how much to foreign stocks. Once the domestic allocation is determined, many investors choose to seek precision by breaking domestic stocks into three ETFs based on the size of the com-
panies: large-cap stocks, mid-caps, and small-caps. Each one has different behavioral aspects and usually one sector will do better than the others. Small-caps usually lead bull markets, while large-caps are usually better during market turbulence and a good place to make defensive moves.
Another reason for breaking down stocks and bonds this way is for tactical asset management. This lets the investor or asset manager be more active in the portfolio management. They can take advantage of market opportunities by tactically tweaking the individual sectors up or down. If, for example, small stocks are doing better than large-cap stocks, the large-
cap weighting of the portfolio could decrease by five percentage points
while the small-cap portion could increase by the same amount.
FIXED-INCOME The nonequity portion of the portfolio is generally divided
among real estate, short- and long-term treasuries, corporate debt, and Trea-
sury Inflation Protection Securities, better known as TIPS. These are U.S.
Treasury bonds that adjust their principal and interest payments to protect
investors from inflation. Fixed-income refers to bonds. It means these as-
sets give off a steady stream of cash in the form of interest, also known as
income.
Short-term bonds mature within five years, and have less risk than
long-term bonds. Short-term bonds make up 32 percent of the port-
folio. The Vanguard Short-Term Bond ETF (symbol: BSV) is a good
choice. It tracks the benchmark index, the Lehman 1-5 Year U.S. Gov-
ernment/Credit Index. This index includes all medium and larger public
issues of U.S. government, investment-grade corporate, and investment-
grade international dollar-denominated bonds that have maturities be-
tween one and five years. The average maturity shouldn’t exceed three
years, and is typically two years. The ETF holds about 700 securities.
Long-term bonds typically have maturities greater than 10 years. The
Vanguard Long-Term Bond ETF (symbol: BLV) follows the Lehman
Long U.S. Government/Credit Index. It would hold 4 percent of the
portfolio.
The iShares Lehman Credit Bond Fund (symbol: CFT), which tracks the eponymous index, holds 5 percent. This index measures investment grade corporate debt and non-U.S. agency bonds with a maturity of greater than one year.
The iShares Lehman TIPS Bond Fund (symbol: TIP) makes up 10 percent of the SAA.
ALTERNATIVE INVESTMENT A broad real estate ETF such as the Vanguard REIT ETF (symbol: VNQ) makes up 9 percent of the portfolio. This follows the MSCI US REIT Index, which covers about two thirds of the value of the entire U.S. real-estate investment trust (REIT) market. The fund invests 98 percent of its assets in REIT stocks and the rest in cash. In light of the current situation in the housing industry, an investor might be better off .
Foundation Portfolios
Another early adopter of the all-ETF portfolio, J. D. Steinhilber, contributed a series of model portfolios to this book. They are very straightforward, simple to understand, and easy to put together. Most investors can use these as a foundation for their own investments, or follow them exactly.
Previously an investment banker doing corporate finance at Nashville, Tennessee, regional bank J.C. Bradford & Co, Steinhilber started Agile Investments, his asset management firm, in 2001, following the popping of the Internet bubble. It was a bear market in full growl.
Building his business in the wake of the iShares launch, he decided
he would never use single-company stocks for client portfolios, only ETFs.
Once in a while, he adds a mutual fund to the ETFs. When he does, he
chooses a fund that gives its portfolio manager wide latitude to add value
to the fund.
The Nashville investment advisor likes the transparency of ETFs and
believes their ability to track the market with broad indexes and low expense
ratios is the best way to build a nest egg. But he doesn’t call the firm Agile
for nothing. Even though he uses passive vehicles, he employs an active
management style called tactical asset allocation. That means the portfolios
are fluid.
Depending on the economic backdrop and fundamentals at the asset class level, he re-evaluates different slices of the market, and tweaks the asset allocations to take advantage of the current market conditions. The strategy appears to work. The aggressive model portfolio he used from 2002 through 2007 saw an average annual return of 9.9 percent, in contrast with the S&P 500’s 6.0 percent.
Steinhilber’s belief in lower fees doesn’t change when it comes to charg-
ing his own clients. He typically requires a client to have a minimum invest-
ment of $250,000 to invest with his firm. His fees start at a very reasonable
0.6 percent of assets for the minimum-sized portfolio, and decrease as the portfolios grow in size.
I asked him to design three fundamental strategies that a typical buyand-hold investor could use as a foundation for a long-term portfolio. These models—conservative, moderate, and aggressive—are designed for an investor saving for retirement.
All three of these models are suitable for an average investor. All the ETFs are liquid. The average expense ratio is very low, with the two bond funds and the domestic REIT fund charging only 0.11 percent. The ETNs charge 0.75 percent or 0.85 percent, but they make up for it in tax efficiency. Which model you choose will be determined by your risk comfort level.
The buy-and-hold portfolios provided by Agile Investments are strategic asset allocations just like the classic portfolios, only these are more high concept. Instead of breaking up the stock portion into funds of differentsized companies, he buys a total market index, so that he can take advantage of ETFs that offer creative strategies.
While both the classic and foundation models are basically stock and bond portfolios, comparing the Agile portfolios with the portfolios in the previous section provides us with a great opportunity to see how two portfolios with similar risk tolerances and strategic asset allocations can be set up in completely different ways.
The Conservative Growth ETF Model
This model is good for investors with a low risk tolerance. They could be very wary of the stock market’s direction or very concerned with protecting capital. Typically, people nearing or just entering retirement might like this model. Capital protection seems to be the overriding theme, but the equity components provide the potential to capture some outsized returns should stocks rally. (See Table 10.4.)
According to Steinhilber:
This portfolio is suitable for clients willing to assume a level of market risk and volatility typical of a traditional balanced investment portfolio. Although asset class weightings will vary based on our tactical asset allocation methodology, and alternative asset classes, such as real estate investment trusts or precious metals, may be employed, an appropriate benchmark for this portfolio is 60% equities and 40% fixed income.
The portfolio presented here breaks down into:
Equities: 40 percent
Fixed-Income: 45 percent
Alternative Investments: 15 percent
The Moderate Growth ETF Model
The Moderate Growth ETF Model and the Aggressive Growth ETF Model
are variations on the theme. They both start with the Conservative Growth
ETF Model then make a few adjustments to increase the profit potential by
taking on more risk. The equity component makes up a greater proportion
of the portfolio, while the total of fixed-income investments decreases.
The Aggressive Growth ETF Model
The Aggressive Growth ETF Model takes on much more risk. Steinhilber describes the Aggressive Growth ETF Model as “suitable for clients willing to sustain substantial volatility and assume a high level of risk in pursuit of higher returns. Although alternative asset classes may be employed, an
Steinhilber describes the Moderate Growth ETF Model as “suitable for clients seeking potentially higher return opportunities and willing to assume a level of market risk and volatility somewhat higher than a traditional, balanced investment portfolio. Although alternative asset classes may be employed, an appropriate benchmark for this portfolio is 75 percent equities and 25 percent fixed income.”8
The Moderate Growth ETF Model is the exact same basket of ETFs as the Conservative model, but the allocation of each ETF is different. In the Moderate Growth Model the total equity allocation jumps to 60 percent from 40 percent, while fixed-income’s allocation drops to 25 percent from 45 percent. The proportion of Alternative Investments remains the same at 15 percent of the portfolio, with the same five ETFs each making up just 3 percent of the total portfolio.
In the equity portion of the moderate-risk model, the Vanguard Total Stock Market ETF allocation rises to 25 percent of the portfolio from 15 percent in the conservative portfolio. The Shares Dow Jones Select Dividend ETF and iPath CBOE S&P 500 BuyWrite Index ETN both remain at 5 percent, bringing the total domestic stock allocation to 35 percent. The Vanguard FTSE All-World ex-U.S. ETF remains the only international equity fund. It now comprises 25 percent of the portfolio, up from 15 percent.
In the fixed-income section, the Vanguard Total Bond Market ETF drops
from 20 percent to 15 percent of the total model, while the Vanguard Short-
Term Bond ETF takes an even bigger hit, falling to 10 percent from 25
percent.
appropriate benchmark for this portfolio is 90 percent equities and 10 percent fixed income.”
In the aggressive model, the equity portion jumps to 73 percent of the total portfolio from 60 percent in the moderate portfolio, and just 40 percent in the conservative model. Bonds drop to just 7 percent of the total strategy. That’s a huge decline from the moderate model’s 25 percent and the 45 percent in the conservative one. Alternative investments jump to 20 percent from 15 percent.
Not Following the Herd
Contrarian investing is choosing to zig when the rest of the market says
“zag”—or more precisely, trying to profit by doing the opposite of the
market’s conventional wisdom. Essentially, contrarian investing is defying
the crowd.
One of the old sayings of Wall Street is that the market climbs a wall of worry. This means the best time to buy stocks is when people are fearful. When there is widespread optimism and most people believe the market will keep going higher, the contrarian investor says the securities are probably fairly priced or overpriced and now is the time to sell. On the other hand, when everyone decides to sell and market pessimism is at high levels, the contrarian finds that a perfect time to buy. Prices are low and if everyone has sold, they can’t go much lower.
Value investing is a kind of contrarian investing because it looks for out-of-favor securities with low P/E ratios.
In this section are two portfolios that don’t follow the herd. These are not the classic portfolios that consist predominantly of U.S. stocks and bonds. Both the Contrarian Fox and Active China Strategy are high-concept portfolios. They each take the idea that the broad U.S. stock market is not the best place to be invested. The Contrarian Fox picks a few under-the-
radar sectors that it expects to outperform the U.S. market. The Active China Strategy essentially says China is where the best growth is, so why bother
with the United States? Both of these portfolios are very risky, but they are presented to offer examples of the kinds of creative portfolios that ETFs make possible.
Contrarian Fox Portfolio
Ron DeLegge, the founder and editor of ETF Guide.com, a Web site focused on the ETF industry, offers sample portfolios to subscribers. DeLegge, a former portfolio manager, agreed to let me publish his contrarian portfolio to give people an idea of what such a portfolio might hold. DeLegge says the objective and strategy of the Contrarian ETF portfolio’s is to “identify and select ETF asset classes that are out-of-favor or undervalued and which exhibit positive growth characteristics and a pending rebound.”10
This is a snapshot of what the portfolio looked like in March 2008. At this time, the U.S. economy was said to be entering a recession. The
U.S. stock market had already fallen 15 percent off its high. The bubble in
the housing market had popped as the subprime mortgage crisis caused
large amounts of homeowners to lose their homes in foreclosure. Across
the country, the real estate market was falling in value. The financial sector,
especially commercial and investment banks, suffered from the fall-out in
the housing market. Many had taken on huge amounts of risk buying and
selling mortgage-backed assets. By this time, many banks had written off
losses in the billions of dollars. Meanwhile, the dollar continued its decline,
sending the price of gold up 25 percent over the previous six months to
$1,000 an ounce.
While a typical portfolio seeks to give an investor a broad overview of
the stock market, this portfolio presents a different picture.
The Contrarian Fox model isn’t a buy-and-hold portfolio. Instead, it is
more of a tactical asset allocation model. The investor or portfolio manager
buys and sells assets to take advantage of the changing market trends.
In buy-and-hold investing, you set your strategic asset allocation and stick with it, for the most part, in both up and down markets. The reason behind holding the same assets and allocation in a down market is that you never know when the market will rebound. You could be out of the market at the wrong time and miss a big move up. However, if you stay pat, you will catch the rebound.
The tactical asset allocation attempts to increase returns by taking advantage of changes in the market. These asset allocations can change often and it is not advisable to copy this portfolio exactly. However, it provides an example of how a portfolio can be structured in a declining stock market.
The best way to take advantage of the benefits of ETFs is to trade them
and build a portfolio yourself. Hiring an investment adviser automatically
adds a layer of fees. And sometimes, it can be very hard to determine what value or service you’re getting for your money. If you’ve gotten through this much of the book, you can definitely build a portfolio by yourself.
You’ve learned the difference between an ETF and a mutual fund. You
know that investing in ETFs is better than investing in single stocks because
you get broad-based diversification with the flexibility and tax efficiency of
equities, but without the single-stock risk. Diversification in one trade makes
ETFs less expensive than buying individual stocks, and usually cheaper
and more tax efficient than mutual funds. You also know you can invest
in alternative asset classes with the same ease as investing in stock or
bond ETFs.
Now it’s time to put that information to good use and build your own investment portfolio. While I can recommend a certain investment strategy, readers will bring their own knowledge and preferences to how long they will hold ETFs and in what manner. You have to determine for yourself the amount of risk with which you feel comfortable. Like the title says, this book is about ETFs for the long run. The long run means buy and hold. Buy your investments, put them away, and let them grow; don’t watch the daily machinations of the stock market. The main benefit of a buy-and-hold strategy is that you don’t incur a lot of trading costs and you never have to worry about being out of the market during an up move. Since the U.S. market over the past century has been in a steady upward progression, betting on the market going up is a calculated bet.
When successful companies grow, so do their stocks. By holding and reinvesting the dividends given off by the stocks in your index, you increase the number of shares you own that can see their value grow. This compounds their value.
A buy-and-hold strategy does not mean buy and forget. Always remem-
ber: past results don’t guarantee future returns. This means that even though
the stock market has advanced over the past century, there’s no guarantee it will in the future.
All investments experience down times. Sometimes these down periods last only months, sometimes they stretch out for years. I’m not recommend-
ing market timing, but it’s good to be aware of the market and the outside world and see how they are affecting each other. Sometimes it’s a very good idea to take profits off the table. If the economic mood is changing, you should reassess your asset allocation and possibly lower your exposure to stocks. The nice thing about ETFs is that they offer many products and op-
portunities that let investors take advantage of both an up and down market.
This chapter will offer concrete suggestions on how to build a portfolio as well as some complicated, more sophisticated strategies. Because I’m not a professional asset manager, I decided to ask some professionals for suggestions on how they put together ETF-only portfolios. It’s rare for financial professionals to offer their portfolios for widespread public consumption like this. It’s what they get paid to do—produce—so I greatly appreciate their contributions. Some are well-respected portfolio managers; others are people and firms I’ve used as sources of information for my articles. They all have a lot of ETF experience. I don’t endorse any one strategy over another, but these are all people I respect.
James Kelly of Kelly Capital Management gives a very detailed road map to determine risk tolerance. I will then outline basic strategic asset allocations for conservative, moderate, and aggressive portfolios. These are precision allocations in that they break down the asset allocations into smaller categories in both the stock and bond allocations.
J. D. Steinhilber of Agile Investments created three easy-to-build strategic asset allocations—conservative, moderate, and aggressive—for the buyand-hold investor saving for retirement. The portfolios take advantage of some strategic ETFs to grab a more diverse market exposure. These creative models provide a nice comparison to the first set of portfolios and show that even two similar strategies, with similar stock and bond ratios, can be constructed in very different ways.
Afterward, I provide two examples of portfolios that depart from the classic format of U.S. stocks and bonds. Ron DeLegge of ETF Guide.com provided his Contrarian Fox portfolio. This provides a good example of a tactical asset allocation and how to construct a portfolio that goes against conventional wisdom. Finally, Burton Malkiel offers a portfolio that is focused entirely on investing in the Chinese economy. Both of these portfolios are riskier than a classic strategic asset allocation.
Altogether, these examples show how ETFs offer investors a lot of
opportunities to be creative in a wide range of portfolio construction possi-
bilities.
The Simplest Portfolio
The easiest and most straightforward portfolio consists of two investments, maybe three.
The first would be an ETF of the entire stock market, such as the SPDR DJ Wilshire Total Market ETF (symbol: TMW) from State Street Global Ad-
visors. This ETF follows the Dow Jones Wilshire 5000 Index. The second investment is an ETF that tracks 10-year U.S. Treasury bonds—for instance, the Vanguard Total Bond Market ETF (symbol: BND). It tracks the Lehman
U.S. Aggregate Bond Index, which measures a wide spectrum of public,
investment-grade U.S. government and corporate bonds. They all have ma-
turities of more than one year, and an average maturity between five and
10 years.
This portfolio is fairly low risk. You adjust the percentages according to
your age. The amount of fixed income you hold is equal to how old you are.
A ten-year-old has the most time to recover from a financial disaster. He can
afford to take on the most risk. So, his portfolio would be 10 percent bonds
and 90 percent stock. A 40-year-old with a house, kids, and looming bills
for college and retirement should put 40 percent in bonds and 60 percent
in stocks. You’re still young enough to take on risk in more than half your
portfolio, but you’re conservative enough so that while a financial disaster
will hurt—a lot—it won’t wipe you out. Then when you’re seventy, you
don’t know if you might live to 90 years old. You still need to take some
risk to grow your money, but you’re not working any more and you need
to make sure you have enough to live. This calls for at least 70 percent in
bonds and 30 percent in stocks.
If you like it simple, stop reading. This portfolio will probably suffice.
Assessing Your Risk
James Kelly is the president of Kelly Capital Management in Philadelphia.
In 2001 he became one of the first, if not the first, asset manager to make
ETF-only portfolios for his clients. Kelly has an excellent track record and is
always accepting new clients. He was kind enough to offer his insights on
creating a portfolio. These are the questions he makes investors answer to
determine their risk profile and what the most suitable investments would
be for them.
These are the questions that a professional money manager asks when
creating a portfolio. If you decide to create a portfolio on your own, these
will be instrumental in preventing you from making disastrous investing
decisions.
How Much Can I Invest, and Will It Be Held in a Taxable Account?
It’s best to put securities that will be taxed the most in tax-exempt accounts such as individual retirement accounts (IRAs), 401(k) plans, or tax shelters. This would include taxable bonds and higher income securities. Securities expected to be sold in less than 12 months and one day should be in tax-
sheltered accounts. If held in a taxable account, the capital gains from these investments would be charged at your base tax rate as ordinary income.
Taxable accounts should hold tax-free debt, unless your tax bracket is so low that the after-tax income is at least as good as the tax-free income from your home-state municipal bonds. Assets with a low turnover, those that won’t be sold for a long time, should be in a taxable portfolio. When they are sold they will be taxed at the lower capital gains tax rate. Currently, this rate is 15 percent.
What Is My Risk Tolerance?
In order for a portfolio to return a profit, one must take on risk. The first variable of risk tolerance is the investment time horizon. How long will it be before you need this money? Can you lock up this money? Can you stay invested a long time if the investment goes through a rough patch?
Can you invest for at least three years?
If the answer is no, don’t invest in securities with a fluctuating market value, such as stock or bonds. Kelly recommends keeping these assets in money-market accounts and certificates of deposit (CDs).
If the answer is yes, then investing in securities with a fluctuating market value is acceptable.
What is the goal for investing this money? Will it be for retirement, a child’s education, a house, or another major purchase?
The longer the time horizon, the more “risky” assets you can use, such as stock ETFs instead of bond ETFs.
What Are My Liquidity Needs?
The second variable of risk tolerance is liquidity. Consider not only how
long before you need the money, but your cash flow needs. How often
do you expect to draw money from your investments? Will you need to
access it immediately or on a regular basis? Liquidity is the ability to access
your money quickly. Stocks are more liquid than a certificate of deposit.
However, your stocks could be trading at a loss on the day you need to
sell. Your liquidity needs will play an important part in determining what
to invest in.
Do you need to spend all or most of your money within the next three years?
If the answer is yes, then don’t invest in “risky” assets.
If the answer is no, then you can invest in “risky” assets.
When you begin to take the money out from your investments, how will you take it?
As needed, such as small lump sums on an ad hoc basis.
On a regular basis, such as an annual required distribution from an IRA account.
Like a pension, on a monthly basis. If so, fixed-income oriented ETFs may help smooth the cash-flow generation processes.
Are there legal restrictions on what you can take, such as trusts paying out only income and a limited amount of principal?
How Do I Feel about Losses?
Obviously, no one likes losing money. As described earlier, risk is the measurement of the likelihood of losing money. Risk is also the degree of volatility that the portfolio can be expected to experience. For only through volatility can a portfolio see great growth. The greater the volatility, the greater the moves up and down. A very risky investment is one that has high volatility. For taking on a large risk the investor has the potential to be compensated with huge returns. However, the large risk also means there is a great potential for a huge decline in the asset’s value.
The best way to determine your tolerance of risk is the sleep factor. In
short, how well can you sleep at night when your portfolio is experiencing
large losses? Are you willing to tolerate fluctuations of 5 percent, 10 percent,
15 percent, 20 percent or more in the portfolio’s value in a single year? Can
you stay the course through a market downturn without becoming a nervous
wreck? The greater the tolerance for risk, then the more stock ETFs you
can use.
Are you looking for a long-term inflation hedge? In this case, stock and real-estate ETFs are the best inflation hedges.
Do you tend to look at your investments daily or less frequently? Curiosity is fine, but if you’re a Nervous Nellie then don’t invest much in stock, commodity, or real-estate oriented ETFs.
Are you influenced by the talking heads on financial programs you see on television? These people are entertainers. Take what they say accordingly.
What Is My Tax Sensitivity?
Obviously, no one likes to pay taxes. But some people go absolutely crazy about paying taxes on investment income. If you’ve held long-term investments for many years, you’ve probably accumulated a lot of gains. And once they become realized, the government will want its share. So, the taxes that must be paid after selling assets must be factored into any strategy.
Do you have substantial unrealized gains in low cost-basis securities?
Do you have company stock acquired over many years of employment?
If so, then set up a tax budget to limit the realized gains each year as
you convert your low cost-basis stock into your ETF-based portfolio
strategy.
Did you inherit a security to which you are emotionally attached? For example, a parent or spouse may have left you some stock and you are reluctant to part with it.
Is there an annual limit on how much tax you are willing to pay on capital gains? Generally 10 percent of your portfolio’s market value is a reasonable limit for realized gains.
From where will the funds come to pay the taxes on gains? The portfolio should pay its own taxes. It needs to keep enough liquidity to pay quarterly estimates to the IRS and your state revenue department.
Do Your Homework
ETF providers supply a lot of free information to investors, so look at their websites.
Some sites give you the means to assess your risk tolerance and create mock portfolios to match. In general, one should seek as much risk as one can tolerate and invest for the long term. Set up a tolerance band of about plus 5 percent and minus 5 percent around your long-term target asset mix. Rebalance this mix quarterly if it falls outside your tolerance band.
In general, unless you have a low risk tolerance, Kelly recommends that you place at least 70 percent of your assets in stocks, regardless of your age. Generally a limit of 30 percent foreign stock ETFs is comfortable for most investors with 10 percent being the minimum. The emerging-market stock ETFs give the greatest return, but are more volatile than developed market stock ETFs.
Real estate via ETFs, or specific REITS, should be limited to 10 percent of assets, which reduces the stock target by five percentage points and the fixed income target, if any, by five percentage points.
Commodities are a volatile asset class and a limit of 10 percent in commodities ETFs is tolerable for most individuals. This weighting further reduces the stock target by 10 percentage points.
A sample stock-only, aggressive portfolio might be 70 percent domestic stock ETFs and 30 percent emerging-market stock ETFs.
A sample balanced-aggressive account could be 60 percent domestic
stock ETFs, 15 percent emerging-market stock ETFs, 10 percent real-estate ETFs and 15 percent fixed income ETFs
Be Disciplined
Discipline is the ability to stick to your strategy in the face of strong head winds. Anybody can have a good strategy; it’s the ability to stick with it even as the market goes against you that determines how disciplined you are. People who are not disciplined will take their money out of the market and then invest it back in at exactly the wrong times.
Most people don’t sell at the beginning of a downturn. Instead, they typically suffer through months of declining asset values, hoping that the market will turn around and they will break even. Eventually, the pain of the losses becomes so overwhelming that the investor finally sells. Typically, this is near the bottom of the market, when he or she should be buying. He will get out at the bottom, and not be invested for the eventual upswing. Not believing the rally to be sustainable, the investor sits on his cash until the market proves to him the rally is real. If he invests at that time, he has to pay a higher price to enter the market. This increases the potential for buying just as the market is peaking.
Develop a thick skin; don’t overreact to short-term swings in market value.
Control risk by rebalancing across the ETFs you have selected and across the asset classes they represent.
Assess why things are going right and why they are going wrong. Don’t change the asset mix target frequently.
Strategic and Tactical Asset Allocation
Two common strategies for creating portfolios are Strategic Asset Alloca-
tion (SAA) and Tactical Asset Allocation (TAA). According to Investopedia, strategic asset allocation is a method that establishes and adheres to what is a “base policy mix.” This is a proportional combination of assets based on expected rates of return for each asset class. “Because the value of the assets can change given market conditions, the portfolio constantly needs to be re-adjusted to meet the policy. For example, if stocks have historically returned 10 percent per year and bonds have returned 5 percent per year, a mix of 50 percent stocks and 50 percent bonds would be expected to return
7.5 percent per year.”1
Putting 60 percent of the portfolio in equities and 40 percent in bonds is your strategic asset allocation. This can be broken down further into many different stock and bond ETFs. Once you’ve researched the funds and created the asset allocation, you buy them. Then you hold them. This is a passive strategy.
Over the course of the year the weighting of each ETF in the portfolio
changes depending on how the markets perform. At the end of the specified
time period, usually the calendar year, the investor rebalances the portfolio
to get back to the strategic asset allocation’s original weightings. Most people
wait until the end of the year to rebalance the portfolio and bring it back
to its original allocations. For example, let’s say your portfolio is 75 percent
stocks and 25 percent bonds. Over the next year, you invest more into the
fund and stock market rallies. The stock allocation grows to 85 percent
of the portfolio, while bonds fall to 15 percent. To bring the allocation
back into its proper weighting of 75 percent, you would sell some equity
ETF shares. Then you take the money from selling stock ETF shares and
buy enough shares in the bond ETFs to bring their allocation back up the
model’s desired 25 percent.
Rebalancing is a way of keeping your model at the appropriate risk level. In addition, it is a disciplined way to take profits in the investments that have been doing well and buy shares in the investments that are out of favor. Typically, these investments have been beaten down and trade at much cheaper prices. This is a systematic, disciplined way to force you to buy low and sell high.
The strategy is relatively rigid, but for many people that works. They want to set up their investments, then go about their daily lives. However, economic conditions often favor one asset class over another, creating un-
usual investment opportunities. In tactical asset allocation, the portfolios aren’t passive. The investor, or asset manager, makes short-term, tactical deviations from the strategic mix to take advantage of these opportunities.
Tactical asset allocation, according to Investopedia, can be described as a moderately active strategy, since this flexibility adds a component of market timing to the portfolio. Tactical movements allow you to then make precise shifts in and out of the asset classes. This allows the asset manager to add value and reduce risk by taking advantage of “security misevaluations across the asset classes.”TAA requires much more work and discipline than regular strategic
asset allocation, because the portfolio must be rebalanced to the original
long-term SAA when the short-term opportunities disappear. Such a strategy
can be difficult for the individual investor. It will also add to your transac-
tion costs.
A big problem with creating asset allocations with mutual funds is that you never really know what a mutual fund holds, so you never really know what your exposures are. ETFs bypass all that. The ETF’s transparency allows for incredible risk management because ETFs offer the ability to create strategic allocations with great precision.
You can model these portfolios exactly or use them as a launching point. Feel free to add other ETFs in allocations appropriate to the model’s benchmark ratio of stocks to bonds
Classic Conservative Portfolio
A portfolio is considered conservative if it has an equity allocation of less than 50 percent. In this case conservative isn’t a political philosophy, but an investing one. Conservative investors shy away from risk and are very concerned with not losing any of their principal investment. Many live off the income produced by their holdings.
In this portfolio, the strategic asset allocation is 40 percent equities, not including real estate trusts. This is a reasonable amount for a person with a fairly low risk tolerance. Most of the portfolio sits in bonds, about 51 percent. Unless you’re nearing retirement, this is probably too little to be holding in stocks. But it’s worthwhile to look at a conservative portfolio to give a base line for more aggressive portfolios.
The final 9 percent could be held in real-estate ETFs or commodity ETFs. For this example it won’t hold commodities, because with expense ratios around 0.5 percent to 0.6 percent, these remain too high for the portfolio.
EQUITIES The first thing to determine is how much of your stock portfo-
lio will go to domestic stocks and how much to foreign stocks. Once the domestic allocation is determined, many investors choose to seek precision by breaking domestic stocks into three ETFs based on the size of the com-
panies: large-cap stocks, mid-caps, and small-caps. Each one has different behavioral aspects and usually one sector will do better than the others. Small-caps usually lead bull markets, while large-caps are usually better during market turbulence and a good place to make defensive moves.
Another reason for breaking down stocks and bonds this way is for tactical asset management. This lets the investor or asset manager be more active in the portfolio management. They can take advantage of market opportunities by tactically tweaking the individual sectors up or down. If, for example, small stocks are doing better than large-cap stocks, the large-
cap weighting of the portfolio could decrease by five percentage points
while the small-cap portion could increase by the same amount.
FIXED-INCOME The nonequity portion of the portfolio is generally divided
among real estate, short- and long-term treasuries, corporate debt, and Trea-
sury Inflation Protection Securities, better known as TIPS. These are U.S.
Treasury bonds that adjust their principal and interest payments to protect
investors from inflation. Fixed-income refers to bonds. It means these as-
sets give off a steady stream of cash in the form of interest, also known as
income.
Short-term bonds mature within five years, and have less risk than
long-term bonds. Short-term bonds make up 32 percent of the port-
folio. The Vanguard Short-Term Bond ETF (symbol: BSV) is a good
choice. It tracks the benchmark index, the Lehman 1-5 Year U.S. Gov-
ernment/Credit Index. This index includes all medium and larger public
issues of U.S. government, investment-grade corporate, and investment-
grade international dollar-denominated bonds that have maturities be-
tween one and five years. The average maturity shouldn’t exceed three
years, and is typically two years. The ETF holds about 700 securities.
Long-term bonds typically have maturities greater than 10 years. The
Vanguard Long-Term Bond ETF (symbol: BLV) follows the Lehman
Long U.S. Government/Credit Index. It would hold 4 percent of the
portfolio.
The iShares Lehman Credit Bond Fund (symbol: CFT), which tracks the eponymous index, holds 5 percent. This index measures investment grade corporate debt and non-U.S. agency bonds with a maturity of greater than one year.
The iShares Lehman TIPS Bond Fund (symbol: TIP) makes up 10 percent of the SAA.
ALTERNATIVE INVESTMENT A broad real estate ETF such as the Vanguard REIT ETF (symbol: VNQ) makes up 9 percent of the portfolio. This follows the MSCI US REIT Index, which covers about two thirds of the value of the entire U.S. real-estate investment trust (REIT) market. The fund invests 98 percent of its assets in REIT stocks and the rest in cash. In light of the current situation in the housing industry, an investor might be better off .
Foundation Portfolios
Another early adopter of the all-ETF portfolio, J. D. Steinhilber, contributed a series of model portfolios to this book. They are very straightforward, simple to understand, and easy to put together. Most investors can use these as a foundation for their own investments, or follow them exactly.
Previously an investment banker doing corporate finance at Nashville, Tennessee, regional bank J.C. Bradford & Co, Steinhilber started Agile Investments, his asset management firm, in 2001, following the popping of the Internet bubble. It was a bear market in full growl.
Building his business in the wake of the iShares launch, he decided
he would never use single-company stocks for client portfolios, only ETFs.
Once in a while, he adds a mutual fund to the ETFs. When he does, he
chooses a fund that gives its portfolio manager wide latitude to add value
to the fund.
The Nashville investment advisor likes the transparency of ETFs and
believes their ability to track the market with broad indexes and low expense
ratios is the best way to build a nest egg. But he doesn’t call the firm Agile
for nothing. Even though he uses passive vehicles, he employs an active
management style called tactical asset allocation. That means the portfolios
are fluid.
Depending on the economic backdrop and fundamentals at the asset class level, he re-evaluates different slices of the market, and tweaks the asset allocations to take advantage of the current market conditions. The strategy appears to work. The aggressive model portfolio he used from 2002 through 2007 saw an average annual return of 9.9 percent, in contrast with the S&P 500’s 6.0 percent.
Steinhilber’s belief in lower fees doesn’t change when it comes to charg-
ing his own clients. He typically requires a client to have a minimum invest-
ment of $250,000 to invest with his firm. His fees start at a very reasonable
0.6 percent of assets for the minimum-sized portfolio, and decrease as the portfolios grow in size.
I asked him to design three fundamental strategies that a typical buyand-hold investor could use as a foundation for a long-term portfolio. These models—conservative, moderate, and aggressive—are designed for an investor saving for retirement.
All three of these models are suitable for an average investor. All the ETFs are liquid. The average expense ratio is very low, with the two bond funds and the domestic REIT fund charging only 0.11 percent. The ETNs charge 0.75 percent or 0.85 percent, but they make up for it in tax efficiency. Which model you choose will be determined by your risk comfort level.
The buy-and-hold portfolios provided by Agile Investments are strategic asset allocations just like the classic portfolios, only these are more high concept. Instead of breaking up the stock portion into funds of differentsized companies, he buys a total market index, so that he can take advantage of ETFs that offer creative strategies.
While both the classic and foundation models are basically stock and bond portfolios, comparing the Agile portfolios with the portfolios in the previous section provides us with a great opportunity to see how two portfolios with similar risk tolerances and strategic asset allocations can be set up in completely different ways.
The Conservative Growth ETF Model
This model is good for investors with a low risk tolerance. They could be very wary of the stock market’s direction or very concerned with protecting capital. Typically, people nearing or just entering retirement might like this model. Capital protection seems to be the overriding theme, but the equity components provide the potential to capture some outsized returns should stocks rally. (See Table 10.4.)
According to Steinhilber:
This portfolio is suitable for clients willing to assume a level of market risk and volatility typical of a traditional balanced investment portfolio. Although asset class weightings will vary based on our tactical asset allocation methodology, and alternative asset classes, such as real estate investment trusts or precious metals, may be employed, an appropriate benchmark for this portfolio is 60% equities and 40% fixed income.
The portfolio presented here breaks down into:
Equities: 40 percent
Fixed-Income: 45 percent
Alternative Investments: 15 percent
The Moderate Growth ETF Model
The Moderate Growth ETF Model and the Aggressive Growth ETF Model
are variations on the theme. They both start with the Conservative Growth
ETF Model then make a few adjustments to increase the profit potential by
taking on more risk. The equity component makes up a greater proportion
of the portfolio, while the total of fixed-income investments decreases.
The Aggressive Growth ETF Model
The Aggressive Growth ETF Model takes on much more risk. Steinhilber describes the Aggressive Growth ETF Model as “suitable for clients willing to sustain substantial volatility and assume a high level of risk in pursuit of higher returns. Although alternative asset classes may be employed, an
Steinhilber describes the Moderate Growth ETF Model as “suitable for clients seeking potentially higher return opportunities and willing to assume a level of market risk and volatility somewhat higher than a traditional, balanced investment portfolio. Although alternative asset classes may be employed, an appropriate benchmark for this portfolio is 75 percent equities and 25 percent fixed income.”8
The Moderate Growth ETF Model is the exact same basket of ETFs as the Conservative model, but the allocation of each ETF is different. In the Moderate Growth Model the total equity allocation jumps to 60 percent from 40 percent, while fixed-income’s allocation drops to 25 percent from 45 percent. The proportion of Alternative Investments remains the same at 15 percent of the portfolio, with the same five ETFs each making up just 3 percent of the total portfolio.
In the equity portion of the moderate-risk model, the Vanguard Total Stock Market ETF allocation rises to 25 percent of the portfolio from 15 percent in the conservative portfolio. The Shares Dow Jones Select Dividend ETF and iPath CBOE S&P 500 BuyWrite Index ETN both remain at 5 percent, bringing the total domestic stock allocation to 35 percent. The Vanguard FTSE All-World ex-U.S. ETF remains the only international equity fund. It now comprises 25 percent of the portfolio, up from 15 percent.
In the fixed-income section, the Vanguard Total Bond Market ETF drops
from 20 percent to 15 percent of the total model, while the Vanguard Short-
Term Bond ETF takes an even bigger hit, falling to 10 percent from 25
percent.
appropriate benchmark for this portfolio is 90 percent equities and 10 percent fixed income.”
In the aggressive model, the equity portion jumps to 73 percent of the total portfolio from 60 percent in the moderate portfolio, and just 40 percent in the conservative model. Bonds drop to just 7 percent of the total strategy. That’s a huge decline from the moderate model’s 25 percent and the 45 percent in the conservative one. Alternative investments jump to 20 percent from 15 percent.
Not Following the Herd
Contrarian investing is choosing to zig when the rest of the market says
“zag”—or more precisely, trying to profit by doing the opposite of the
market’s conventional wisdom. Essentially, contrarian investing is defying
the crowd.
One of the old sayings of Wall Street is that the market climbs a wall of worry. This means the best time to buy stocks is when people are fearful. When there is widespread optimism and most people believe the market will keep going higher, the contrarian investor says the securities are probably fairly priced or overpriced and now is the time to sell. On the other hand, when everyone decides to sell and market pessimism is at high levels, the contrarian finds that a perfect time to buy. Prices are low and if everyone has sold, they can’t go much lower.
Value investing is a kind of contrarian investing because it looks for out-of-favor securities with low P/E ratios.
In this section are two portfolios that don’t follow the herd. These are not the classic portfolios that consist predominantly of U.S. stocks and bonds. Both the Contrarian Fox and Active China Strategy are high-concept portfolios. They each take the idea that the broad U.S. stock market is not the best place to be invested. The Contrarian Fox picks a few under-the-
radar sectors that it expects to outperform the U.S. market. The Active China Strategy essentially says China is where the best growth is, so why bother
with the United States? Both of these portfolios are very risky, but they are presented to offer examples of the kinds of creative portfolios that ETFs make possible.
Contrarian Fox Portfolio
Ron DeLegge, the founder and editor of ETF Guide.com, a Web site focused on the ETF industry, offers sample portfolios to subscribers. DeLegge, a former portfolio manager, agreed to let me publish his contrarian portfolio to give people an idea of what such a portfolio might hold. DeLegge says the objective and strategy of the Contrarian ETF portfolio’s is to “identify and select ETF asset classes that are out-of-favor or undervalued and which exhibit positive growth characteristics and a pending rebound.”10
This is a snapshot of what the portfolio looked like in March 2008. At this time, the U.S. economy was said to be entering a recession. The
U.S. stock market had already fallen 15 percent off its high. The bubble in
the housing market had popped as the subprime mortgage crisis caused
large amounts of homeowners to lose their homes in foreclosure. Across
the country, the real estate market was falling in value. The financial sector,
especially commercial and investment banks, suffered from the fall-out in
the housing market. Many had taken on huge amounts of risk buying and
selling mortgage-backed assets. By this time, many banks had written off
losses in the billions of dollars. Meanwhile, the dollar continued its decline,
sending the price of gold up 25 percent over the previous six months to
$1,000 an ounce.
While a typical portfolio seeks to give an investor a broad overview of
the stock market, this portfolio presents a different picture.
The Contrarian Fox model isn’t a buy-and-hold portfolio. Instead, it is
more of a tactical asset allocation model. The investor or portfolio manager
buys and sells assets to take advantage of the changing market trends.
In buy-and-hold investing, you set your strategic asset allocation and stick with it, for the most part, in both up and down markets. The reason behind holding the same assets and allocation in a down market is that you never know when the market will rebound. You could be out of the market at the wrong time and miss a big move up. However, if you stay pat, you will catch the rebound.
The tactical asset allocation attempts to increase returns by taking advantage of changes in the market. These asset allocations can change often and it is not advisable to copy this portfolio exactly. However, it provides an example of how a portfolio can be structured in a declining stock market.
ETF - BASICS
The exchange-traded fund, better known as an ETF, is the mutual fund
for the twenty-first century. Like mutual funds, ETFs hold a diversified
portfolio of stocks, bonds, or some other asset class. Yet, their structure is different enough that almost every ETF is less expensive, more tax-efficient, more transparent, and more flexible than any comparable mutual fund. That means more money for you. And in the end, isn’t that what investing is all about, having more money in your pocket?
You need to prepare for retirement. You might need to save for your child’s education. You might just want to grow capital to buy some other big expenditure, such as a house, a car , or a vacation. Whether you’re the kind of person who likes to manage his or her own finances or who just wants to understand what your investment advisor is talking about, this book is for you. I will explain, in easy-to-understand language, why you should be investing in ETFs over almost any other investment vehicle. No use any mathematical formulas is done here.
Investing and increasing your assets is difficult. It means having to choose from a multitude of choices and decide which will be a winner. It’s taking a risk on the unknown and then waiting. Basically, it’s predicting the future, and that’s hard to do well. Investment advisors tell you this is a very complex process, and thus individual investors need their services to navigate these difficult waters. But it doesn’t have to be that way. It can be very simple if you follow a systematic approach. One way to simplify your investing life is to buy ETFs. Mutual fund investors know that funds are great investment vehicles. Buying mutual funds is much easier than buying individual stocks. You get a professional manager to do the hard work for you. Plus, they offer diversification with a low minimum investment.
With more than 8,000 mutual funds on the market, you can buy a portfolio to suit any strategy. A single fund can hold as few as 20 underlying securities or thousands.
High fees are a huge offense mutual funds commit against their own shareholders. In investments, high fees can mean the difference between earning an annual profit or a loss. And the more fees decrease the size of your investment, the longer you will need to save. So, if you found an investment very similar to a mutual fund for a much lower price, would you buy it? Of course you would.
ETFs are that product.
ETFs offer everything a mutual fund does, and usually cost less to own. With the flexibility to trade during the hours of the stock market, and daily portfolio transparency.
If you’re one of those hedge fund investors who believe that you get what you pay for, then ETFs are not for you. Unregulated hedge funds offer the potential for huge profits for people who can make a minimum investment in the millions of dollars and stomach massive amounts of risk. With no transparency, the hedge fund investor has no idea what he owns and it can often take weeks or months to get his money out. You need to be rich to invest in hedge funds because there is a much greater risk of their blowing up.
Most investors can neither manage the minimum investment nor stom-
ach the risk of a hedge fund. ETFs are the opposite of hedge funds. These highly regulated funds are much safer than hedge funds. They are open to anyone, very liquid, highly transparent, much cheaper to own, and filled with the potential to beat hedge fund returns with much less risk.
This isn’t to say ETFs have no risk. Like hedge funds and mutual funds, ETFs are as risky as the assets they hold. So an ETF tracking the broad market benchmark, the S&P 500 Index, would be much less risky than an ETF with just companies from the biotechnology industry. The ETF tracking the S&P 500 would have the same amount of risk as a mutual fund tracking the same index, while a biotech ETF would be just as risky as any biotech sector mutual fund. Meanwhile, an ETF holding bonds would typically have less risk than a mutual fund owning equities, and vice versa.
ETFs—The Newfangled Mutual Funds
How ETFs Stack Up against Mutual Funds
ETFs combine many features of a mutual fund into a tradable stock, making the claim “new and improved” much more than a marketing ploy. The top six benefits that exchange-traded funds offer over mutual funds:
1. greater flexibility
2. lower fees
3. increased tax efficiency
4. greater transparency
5. ability to invest in more asset classes
6. ability to create more precise tactical investment strategies
Greater Flexibility
The biggest improvement and most important benefit that ETFs offer over
mutual funds is the ability to be traded on a stock exchange. This is a
huge advantage. Trading offers greater flexibility by allowing individual
investors to buy and sell when they choose, as opposed to the once-a-day
option offered by mutual funds. Because they trade on a stock exchange
for the entire market session, the price of an ETF fluctuates all day long.
This may seem like more of an advantage to day traders and institutional
investors, who are most likely to hold funds less than one day, but in fact
this flexibility is a great benefit for buy-and-hold investors. The ETF investor
can pinpoint the exact price at which he or she wants to buy or sell their
investment.
That’s not the case with mutual funds. Mutual funds can only be bought or sold from the fund company once a day—after the 4 P.M. market close—at one price, the net asset value, or NAV. The NAV is basically the average price of all the shares in the fund, but it isn’t calculated until after all the stocks have closed for the day. This leaves mutual fund investors at a distinct disadvantage. Investors must decide during a trading session to buy or sell a fund without knowing what the price will be.
For example, say the stock market receives a very negative economic report at 10:00 A.M. Most likely the market would begin a drastic move lower. Now compare the different experiences on that same hypothetical day of an ETF investor and a mutual fund shareholder, who each have portfolios of $100,000. Both investors are tuned into the financial news, so both become aware of the report at the same time. The news provides the catalyst for a major market sell-off that by the end of the day will send the Standard & Poor’s 500 index 2 percent lower.
At 10:05 A.M., the mutual fund investor calls his fund company and says he wants to sell all the shares in his fund. The company tells him that they will be sold at the NAV calculated after the trading session ends. So, even though the mutual fund investor tried to get out quickly by calling his fund company early in the day, it doesn’t matter. The fund calculates the sale price after 4 P.M. By that time, the market has already fallen, and the NAV is calculated with all the lowered stock prices. The likelihood is that the fund sells the investor’s shares at the lowest price of the day.
Meanwhile, the ETF investor calls his stockbroker at 10:05 A.M. and tells the broker to sell all his shares. Because the ETF trades all day long, the broker makes a market order to sell the shares immediately. Even though the market falls 2 percent by the end of the day, the ETF investor gets out before most of the damage occurs, locking in a price near the high of the day. With our hypothetical portfolios, the ETF investor walks away with nearly $2,000 more than the mutual fund investor. The same scenario would also apply in an up market. The ETF investor buys early in the rally and profits from the day’s rise. Meanwhile the mutual fund investor may see the rally, but cannot enter during the trading session. Instead, his share price is determined after the market rallied. Essentially, he buys near the top.
This ability to catch the beginning of a market move rather than only its conclusion gives investors greater profit potential. This flexibility also allows ETFs to be bought or sold with a market , limit, or stop-loss order, or on margin. Many ETFs also offer tradable put and call options. Another option not available to mutual fund shareholders is the ability to sell short. An investor can sell short an ETF or stock in anticipation of a downward move in the shares. The investor borrows the shares from a broker, then sells the shares first with the hope of closing the transaction by buying them back later at a lower price.
Greater flexibility gives the investor both more control over the purchase and sale price of the investment and an opportunity to take advantage of market moves.
Lower Fees
ETFs are essentially index funds. Index funds track a particular market by holding a basket of the exact same securities as the index, or an extremely close approximation.
The first ETF, the Standard & Poor’s Depositary Receipt (better known
as the SPDR, or Spider) began trading in 1993. It tracked the S&P 500, the
very vanilla, U.S. large-cap stock index. Subsequent ETFs followed other
major market indexes, such as DIAmonds, which follows the Dow Jones
Industrial Average, and the PowerShares Triple Qs or Cubes (Qubes), which
track the NASDAQ 100 Index. At the end of 2007, all ETFs were required to
follow an index.
Because these baskets of stocks follow indexes, they are passively man-
aged with infrequent asset turnover. Like index mutual funds, this results in extremely low annual expense ratios; in addition, the fees for ETFs are often lower than even those for the corresponding index funds. For instance, the Vanguard 500 Index fund, the largest and oldest index fund available to re-
tail investors, tracks the S&P 500 Index. It has one of the lowest annual fees among mutual funds: only 0.18 percent of assets. Compare that with two ETFs, the Spider and Barclay’s iShares S&P 500 Index, which charge a mi-
nuscule expense ratio of 0.08 percent and 0.09 percent, respectively. These are half Vanguard’s fee. And Vanguard’s tiny fee is the exception among mutual funds. Most mutual funds charge management fees of more than 1 percent, and some are as high as 5 percent. Currently, no ETF charges more than 1 percent. Fees are one of the biggest wealth destroyers for investors, so small fees add up to significant savings over time.
“Why is it so difficult to capture the market’s returns? Because the market
returns we read about ignore the costs of investing,” says John Bogle, the
founder and former chairman of the Vanguard Group, and the creator of the
Vanguard 500 fund. “In the search for the Holy Grail of superior returns, real-
life investors incur heavy costs—fund management fees, operating costs,
brokerage commissions, sales loads, transaction costs, fees to advisers, out-
of-pocket charges, and so on. Performance comes and goes, but costs roll
on forever.”
More Tax Efficient
The third major benefit that ETFs hold over mutual funds is greater tax efficiency, primarily by delaying taxes on capital gains. Whenever a mutual fund, even an index fund, sells a security, it is a taxable event. All profits are capital gains. Profits earned by mutual funds, pass through the fund to the individual shareholders. And when a shareholder earns capital gains, he or she must pay capital gains taxes. Even if index-fund investors hold their funds for decades, every year they must pay taxes on the capital gains that the funds incur during the previous 12 months.
Capital gains taxes can be especially onerous when many investors pull their money out of a fund, as occurred in the wake of the stock market’s dotcom crash in 2000. As investors pulled their money out, mutual funds were forced to sell their underlying assets in order to cash out these investors. To add insult to injury, the investors who chose to stay in the funds took a double hit. Not only had their investments fallen in price, but as the other investors left, the ones who stayed were stuck with paying the capital gains taxes from all the stock the fund needed to sell.
Meanwhile, because ETF investors own shares in their own personal
accounts, rather than investing in a fund’s pool of assets, their investment
isn’t connected to any other shareholder. ETF investors therefore only pay
capital gains taxes when they sell their shares. Delaying the payment of
taxes can make a significant difference in overall returns. When an investor
isn’t forced to pay out part of their principle in taxes every year, that means
there is more principle to grow. In addition, the buy-and-hold investor who
doesn’t sell his ETF until after retirement may find himself in a lower tax
bracket.
Greater Transparency
Transparency means that at any specific moment, investors have the ability to see the price and holdings of the ETF.
Because they are index funds, it’s reasonably easy to determine what stocks are included in an ETF or index mutual fund: simply look at the index. Of course, sometimes ETFs and index funds don’t hold every single stock in the index. How far an index mutual fund veers away from the index is not apparent, but with ETFs you always know what stocks are held.
Due to its unique structure, the ETF must make available every day a
list of all the securities that make up the fund, so that new shares can be
created.
Mutual funds have a measure of transparency, but even that is a bit
dubious. The portfolios of mutual funds are not transparent on a daily basis.
Every six months the mutual fund is required to send to its shareholders
a list of its holdings. This means shareholders see what’s in the fund only
twice a year, and even then, the report is suspect. Funds are given 60 days
to deliver this list to shareholders. Because mutual funds are allowed to buy
and sell securities every day, the portfolio documented at the end of the
six-month period is often not the same as the one actually held 60 days
later.
The transparency of the ETF’s portfolio during the trading session gives the investor the ability to see the ETF’s share price above, the ability to see the share prices gives the investor greater control over the purchase and sale of the investment.
Precise Allocations
Transparency allows investors to create precise strategic asset allocations and tactical investment strategies. While all mutual funds have an investment strategy they must follow, it’s not uncommon for a fund manager to sometimes stray from the strategy. This can happen for a variety of reasons. If the investment strategy is out of favor, the manager might want to hold some stocks on the rise in order to boost his returns.
Transparency allows the investor to see exactly what his holdings are
on a daily basis. This is important because a group of mutual funds with
different investment objectives may actually hold the same or very sim-
ilar securities. Thus, with mutual funds the investor could inadvertently
be overweight in areas of the market that are not advantageous to the
portfolio.
For example, you own a large stock mutual fund and a small stock
technology fund. However, small stocks aren’t doing well, so the mutual
fund manager buys some large tech stocks that are doing well. However,
this could cause the investor’s portfolio to have a greater weighting in large
tech stocks than he wanted. Because fund managers have a lot of leeway
and their portfolios are typically hidden from view, the investor is at a
disadvantage.
Most ETFs track an index. This is an advantage because it restricts what the ETF can hold. By knowing exactly what each ETF holds, the investor can make very precise asset allocations for his or her portfolio. The investor can fine-tune the portfolio to hold the exact amount of large stocks, small stocks, and international stocks he or she wants, without overlap or overweightings.
Investment in Alternative Asset Classes
Finally, ETFs offer another big benefit for individual investors—the ability to buy alternative asset classes as easily as stocks. This benefit doesn’t easily roll off the tongue of the person advocating ETFs, but it may be the biggest boon to individual investors since the creation of the original ETF.
In the past, commodity and currency markets were difficult for individual investors to enter. But as the world economy changes, these asset classes have taken on greater significance. To not have the opportunity to take advantage of these asset classes is a severe disadvantage to small investors. But companies using the ETF structure have given the investor the ability to participate in these markets with the same ease and minimal investment as the ETF itself.
With increased demand for gold, oil, and other commodities, as well as foreign currencies, investors have more tools with which to create more diversified portfolios.
One Caveat
For all the laudatory benefits of ETFs, in some cases mutual funds may actually be preferred. ETFs have one big drawback: the price of admission. Because they trade like stocks, they can only be bought or sold through a stockbroker, who, of course, charges a commission. Even with a discount broker, these transaction costs can eat into principle, making ETFs prohibitively expensive for adherents of dollar-cost averaging, one of the mainstay strategies for long-term investing.
While mutual funds sold through brokers carry commissions, known
as loads, savvy investors know to stay clear of those and invest in no-
load funds. With no-loads, every investment dollar lands in the fund and
not in a broker’s pocket, maximizing the investment. And no-loads don’t
charge a fee to sell. So dollar-cost averaging remains the index funds’ ace in
the hole.
for the twenty-first century. Like mutual funds, ETFs hold a diversified
portfolio of stocks, bonds, or some other asset class. Yet, their structure is different enough that almost every ETF is less expensive, more tax-efficient, more transparent, and more flexible than any comparable mutual fund. That means more money for you. And in the end, isn’t that what investing is all about, having more money in your pocket?
You need to prepare for retirement. You might need to save for your child’s education. You might just want to grow capital to buy some other big expenditure, such as a house, a car , or a vacation. Whether you’re the kind of person who likes to manage his or her own finances or who just wants to understand what your investment advisor is talking about, this book is for you. I will explain, in easy-to-understand language, why you should be investing in ETFs over almost any other investment vehicle. No use any mathematical formulas is done here.
Investing and increasing your assets is difficult. It means having to choose from a multitude of choices and decide which will be a winner. It’s taking a risk on the unknown and then waiting. Basically, it’s predicting the future, and that’s hard to do well. Investment advisors tell you this is a very complex process, and thus individual investors need their services to navigate these difficult waters. But it doesn’t have to be that way. It can be very simple if you follow a systematic approach. One way to simplify your investing life is to buy ETFs. Mutual fund investors know that funds are great investment vehicles. Buying mutual funds is much easier than buying individual stocks. You get a professional manager to do the hard work for you. Plus, they offer diversification with a low minimum investment.
With more than 8,000 mutual funds on the market, you can buy a portfolio to suit any strategy. A single fund can hold as few as 20 underlying securities or thousands.
High fees are a huge offense mutual funds commit against their own shareholders. In investments, high fees can mean the difference between earning an annual profit or a loss. And the more fees decrease the size of your investment, the longer you will need to save. So, if you found an investment very similar to a mutual fund for a much lower price, would you buy it? Of course you would.
ETFs are that product.
ETFs offer everything a mutual fund does, and usually cost less to own. With the flexibility to trade during the hours of the stock market, and daily portfolio transparency.
If you’re one of those hedge fund investors who believe that you get what you pay for, then ETFs are not for you. Unregulated hedge funds offer the potential for huge profits for people who can make a minimum investment in the millions of dollars and stomach massive amounts of risk. With no transparency, the hedge fund investor has no idea what he owns and it can often take weeks or months to get his money out. You need to be rich to invest in hedge funds because there is a much greater risk of their blowing up.
Most investors can neither manage the minimum investment nor stom-
ach the risk of a hedge fund. ETFs are the opposite of hedge funds. These highly regulated funds are much safer than hedge funds. They are open to anyone, very liquid, highly transparent, much cheaper to own, and filled with the potential to beat hedge fund returns with much less risk.
This isn’t to say ETFs have no risk. Like hedge funds and mutual funds, ETFs are as risky as the assets they hold. So an ETF tracking the broad market benchmark, the S&P 500 Index, would be much less risky than an ETF with just companies from the biotechnology industry. The ETF tracking the S&P 500 would have the same amount of risk as a mutual fund tracking the same index, while a biotech ETF would be just as risky as any biotech sector mutual fund. Meanwhile, an ETF holding bonds would typically have less risk than a mutual fund owning equities, and vice versa.
ETFs—The Newfangled Mutual Funds
How ETFs Stack Up against Mutual Funds
ETFs combine many features of a mutual fund into a tradable stock, making the claim “new and improved” much more than a marketing ploy. The top six benefits that exchange-traded funds offer over mutual funds:
1. greater flexibility
2. lower fees
3. increased tax efficiency
4. greater transparency
5. ability to invest in more asset classes
6. ability to create more precise tactical investment strategies
Greater Flexibility
The biggest improvement and most important benefit that ETFs offer over
mutual funds is the ability to be traded on a stock exchange. This is a
huge advantage. Trading offers greater flexibility by allowing individual
investors to buy and sell when they choose, as opposed to the once-a-day
option offered by mutual funds. Because they trade on a stock exchange
for the entire market session, the price of an ETF fluctuates all day long.
This may seem like more of an advantage to day traders and institutional
investors, who are most likely to hold funds less than one day, but in fact
this flexibility is a great benefit for buy-and-hold investors. The ETF investor
can pinpoint the exact price at which he or she wants to buy or sell their
investment.
That’s not the case with mutual funds. Mutual funds can only be bought or sold from the fund company once a day—after the 4 P.M. market close—at one price, the net asset value, or NAV. The NAV is basically the average price of all the shares in the fund, but it isn’t calculated until after all the stocks have closed for the day. This leaves mutual fund investors at a distinct disadvantage. Investors must decide during a trading session to buy or sell a fund without knowing what the price will be.
For example, say the stock market receives a very negative economic report at 10:00 A.M. Most likely the market would begin a drastic move lower. Now compare the different experiences on that same hypothetical day of an ETF investor and a mutual fund shareholder, who each have portfolios of $100,000. Both investors are tuned into the financial news, so both become aware of the report at the same time. The news provides the catalyst for a major market sell-off that by the end of the day will send the Standard & Poor’s 500 index 2 percent lower.
At 10:05 A.M., the mutual fund investor calls his fund company and says he wants to sell all the shares in his fund. The company tells him that they will be sold at the NAV calculated after the trading session ends. So, even though the mutual fund investor tried to get out quickly by calling his fund company early in the day, it doesn’t matter. The fund calculates the sale price after 4 P.M. By that time, the market has already fallen, and the NAV is calculated with all the lowered stock prices. The likelihood is that the fund sells the investor’s shares at the lowest price of the day.
Meanwhile, the ETF investor calls his stockbroker at 10:05 A.M. and tells the broker to sell all his shares. Because the ETF trades all day long, the broker makes a market order to sell the shares immediately. Even though the market falls 2 percent by the end of the day, the ETF investor gets out before most of the damage occurs, locking in a price near the high of the day. With our hypothetical portfolios, the ETF investor walks away with nearly $2,000 more than the mutual fund investor. The same scenario would also apply in an up market. The ETF investor buys early in the rally and profits from the day’s rise. Meanwhile the mutual fund investor may see the rally, but cannot enter during the trading session. Instead, his share price is determined after the market rallied. Essentially, he buys near the top.
This ability to catch the beginning of a market move rather than only its conclusion gives investors greater profit potential. This flexibility also allows ETFs to be bought or sold with a market , limit, or stop-loss order, or on margin. Many ETFs also offer tradable put and call options. Another option not available to mutual fund shareholders is the ability to sell short. An investor can sell short an ETF or stock in anticipation of a downward move in the shares. The investor borrows the shares from a broker, then sells the shares first with the hope of closing the transaction by buying them back later at a lower price.
Greater flexibility gives the investor both more control over the purchase and sale price of the investment and an opportunity to take advantage of market moves.
Lower Fees
ETFs are essentially index funds. Index funds track a particular market by holding a basket of the exact same securities as the index, or an extremely close approximation.
The first ETF, the Standard & Poor’s Depositary Receipt (better known
as the SPDR, or Spider) began trading in 1993. It tracked the S&P 500, the
very vanilla, U.S. large-cap stock index. Subsequent ETFs followed other
major market indexes, such as DIAmonds, which follows the Dow Jones
Industrial Average, and the PowerShares Triple Qs or Cubes (Qubes), which
track the NASDAQ 100 Index. At the end of 2007, all ETFs were required to
follow an index.
Because these baskets of stocks follow indexes, they are passively man-
aged with infrequent asset turnover. Like index mutual funds, this results in extremely low annual expense ratios; in addition, the fees for ETFs are often lower than even those for the corresponding index funds. For instance, the Vanguard 500 Index fund, the largest and oldest index fund available to re-
tail investors, tracks the S&P 500 Index. It has one of the lowest annual fees among mutual funds: only 0.18 percent of assets. Compare that with two ETFs, the Spider and Barclay’s iShares S&P 500 Index, which charge a mi-
nuscule expense ratio of 0.08 percent and 0.09 percent, respectively. These are half Vanguard’s fee. And Vanguard’s tiny fee is the exception among mutual funds. Most mutual funds charge management fees of more than 1 percent, and some are as high as 5 percent. Currently, no ETF charges more than 1 percent. Fees are one of the biggest wealth destroyers for investors, so small fees add up to significant savings over time.
“Why is it so difficult to capture the market’s returns? Because the market
returns we read about ignore the costs of investing,” says John Bogle, the
founder and former chairman of the Vanguard Group, and the creator of the
Vanguard 500 fund. “In the search for the Holy Grail of superior returns, real-
life investors incur heavy costs—fund management fees, operating costs,
brokerage commissions, sales loads, transaction costs, fees to advisers, out-
of-pocket charges, and so on. Performance comes and goes, but costs roll
on forever.”
More Tax Efficient
The third major benefit that ETFs hold over mutual funds is greater tax efficiency, primarily by delaying taxes on capital gains. Whenever a mutual fund, even an index fund, sells a security, it is a taxable event. All profits are capital gains. Profits earned by mutual funds, pass through the fund to the individual shareholders. And when a shareholder earns capital gains, he or she must pay capital gains taxes. Even if index-fund investors hold their funds for decades, every year they must pay taxes on the capital gains that the funds incur during the previous 12 months.
Capital gains taxes can be especially onerous when many investors pull their money out of a fund, as occurred in the wake of the stock market’s dotcom crash in 2000. As investors pulled their money out, mutual funds were forced to sell their underlying assets in order to cash out these investors. To add insult to injury, the investors who chose to stay in the funds took a double hit. Not only had their investments fallen in price, but as the other investors left, the ones who stayed were stuck with paying the capital gains taxes from all the stock the fund needed to sell.
Meanwhile, because ETF investors own shares in their own personal
accounts, rather than investing in a fund’s pool of assets, their investment
isn’t connected to any other shareholder. ETF investors therefore only pay
capital gains taxes when they sell their shares. Delaying the payment of
taxes can make a significant difference in overall returns. When an investor
isn’t forced to pay out part of their principle in taxes every year, that means
there is more principle to grow. In addition, the buy-and-hold investor who
doesn’t sell his ETF until after retirement may find himself in a lower tax
bracket.
Greater Transparency
Transparency means that at any specific moment, investors have the ability to see the price and holdings of the ETF.
Because they are index funds, it’s reasonably easy to determine what stocks are included in an ETF or index mutual fund: simply look at the index. Of course, sometimes ETFs and index funds don’t hold every single stock in the index. How far an index mutual fund veers away from the index is not apparent, but with ETFs you always know what stocks are held.
Due to its unique structure, the ETF must make available every day a
list of all the securities that make up the fund, so that new shares can be
created.
Mutual funds have a measure of transparency, but even that is a bit
dubious. The portfolios of mutual funds are not transparent on a daily basis.
Every six months the mutual fund is required to send to its shareholders
a list of its holdings. This means shareholders see what’s in the fund only
twice a year, and even then, the report is suspect. Funds are given 60 days
to deliver this list to shareholders. Because mutual funds are allowed to buy
and sell securities every day, the portfolio documented at the end of the
six-month period is often not the same as the one actually held 60 days
later.
The transparency of the ETF’s portfolio during the trading session gives the investor the ability to see the ETF’s share price above, the ability to see the share prices gives the investor greater control over the purchase and sale of the investment.
Precise Allocations
Transparency allows investors to create precise strategic asset allocations and tactical investment strategies. While all mutual funds have an investment strategy they must follow, it’s not uncommon for a fund manager to sometimes stray from the strategy. This can happen for a variety of reasons. If the investment strategy is out of favor, the manager might want to hold some stocks on the rise in order to boost his returns.
Transparency allows the investor to see exactly what his holdings are
on a daily basis. This is important because a group of mutual funds with
different investment objectives may actually hold the same or very sim-
ilar securities. Thus, with mutual funds the investor could inadvertently
be overweight in areas of the market that are not advantageous to the
portfolio.
For example, you own a large stock mutual fund and a small stock
technology fund. However, small stocks aren’t doing well, so the mutual
fund manager buys some large tech stocks that are doing well. However,
this could cause the investor’s portfolio to have a greater weighting in large
tech stocks than he wanted. Because fund managers have a lot of leeway
and their portfolios are typically hidden from view, the investor is at a
disadvantage.
Most ETFs track an index. This is an advantage because it restricts what the ETF can hold. By knowing exactly what each ETF holds, the investor can make very precise asset allocations for his or her portfolio. The investor can fine-tune the portfolio to hold the exact amount of large stocks, small stocks, and international stocks he or she wants, without overlap or overweightings.
Investment in Alternative Asset Classes
Finally, ETFs offer another big benefit for individual investors—the ability to buy alternative asset classes as easily as stocks. This benefit doesn’t easily roll off the tongue of the person advocating ETFs, but it may be the biggest boon to individual investors since the creation of the original ETF.
In the past, commodity and currency markets were difficult for individual investors to enter. But as the world economy changes, these asset classes have taken on greater significance. To not have the opportunity to take advantage of these asset classes is a severe disadvantage to small investors. But companies using the ETF structure have given the investor the ability to participate in these markets with the same ease and minimal investment as the ETF itself.
With increased demand for gold, oil, and other commodities, as well as foreign currencies, investors have more tools with which to create more diversified portfolios.
One Caveat
For all the laudatory benefits of ETFs, in some cases mutual funds may actually be preferred. ETFs have one big drawback: the price of admission. Because they trade like stocks, they can only be bought or sold through a stockbroker, who, of course, charges a commission. Even with a discount broker, these transaction costs can eat into principle, making ETFs prohibitively expensive for adherents of dollar-cost averaging, one of the mainstay strategies for long-term investing.
While mutual funds sold through brokers carry commissions, known
as loads, savvy investors know to stay clear of those and invest in no-
load funds. With no-loads, every investment dollar lands in the fund and
not in a broker’s pocket, maximizing the investment. And no-loads don’t
charge a fee to sell. So dollar-cost averaging remains the index funds’ ace in
the hole.
Saturday, December 20, 2008
ETF – IS IT THE RIGHT OPTION NOW
Tempted by the present "attractive" Sensex levels? Are you one of those convinced that this is a good time to enter the equity market? If yes, read on.
If you are not technically qualified to understand the nuances of a company's financial statements, then the easy way to buy stocks is to invest in companies that are well-known — blue-chip companies traded on the stock exchanges for decades. There are two ways to do this.
Buying large-caps
Based on the value of a company's outstanding shares, companies are broadly categorised as large-, mid- and small-cap companies. Companies such as Reliance Industries, Infosys, Hindalco or, for that matter, any of the Sensex constituents (the large caps) are scrips that have withstood the test of time.
Though the prices of these stocks too have been beaten down since January, the fall in mid-cap and small-cap stocks is much higher than that of the Sensex.
While the latter shed 55 per cent during this period, mid-caps and small-caps registered a loss of over 60 per cent each. This is because large companies are expected to weather any economic slowdown better than their smaller peers.
Even within sectors, Sensex stocks have performed better than the mid- and small-cap stocks. For example, in the IT sector (whose performance in the stock market has been wobbly since January), while Infosys lost more than 30 per cent since January, HCL Technologies and Hexaware shed about 63 per cent and 75 per cent, respectively.
The same is the case with some other sectors such as power generation, telecom and capital goods. NTPC, a blue-chip scrip, lost about 32 per cent while the mid-cap Neyveli Lignite Corporation lost over 50 per cent.
Such trends are visible across most sectors, making the case stronger for first-time investors to stick to large-caps.
Welcome to EFT!
How do you choose which Sensex stock to buy when it is a collection of India's best-known names and each looking lucrative in its own way? To step-side this problem, you'll need to buy the entire Sensex basket. But won't that require a lot of money? Confused?
Welcome to ETFs, or Exchange Traded Funds! They are funds that mimic baskets of securities in an index, and are traded like individual stocks on an exchange. In India, there are now six ETF options. Table shows the popularly traded ETFs.
ETF Vs MF
These funds may be look-alikes of mutual funds but actually have two major differences. One, they are 'passive', unlike mutual funds, where fund managers actively choose which stocks to buy. The movement of the ETF is almost a mirror image of the respective stock market index.
Two, in contrast to MFs, one buys and sells ETFs through the market and not through a fund house. This means you may buy and sell an ETF at any point during a trading session, just as you trade in shares. All you need to buy and sell these funds is a demat account.
Many mutual fund houses also offer investors open-end index-based funds. But these funds may not be fully invested at all times. They do hold back some portion as cash to meet redemption.
This leads to a "tracking error" error (difference between ETF returns as against that given by the index it tracks) where such funds may not completely replicate indices. The fact that Nifty BeES and S&P CNX Nifty are now trading 52 per cent below their respective January levels is a good indicator of how closely the ETFs track the indices.
Just like how an investor may be confused about which stock to pick, he may be confused about which MF to invest in as well!
The reason is fund houses often offer products across diverse sectors such as infrastructure, power, realty and so on. Sometimes, a particular sector may not participate in a market upswing and your money may go for an absolute toss. So, an investor is expected to apply reasonable judgement in selecting the fund(s). If that be the case, a beginner might as well put his money directly into the equity market, why MFs? ETFs offer a solution by picking the whole basket and thereby minimising the risk of wrong choice.
Advantage ETF
To wrap up, ETFs are a good bet for more reasons than one. Statistics show that, in the long term, equity returns have surpassed that of every other asset class.
Since ETFs invest in securities that form a part of a particular index, their returns are more or less in line with index returns (though it is not expected to outperform the index, which individual stocks may).
Their low-cost structure makes ETFs more economical than MFs. The Nifty BeES, for instance, has a cost structure of around 0.50 per cent, much lower than what conventional mutual funds levy (around 2.5 per cent). But the ultimate advantage is the real-time trading, which allows you to buy or sell at the exact time of your choice.
ETFs don the role of a good teacher for lay investors, who have the appetite for equity market. Once you are comfortable with trading in ETFs, you are all set to make the big plunge. In short, for a rookie, ETFs offer the best of both worlds — they give benefits of mutual funds and the convinience of stocks.
Tuesday, December 16, 2008
COMMODITIES VS STOCK MARKETS
Commodities Vs Stock markets
| Stock markets | Commodity markets |
Quality | One unit of a security does not differ from another of the same type in terms of its face value and characteristics. | Each commodity/product have several grades or varieties and each lot in a grade may vary from other lots in the same grade |
|
| Quality also deteriorates due to improper storage and transport conditions. Commodity deliveries therefore have far greater implications for buyers and sellers than mere payment or receipt of contractual price, as in the case of buying or selling of securities |
| Most investors in securities do not need any facility for hedging. They invest in securities either to earn regular income from dividend or interest, or to profit from the subsequent price rise. | A commodity futures market is primarily a hedging market, and not a market for delivery. Deliveries need to be issued and received only in a residual sense to maintain a parallel or near-parallel relationship between the physical and futures market prices to facilitate efficient hedging |
Price Discovery | Security futures prices have no such equivalent role. | Price discovery by a futures market also has a much more basic role to play in a commodity market than in the securities market. |
Factors | Not many (its supply is almost fixed, with demand varying as per the financial performance of the company, or the authority, and general market expectations), | Factors affecting commodity prices are far too many and complex Supply side: depends on conditions such as area or production capacity, weather, infrastructure supplies and inputs like water, power, seeds, yields or processing/ manufacturing out-turns, imports and exports. Demand is determined by the population growth and shifts in demographic characteristics, changes in incomes and exports, besides the diverse elasticities of incomes and prices. |
Contract Specifications | For an individual security futures, or even for an index futures of several securities put together, is a relatively simple exercise | More complex and involves specification of quality, delivery, duration etc., |
INVESTING IN COMMODITIES PART 2
Commodity investment options
An important aspect we need to cover is which instrument or investment vehicle you will use to participate in this commodity bull market. For those readers domiciled in the United Kingdom, I suggest you consider establishing all your investment positions as spread bets.
Tax-free investing
Spread betting offers the exciting opportunity to participate in and profit from this investment boom without having to pay any capital gains tax (applicable to UK residents - investors from other countries need to conduct their own due diligence). Yes, if you establish and maintain your commodity investments via spread betting, all your profits will be tax free and, not only that, this type of investing is regulated by the Financial Services Authority (the UK financial services regulator).
Spread betting in the UK has been around for over 20 years. Initially aimed at and used by dealers in the City of London, spread betting is now growing in popularity throughout the country. As I mentioned earlier, its main benefit is that, under current UK legislation (which could always change in the future), investment profits are not subject to capital gains tax. To illustrate just how powerful this tax-free status is to your investment returns, let’s look at the following example. We have two hypothetical investments of £50,000 each. Both investments are identical in every way except investment A pays a capital gains tax of 40 per cent on all annual profits whilst investment B is allowed to compound all annual profits as it doesn’t pay any tax. Assuming a 10-year performance where each year saw both investments gross a 10 per cent annual return, investment A would have grown to £89,542 (a gain of 79 per cent) whilst investment B would have grown to £129,687 (a gain of 159 per cent). Where else can you double the performance of an investment without any additional risk?
Another advantage to spread betting is the ability to establish a
credit account. Subject to satisfying the spread-betting firm you have
the necessary money, using a credit account means you can hold a
spread-betting position whilst still retaining your investment cash
in an interest-bearing bank or building society account. Should the
commodity investment prove immediately profitable, you could
find yourself in the comfortable position of earning interest on your
investment cash whilst also building up profits from the commodity
markets. However, if your market position begins to show a loss, you
will be required to cover the deficit with a transfer of cash to the credit
account.
How spread betting works
Spread betting has a wide range of applications suitable for a broad
spectrum of investors, enabling them to ‘bet’ on the price movements
of numerous shares, stock indices, bonds, currencies and commodity
futures. Typically, the larger spread-betting firms will quote on all the
major markets 24 hours a day between Sunday night and the close of
business in the United States on a Friday night. When you make a spread
bet, you never actually own the stock, bond or commodity. Instead you
‘buy’ the spread-betting broker ’s quote when you bet that a market
will rise. If the market subsequently goes up as you predicted, your
winnings multiply. Conversely, if the market moves in the opposite
direction to your prediction, then your losses will multiply. Similarly
to using futures, it is also possible with spread betting to control a large
amount of money with a small cash deposit and, whilst this leverage
sounds exciting, I want firmly to dissuade any novice from investing in
this fashion. A spread is a quote made up of two prices, which straddle the underlying market price. The higher ‘offer ’ price is for buyers and the lower ‘bid’ price is for sellers. Let’s look at an example of investing in silver. The commodity has a futures contract and the price quoted by the spread-betting broker will be based upon the market price of this futures contract. It’s July, and your strategy indicates that you should invest in this commodity. You call your spread-betting broker for a price of the September contract (the nearest and most active futures contract is usually known as the ‘front month’) and the quote is 725-729. You buy £10 a point at 729. This is the equivalent of approximately a £7,300 investment in silver (£10 multiplied by the spread-bet purchase price of 729 = £7,290). Let’s suppose your position turns out to be correct and a few weeks later your strategy instructs you to close your position for a profit. The spread-betting broker is now quoting 838-842 for the September contract and you close your position by selling the spread £10 a point at 838. You have now made a profit of 838 − 729 = 109 points. At £10 a point this represents a £1,090 profit (109 × £10), and a 15 per cent gain in the value of the commodity has produced a tax-free return of around 15 per cent on your £7,300 original investment.
If your strategy hasn’t provided an exit signal and the futures contract in which you hold your position reaches its expiry, you will have to ‘roll over ’ your position as this ‘front month’ contract matures. ‘Roll-over ’ is simply market terminology for moving your position from one contract to another. This is not as complicated as it sounds, because the spread-betting broker usually advises by letter when a contract is approaching its expiry date. When they write, they will ask if you wish to close the position upon expiry or ‘roll’ the position to the next contract. Unless you wish to close or readjust the size of your position, all you need to do is call them and confirm that you wish the position to be ‘rolled over ’. Typically, for this type of instruction, the spread-betting firm charges only a minimal spread (fee). It’s important to be aware that, as this commodity boom could run for many years, you may need to keep rolling your spread-betting position forward as each futures contract expires until such time as you ‘cash in your chips’ and close your investment. To close a position, simply sell whichever contract month your position is currently held in.
If you ever need help in identifying the current front month or in calculating the size of your spread bet relative to your financial commitment, the broker will always be able to help, and you should never feel uncomfortable about asking even the most basic of questions. It’s better to be safe than sorry.
Getting started in spread betting
To begin spread betting, you first need to open an account with a
regulated spread-betting broker. The Financial Services Authority
(details in Appendix A) will be able to provide a list of all the regulated
spread-betting firms. You should contact a number of these to obtain
the most competitive bid-offer spread rates, and once you have found
a suitable candidate you are ready to open an account. Typically, a
spread-betting account involves the extension of credit to the client via
a review of their personal finances and proof of liquid assets (cash). All
this is normally covered in the formal account-opening documentation,
but this can take a couple of weeks to process, so if you want to set
up your account more quickly you should consider opening a deposit
account instead. A deposit account is slightly different in that you are
required to ‘deposit’ cash with the spread-betting broker before you
can begin investing.
In addition, spread-betting brokers can provide you with detailed regulatory approved literature that further explains the mechanics and process of spread betting, and some even conduct free seminars to help new participants gain a greater understanding. If you are new to the business, I recommend you take full advantage of all the helpful information these brokers provide. After all, it’s in their interest to see you succeed, as the more money you make the more you will use them and the greater their commission revenue will become. Nobody benefits if a new customer loses money and then quits.
Another investment option the futures contract
As I’ve just reviewed, spread-betting brokers use an underlying futures contract on which to base their quotes, so for the benefit of those new to spread betting and for the non-UK-domiciled investors who gain no tax benefit from spread betting I want briefly to provide a little more information about the futures contract itself.
The idea of using futures is not new. This notion of fixing a price now
and settling later can be traced back to 2000 BC when the merchants of
Bahrain took goods on consignment for barter in India. A rudimentary
form of the risk-eliminating futures contract originated in England in
the 18th century, whereby two parties would agree in advance to the
terms of a sale, which was not finalized until the goods arrived. Such
contracts of sale on a ‘to arrive’ basis were made as early as 1780 in the
Liverpool cotton trade. Commodity exchanges originated in the latter
part of the 19th century as a means whereby merchants could rely on a
guaranteed price for goods they had to ship over great distances. In this
way, they could avoid the risk of price fluctuations eradicating their
profits during the long, slow shipment. The sale price was fixed at the
time of shipment and a deposit paid but the goods themselves were not
delivered until a future date, at which time the balance of the purchase
price became payable. In 1884, an organized futures market with rules
and regulations was founded in Chicago, Illinois. The Chicago Board
of Trade was to go on to fashion and operate the first futures contract
in a form that the English grain markets were to copy over 30 years
later. In the mid-1970s a revolution began to take place in the futures
markets with the introduction of financial futures. The main Chicago
exchanges, looking at the behaviour of some financial securities
such as shares and bonds, which were bought and sold around the
world, realized that many of them behaved in much the same way
as commodity markets. There appeared to be a need to provide the
financial world with an opportunity to hedge and speculate against
the underlying cash markets and so the financial futures contract
was born. Warning - futures contracts enable participants to leverage
their cash aggressively and it is for this reason that I caution you to
understand fully the subject of leverage, which was discussed earlier
in the book, before using them.
How futures contracts work
Basically, a futures contract is an agreement between two parties (a buyer and seller) for settlement of a specified security or commodity at a certain price on a given future date, as established on the floor of
an authorized futures exchange. It is a legal contract and in certain
cases can be fulfilled by the delivery and acceptance of the physical
commodity. However, the existence of clearing houses makes each
contract transferable and most futures contracts are closed out with an
offsetting futures transaction. To facilitate the clearing process, futures
contracts on the organized exchanges are standardized with regard
to the quantity and specific characteristics of the relevant underlying
commodity or financial security. In all cases, the relevant market
authority determines the minimum tradable quantity; the prescribed
minimum is called a ‘lot’ or ‘contract’. Lot sizes are published for
each futures market. The variables are the price, the delivery date, the
contract month and the identity of the buyer and seller. Most futures
contracts start one year before their maturity but some have lives as
long as three years or more.
A futures contract is quoted in two prices. The higher ‘offer ’ price is for buyers and the lower ‘bid’ price is for sellers. The process of using a futures contract to invest, including both ‘front month’ and ‘roll-over ’ procedures, is identical to spread betting, the only difference being that the bid and offer spread prices will be smaller. This is because you pay a commission to the futures broker whenever you trade, whereas the spread-betting firm include any costs in the spread itself, which makes their bid-offer price difference larger. In addition, because futures contracts have a fixed value with specified minimum price movements, they are slightly less flexible than spread betting.
Getting started in futures
To begin using futures contracts, you first need to open an account with a regulated futures broker. The Financial Services Authority (details in Appendix A) will be able to provide a list of all the regulated futures brokerage firms. You should contact a number of these to obtain the most competitive commission rates and, once you have found a suitable candidate, you are ready to open an account. Typically, a futures account operates in exactly the same way as a spread-betting deposit account where you are required to ‘deposit’ cash with the broker before you can begin investing. In addition, some futures brokers will provide you with detailed regulatory approved literature that further explains the mechanics and processes of using futures contracts. If you are new to the business, I recommend you take full advantage of all the helpful information these brokers provide. After all, it’s in their interest to see you succeed, as the more money you make the more you will use them and the greater their commission revenue will become. Just as with spread betting, nobody benefits if a new customer loses money and then quits.
Another investment option commodity-based funds
Although I rarely invest in mutual funds, there are a couple on the
radar offering general exposure to commodities. In addition, there
are numerous other funds available that primarily concentrate on the
energy and/or metals sectors. Those investors who wish to participate
in the boom but do not want to use spread betting or futures contracts
should consider using these funds as an alternative. I have included
these two funds for your information only and strongly recommend
you consult an independent financial adviser (IFA) to obtain recent and
past performance data and discuss fees, bid-offer spreads, minimum
subscription terms, redemption periods and other related items before
investing.
Oppenheimer Real Asset Fund. This is an actively managed product
managed by a large and well-respected company. As with most
commodity proxies, it is heavily weighted towards the energy
sector with more than a 70 per cent exposure according to an article
in Forbes (June 2005).
Pimco Commodity Real Return Fund. This product is the larger of
the two, based upon assets under management, and is designed
passively to track the performance of the Dow Jones-AIG Commod-
ity Index. It primarily achieves this goal through using futures
contracts based upon the DJ-AIGCI.
I’m sure as the commodity boom unfolds there will be plenty more commodity-based funds on offer as institutions attempt to cash in on the rally. The fact that there aren’t that many funds around at the
moment is further confirmation that this boom is still in its early stages
and when an exponential increase in the number of these products
does occur it will help us identify that the trend has entered its final
stage.
Another investment option - commodity stocks and shares
Another way to play this commodity boom is to identify and monitor listed companies whose business activity is primarily commodity based. Mining and oil exploration companies have been in the headlines recently and I’m sure there is plenty of potential for these and other similar stocks. My only reservation about investing in individual stocks and shares over and above the commodity markets themselves is that individual companies are susceptible to additional performance risks such as industrial action, taxation and general mismanagement.
Which investment option you decide to use is, of course, your decision. Personally, I direct all my long-term investing through the tax-efficient route of spread betting, but all of the options I’ve discussed here are viable ways to participate in a commodity bull market.
An important aspect we need to cover is which instrument or investment vehicle you will use to participate in this commodity bull market. For those readers domiciled in the United Kingdom, I suggest you consider establishing all your investment positions as spread bets.
Tax-free investing
Spread betting offers the exciting opportunity to participate in and profit from this investment boom without having to pay any capital gains tax (applicable to UK residents - investors from other countries need to conduct their own due diligence). Yes, if you establish and maintain your commodity investments via spread betting, all your profits will be tax free and, not only that, this type of investing is regulated by the Financial Services Authority (the UK financial services regulator).
Spread betting in the UK has been around for over 20 years. Initially aimed at and used by dealers in the City of London, spread betting is now growing in popularity throughout the country. As I mentioned earlier, its main benefit is that, under current UK legislation (which could always change in the future), investment profits are not subject to capital gains tax. To illustrate just how powerful this tax-free status is to your investment returns, let’s look at the following example. We have two hypothetical investments of £50,000 each. Both investments are identical in every way except investment A pays a capital gains tax of 40 per cent on all annual profits whilst investment B is allowed to compound all annual profits as it doesn’t pay any tax. Assuming a 10-year performance where each year saw both investments gross a 10 per cent annual return, investment A would have grown to £89,542 (a gain of 79 per cent) whilst investment B would have grown to £129,687 (a gain of 159 per cent). Where else can you double the performance of an investment without any additional risk?
Another advantage to spread betting is the ability to establish a
credit account. Subject to satisfying the spread-betting firm you have
the necessary money, using a credit account means you can hold a
spread-betting position whilst still retaining your investment cash
in an interest-bearing bank or building society account. Should the
commodity investment prove immediately profitable, you could
find yourself in the comfortable position of earning interest on your
investment cash whilst also building up profits from the commodity
markets. However, if your market position begins to show a loss, you
will be required to cover the deficit with a transfer of cash to the credit
account.
How spread betting works
Spread betting has a wide range of applications suitable for a broad
spectrum of investors, enabling them to ‘bet’ on the price movements
of numerous shares, stock indices, bonds, currencies and commodity
futures. Typically, the larger spread-betting firms will quote on all the
major markets 24 hours a day between Sunday night and the close of
business in the United States on a Friday night. When you make a spread
bet, you never actually own the stock, bond or commodity. Instead you
‘buy’ the spread-betting broker ’s quote when you bet that a market
will rise. If the market subsequently goes up as you predicted, your
winnings multiply. Conversely, if the market moves in the opposite
direction to your prediction, then your losses will multiply. Similarly
to using futures, it is also possible with spread betting to control a large
amount of money with a small cash deposit and, whilst this leverage
sounds exciting, I want firmly to dissuade any novice from investing in
this fashion. A spread is a quote made up of two prices, which straddle the underlying market price. The higher ‘offer ’ price is for buyers and the lower ‘bid’ price is for sellers. Let’s look at an example of investing in silver. The commodity has a futures contract and the price quoted by the spread-betting broker will be based upon the market price of this futures contract. It’s July, and your strategy indicates that you should invest in this commodity. You call your spread-betting broker for a price of the September contract (the nearest and most active futures contract is usually known as the ‘front month’) and the quote is 725-729. You buy £10 a point at 729. This is the equivalent of approximately a £7,300 investment in silver (£10 multiplied by the spread-bet purchase price of 729 = £7,290). Let’s suppose your position turns out to be correct and a few weeks later your strategy instructs you to close your position for a profit. The spread-betting broker is now quoting 838-842 for the September contract and you close your position by selling the spread £10 a point at 838. You have now made a profit of 838 − 729 = 109 points. At £10 a point this represents a £1,090 profit (109 × £10), and a 15 per cent gain in the value of the commodity has produced a tax-free return of around 15 per cent on your £7,300 original investment.
If your strategy hasn’t provided an exit signal and the futures contract in which you hold your position reaches its expiry, you will have to ‘roll over ’ your position as this ‘front month’ contract matures. ‘Roll-over ’ is simply market terminology for moving your position from one contract to another. This is not as complicated as it sounds, because the spread-betting broker usually advises by letter when a contract is approaching its expiry date. When they write, they will ask if you wish to close the position upon expiry or ‘roll’ the position to the next contract. Unless you wish to close or readjust the size of your position, all you need to do is call them and confirm that you wish the position to be ‘rolled over ’. Typically, for this type of instruction, the spread-betting firm charges only a minimal spread (fee). It’s important to be aware that, as this commodity boom could run for many years, you may need to keep rolling your spread-betting position forward as each futures contract expires until such time as you ‘cash in your chips’ and close your investment. To close a position, simply sell whichever contract month your position is currently held in.
If you ever need help in identifying the current front month or in calculating the size of your spread bet relative to your financial commitment, the broker will always be able to help, and you should never feel uncomfortable about asking even the most basic of questions. It’s better to be safe than sorry.
Getting started in spread betting
To begin spread betting, you first need to open an account with a
regulated spread-betting broker. The Financial Services Authority
(details in Appendix A) will be able to provide a list of all the regulated
spread-betting firms. You should contact a number of these to obtain
the most competitive bid-offer spread rates, and once you have found
a suitable candidate you are ready to open an account. Typically, a
spread-betting account involves the extension of credit to the client via
a review of their personal finances and proof of liquid assets (cash). All
this is normally covered in the formal account-opening documentation,
but this can take a couple of weeks to process, so if you want to set
up your account more quickly you should consider opening a deposit
account instead. A deposit account is slightly different in that you are
required to ‘deposit’ cash with the spread-betting broker before you
can begin investing.
In addition, spread-betting brokers can provide you with detailed regulatory approved literature that further explains the mechanics and process of spread betting, and some even conduct free seminars to help new participants gain a greater understanding. If you are new to the business, I recommend you take full advantage of all the helpful information these brokers provide. After all, it’s in their interest to see you succeed, as the more money you make the more you will use them and the greater their commission revenue will become. Nobody benefits if a new customer loses money and then quits.
Another investment option the futures contract
As I’ve just reviewed, spread-betting brokers use an underlying futures contract on which to base their quotes, so for the benefit of those new to spread betting and for the non-UK-domiciled investors who gain no tax benefit from spread betting I want briefly to provide a little more information about the futures contract itself.
The idea of using futures is not new. This notion of fixing a price now
and settling later can be traced back to 2000 BC when the merchants of
Bahrain took goods on consignment for barter in India. A rudimentary
form of the risk-eliminating futures contract originated in England in
the 18th century, whereby two parties would agree in advance to the
terms of a sale, which was not finalized until the goods arrived. Such
contracts of sale on a ‘to arrive’ basis were made as early as 1780 in the
Liverpool cotton trade. Commodity exchanges originated in the latter
part of the 19th century as a means whereby merchants could rely on a
guaranteed price for goods they had to ship over great distances. In this
way, they could avoid the risk of price fluctuations eradicating their
profits during the long, slow shipment. The sale price was fixed at the
time of shipment and a deposit paid but the goods themselves were not
delivered until a future date, at which time the balance of the purchase
price became payable. In 1884, an organized futures market with rules
and regulations was founded in Chicago, Illinois. The Chicago Board
of Trade was to go on to fashion and operate the first futures contract
in a form that the English grain markets were to copy over 30 years
later. In the mid-1970s a revolution began to take place in the futures
markets with the introduction of financial futures. The main Chicago
exchanges, looking at the behaviour of some financial securities
such as shares and bonds, which were bought and sold around the
world, realized that many of them behaved in much the same way
as commodity markets. There appeared to be a need to provide the
financial world with an opportunity to hedge and speculate against
the underlying cash markets and so the financial futures contract
was born. Warning - futures contracts enable participants to leverage
their cash aggressively and it is for this reason that I caution you to
understand fully the subject of leverage, which was discussed earlier
in the book, before using them.
How futures contracts work
Basically, a futures contract is an agreement between two parties (a buyer and seller) for settlement of a specified security or commodity at a certain price on a given future date, as established on the floor of
an authorized futures exchange. It is a legal contract and in certain
cases can be fulfilled by the delivery and acceptance of the physical
commodity. However, the existence of clearing houses makes each
contract transferable and most futures contracts are closed out with an
offsetting futures transaction. To facilitate the clearing process, futures
contracts on the organized exchanges are standardized with regard
to the quantity and specific characteristics of the relevant underlying
commodity or financial security. In all cases, the relevant market
authority determines the minimum tradable quantity; the prescribed
minimum is called a ‘lot’ or ‘contract’. Lot sizes are published for
each futures market. The variables are the price, the delivery date, the
contract month and the identity of the buyer and seller. Most futures
contracts start one year before their maturity but some have lives as
long as three years or more.
A futures contract is quoted in two prices. The higher ‘offer ’ price is for buyers and the lower ‘bid’ price is for sellers. The process of using a futures contract to invest, including both ‘front month’ and ‘roll-over ’ procedures, is identical to spread betting, the only difference being that the bid and offer spread prices will be smaller. This is because you pay a commission to the futures broker whenever you trade, whereas the spread-betting firm include any costs in the spread itself, which makes their bid-offer price difference larger. In addition, because futures contracts have a fixed value with specified minimum price movements, they are slightly less flexible than spread betting.
Getting started in futures
To begin using futures contracts, you first need to open an account with a regulated futures broker. The Financial Services Authority (details in Appendix A) will be able to provide a list of all the regulated futures brokerage firms. You should contact a number of these to obtain the most competitive commission rates and, once you have found a suitable candidate, you are ready to open an account. Typically, a futures account operates in exactly the same way as a spread-betting deposit account where you are required to ‘deposit’ cash with the broker before you can begin investing. In addition, some futures brokers will provide you with detailed regulatory approved literature that further explains the mechanics and processes of using futures contracts. If you are new to the business, I recommend you take full advantage of all the helpful information these brokers provide. After all, it’s in their interest to see you succeed, as the more money you make the more you will use them and the greater their commission revenue will become. Just as with spread betting, nobody benefits if a new customer loses money and then quits.
Another investment option commodity-based funds
Although I rarely invest in mutual funds, there are a couple on the
radar offering general exposure to commodities. In addition, there
are numerous other funds available that primarily concentrate on the
energy and/or metals sectors. Those investors who wish to participate
in the boom but do not want to use spread betting or futures contracts
should consider using these funds as an alternative. I have included
these two funds for your information only and strongly recommend
you consult an independent financial adviser (IFA) to obtain recent and
past performance data and discuss fees, bid-offer spreads, minimum
subscription terms, redemption periods and other related items before
investing.
Oppenheimer Real Asset Fund. This is an actively managed product
managed by a large and well-respected company. As with most
commodity proxies, it is heavily weighted towards the energy
sector with more than a 70 per cent exposure according to an article
in Forbes (June 2005).
Pimco Commodity Real Return Fund. This product is the larger of
the two, based upon assets under management, and is designed
passively to track the performance of the Dow Jones-AIG Commod-
ity Index. It primarily achieves this goal through using futures
contracts based upon the DJ-AIGCI.
I’m sure as the commodity boom unfolds there will be plenty more commodity-based funds on offer as institutions attempt to cash in on the rally. The fact that there aren’t that many funds around at the
moment is further confirmation that this boom is still in its early stages
and when an exponential increase in the number of these products
does occur it will help us identify that the trend has entered its final
stage.
Another investment option - commodity stocks and shares
Another way to play this commodity boom is to identify and monitor listed companies whose business activity is primarily commodity based. Mining and oil exploration companies have been in the headlines recently and I’m sure there is plenty of potential for these and other similar stocks. My only reservation about investing in individual stocks and shares over and above the commodity markets themselves is that individual companies are susceptible to additional performance risks such as industrial action, taxation and general mismanagement.
Which investment option you decide to use is, of course, your decision. Personally, I direct all my long-term investing through the tax-efficient route of spread betting, but all of the options I’ve discussed here are viable ways to participate in a commodity bull market.
TRADING IN COMMODITIES part 1 - THE NEXT INVESTMENT BOOM
The following is a brief overview of the most active commodity markets. They all have different qualities, different supply and production criteria and different demands and uses. Some have fascinating histories that date back beyond the dawn of civilization but they all have one thing in common - sooner or later they will come back into fashion and their respective values will soar. It seems as if commodities are the ‘black sheep’ of the investment family. This is wrong. They deserve your respect and your consideration both from the basis of absolute return and as a hedge against inflation.
Ignore them at your peril
Aluminium
What is it?
Aluminium is the most abundant metallic element found in the world. The ancient Greeks and Romans used salts of this metal as dyeing mordants and for dressing wounds. Since it was first discovered, aluminium has been extremely difficult to separate from rock and it is still the world’s most difficult metal to recover despite being the most common. First isolated in 1825, it wasn’t until 1886 that the first practical process for producing this silvery, lightweight metal was discovered and, today, electrolytic reduction is still the primary method.
Who produces it?
The world’s largest producers of aluminium are China, Russia, the United States and Canada.
What is it used for?
Aluminium’s excellent strength-to-weight ratio makes it very popular in the construction of automobiles, boat hulls, railway carriages and aircraft. In addition, because of its high heat conductivity, it is used to make the pistons of the internal combustion engine as well as cooking equipment. Aluminium is also used in low-temperature nuclear reactors owing to the fact that it absorbs very few neutrons.
Cocoa
What is it?
Cocoa is the name given to the powder derived from the seeds of the cacao tree, a tree that can take over five years to reach maturity but then live for another 45 years or more. Labelled by the Spanish over 500 years ago as ‘the food of the gods’, it still remains a commodity in strong demand. Essentially, cocoa comprises 40 per cent fat, 20 per cent protein and 40 per cent carbohydrate and also contains the stimulant theobromine, an alkaloid related to caffeine.
Who produces it?
Nearly half of the world’s production is accounted for by the Ivory Coast with two other African nations, Ghana and Nigeria, supplying a further 20 per cent. Outside of Africa, the main producers are Brazil, Malaysia, Indonesia and the Dominican Republic.
What is it used for?
Originally used by the Aztecs as a drink, nowadays nearly two-thirds of cocoa bean production is used to make chocolate and chocolate-based products. It’s still, in my humble opinion, ‘the food of the gods’.
Coffee
What is it?
As a cash commodity it is the second most valuable in the world. The coffee tree is actually a tropical evergreen shrub but it has the potential to grow to 100 feet tall. It grows in the regions between the Tropics of Cancer and Capricorn, where it requires and receives year-round warm temperatures combined with a plentiful amount of rainfall. Coffee is classified into two types of beans: arabica, which is the most widely produced representing nearly 70 per cent of world production, and robusta, which is grown at lower altitudes and has a stronger flavour.
Who produces it?
Behind the obvious leader in world production, Brazil, you might be surprised to learn that the second-biggest coffee grower is Vietnam whose recent production numbers have knocked Colombia into third place. Indonesia is also another significant producer.
What is it used for?
Although wine was actually the first drink to be produced from coffee, we are now all familiar with the warm beverage made from the roasted coffee bean, be it a latte, cappuccino, mocha or espresso.
Copper
What is it?
Dating back over 10,000 years, copper is humankind’s oldest metal,
with its name derived from the Mediterranean island of Cyprus,
which was originally the primary source of the metal. Copper is one
of the most widely used industrial metals because of its many varied
qualities. It is an excellent conductor of electricity, has strong corrosion-
resistant properties and is ‘biostatic’, which means that bacteria cannot
grow on its surface, making it very attractive for hygienic applications
such as food processing and air-conditioning equipment. In addition,
it is also used to produce the alloys bronze (a copper-tin alloy) and
brass (a copper-zinc alloy), both of which are actually stronger than
the pure metal itself.
Who produces it?
Chile is the world’s largest producer of copper and responsible for over a third of its supply, with the United States, Indonesia and Australia also accounting for significant output.
What is it used for?
Nearly three-quarters of copper demand relates to electrical products, particularly in relation to building and construction.
Corn
What is it?
Corn is a native grain of the American continents with fossils of its pollen found under Mexico City dating back over 80,000 years. A member of the grass family, it is a hardy plant capable of being grown at a wide variety of altitudes from sea level up to 12,000 feet, and it can also grow in areas with little natural water right up to tropical climates with extensive annual rainfall.
Who produces it?
The United States accounts for over 40 per cent of world corn production with China contributing a further 20 per cent. The next largest producers are Brazil and the European Union. Particularly important for the supply/demand argument of this book is the fact that China, despite being the world’s second-largest producer, actually consumes more corn than it produces!
What is it used for?
Predominately as a feed for livestock. Other uses for corn include gasoline additives, adhesives, cooking oil, sweeteners, margarine and food for humans.
Cotton
What is it?
Used by humans for many thousands of years and in particular by the ancient civilizations of China, India and Egypt, cotton is a vegetable fibre grown naturally from small trees and shrubs. It requires stable conditions of sunshine and water during its growth season and then a dry period for harvesting, which can make it extremely vulnerable to changes in weather patterns.
Who produces it?
The world’s largest cotton producers, namely China, India, Pakistan and the United States, are also the world’s largest consumers, which can lead to very tight supply/demand margins during periods of poor crop production.
What is it used for?
It is used in a wide range of products from clothing and linen to medical supplies.
Crude oil
What is it?
Crude oil, also known as ‘black gold’ to many commodity players, was formed many millions of years ago from the decayed remains of tiny aquatic life. Believed to have medicinal properties by many ancient civilizations, it was also used as an adhesive for the building of ships and the making of weapons and jewellery. The pyramids were held together by it, as were the great walls of Babylon. Until the invention of the kerosene lamp in 1854, most oil discoveries made by prospectors drilling for water or brine were met with dismay. The Industrial Revolution and the subsequent advances made during the 20th century changed this perception of oil for ever. Today, it is the single-largest product in world trade.
Who produces it?
The world’s largest producers of oil are Saudi Arabia, Russia, Norway, the United States, Iran, China, Mexico, Venezuela and Indonesia although, as widely documented, the United States, China and Indonesia all now consume more oil than they produce!
What is it used for?
Various grades of crude oil from the heavy ‘sour ’ crude to the lighter
‘sweet’ crude have different applications dependent upon the capacity
of each respective refinery. For example, sweet crude is preferred by
refiners in the production of diesel fuel, jet fuel, gasoline and heating
oil.
Gold
What is it?
Mined by the Egyptians over 4,000 years ago, gold has been coveted for centuries for its unique blend of beauty and rarity. The first gold coins date back to the 6th century BC, when they were produced upon the command of King Croesus of Lydia. It is a yellow, dense metallic element with a high lustre and is an inactive substance, unaffected by heat, air, moisture and most solvents. Because of this virtual indestructibility, all the gold that has ever been mined is still in circulation around the world in one form or another.
Who produces it?
It is mined on every continent except Antarctica, where mining is banned. South Africa is the largest producing nation, closely followed by the United States, Australia, China, Russia and Canada.
What is it used for?
Apart from the obvious cosmetic uses such as jewellery and decorative gold leaf, it is a vital industrial commodity, where its prime application is in electronics because of its excellent qualities as a conductor of heat and electricity. Another important industrial demand comes from dentistry, where gold has been used for nearly 3,000 years.
Heating oil
What is it?
Heating oil is a petroleum-based product that represents approximately a quarter of the refining output from a barrel of crude oil.
Who produces it?
The main consumer of heating oil, namely the United States, produces 85 per cent of its own requirement and imports the remainder from Canada, Venezuela and the Virgin Islands.
What is it used for?
As the name suggests, it is primarily used for providing fuel to heat properties.
Lead
What is it? d
Lead was one of the first metals known to humankind. It is a dense, bluish-grey and highly toxic metallic element. Originally used in paints, plumbing and face powders and as a preservative in wine, many civilizations, including the Roman Empire, were unaware of its toxic effect, which resulted in vast numbers of their citizens being slowly poisoned by its use in everyday applications. Lead is usually found in ore with copper, silver and zinc but more than 50 per cent of the lead currently in use comes from recycling.
Who produces it?
China and the United States combined are responsible for nearly half of the world’s lead smelter production, with Germany and the United Kingdom also smelting a notable percentage.
What is it used for?
Owing to its high density and nuclear properties, lead is used extensively in protective shielding for radioactive materials such as X-ray apparatus. It is also used in the construction industry and in the manufacture of electric cables and storage batteries.
Lean hogs (I do not participate in this market) What are they?
‘Hogs’ is a US term for pigs. They are generally bred twice a year in a continuous cycle. The gestation period is three and a half months, producing an average litter of 9-10 piglets, and the time period from birth to slaughter is usually around six months.
Who produces them?
China is the largest producer of pork, followed by the European Union and then the United States. For the supply/demand argument of this book, as well as being the biggest producer of pork China is also the world’s biggest consumer.
What are they used for?
The meat is primarily used as a food for humans. Following slaughter, an average carcass produces 85 pounds of lean meat, of which 21 per cent is ham, 20 per cent is loin, 14 per cent is belly and 3 per cent is spare ribs, with the remainder providing sundry carnivore products. The skin is often used to produce suede for clothing and footwear.
Live cattle (I do not participate in this market) What are they?
Live cattle form part of the beef industry. Most ranchers manage their herds to produce new crops of calves every spring following a gestation period of nine months. Calves are weaned from their mothers after approximately six months and then spend the next 10 months foraging on summer grass or winter wheat until their weight reaches around 600 pounds. The cattle are then sent to a feedlot where they add a further 600 pounds and are ready for slaughter.
Who produces them?
The world’s largest producer of beef is the United States, followed by Brazil, the European Union and China.
What are they used for?
The meat is primarily used as a food for humans and its consumption has recently enjoyed an increase following the popularity of high-protein diets such as the Atkins. The animal skin is used in the supply of leather for the manufacture of clothing and footwear.
Lumber
What is it?
Basically lumber is wood. It is produced from both hardwood, which comes from deciduous trees with broad leaves, and softwood, which comes from cone-bearing trees. Humankind has used wood for tools, building and energy since prehistoric times, and despite advances in the building and construction industry demand for this raw material remains as strong as ever.
Who produces it?
Wood is grown and utilized throughout the world, with the largest producers being the United States, Canada and Russia.
What is it used for?
Higher-quality wood is used for furniture, panelling, flooring and other decorative pieces whilst the lower grades are used for all manner of industrial applications, in particular home building.
Natural gas
What is it?
Natural gas is a colourless and odourless fossil fuel when in its natural form and is a mixture of many hydrocarbon gases including methane, propane and butane. Over 2,500 years ago, the Chinese harnessed the power of natural gas energy when they directed it through bamboo-shoot pipes and then burnt it to boil sea water to create fresh water
Who produces it?
Russia and the United States are responsible for nearly two-thirds of the world’s natural gas production, with Canada the other significant producer.
What is it used for?
Being a far cheaper source of energy than electricity, natural gas is
widely used in residential properties for both heating and cooking.
Large industry is also a major consumer for the same economic
reasons.
Nickel
What is it?
Nickel is a hard, ductile metal and slightly silvery in appearance. It is found in all soil and also on the ocean floor and in meteorites. Its uses can be traced back as far as 3500 BC, when bronzes from what is now Syria had a nickel content. The Chinese also minted coins from this transition metal over 2,000 years ago. It is a good conductor of electricity and heat and is often combined with other metals, such as iron, copper, zinc and chromium, to form alloys.
Who produces it?
Russia, Australia, Canada and Indonesia are the world’s largest miners of nickel.
What is it used for?
Nickel is primarily used in the production of corrosion-resistant alloys such as stainless steel. It is also employed as a replacement for silver in coins and in electronic circuitry, and nickel-plating techniques are uti-
lized on rolled steel strip, helicopter rotor blades and turbine blades.
Orange juice
What is it?
Apart from drinking orange juice, the other exposure you may have
had to this market is if you remember watching the hit film Trading
Places starring Eddie Murphy, Dan Ackroyd and Jamie Lee Curtis
where the final sequences heavily featured the orange juice futures pit
in New York. The orange tree is semi-tropical and its fruit, the orange,
is technically a kind of berry. There are three varieties of oranges: the
sweet orange, the mandarin orange (also known as a tangerine) and
the sour orange.
Who produces it?
Brazil is the largest producer, responsible for over a third of the world’s oranges, with the United States and Mexico combining to produce another 30 per cent plus.
What is it used for?
Sweet oranges are primarily used for the production of orange juice, a healthy drink rich in vitamin C. Sour oranges are predominately used in the manufacture of marmalade and also as an ingredient in some liqueurs. Orange oil is a by-product obtained from the peel prior to juice extraction and is used in a variety of products from cleaning agents through to flavourings and perfumes.
Platinum What is it?
Often referred to as ‘the noble metal’, it is one of the world’s rarest commodities. To illustrate, if all the platinum ever mined in the world was collected together, it wouldn’t fill an average-size living room. In addition to being limited in supply it is also extremely hard to produce, requiring the mining of between 8 and 10 tons of ore to produce just one pure ounce of platinum. It is a greyish-white, chemically inert metallic element that weighs almost twice as much as gold and has a greater value. It is also considered to be ‘the metal of the future’ because of its importance in various environmentally friendly applications.
Who produces it?
South Africa accounts for nearly 75 per cent of world supply with Russia, Canada and the United States the other principal producers.
What is it used for?
Platinum is highly prized by the jewellery industry, which accounts
for just over half its consumption. The remaining demand comes from
a variety of applications from fibre optic cables and infrared detectors
through to anti-cancer drugs. However, the largest industrial use for
platinum comes from the manufacture of automobile catalytic con-
verters, devices fitted to vehicles and designed to convert harmful
exhaust emissions such as oxides of nitrogen into water and other
harmless substances.
Silver
What is it?
Mined in Asia Minor since before 2500 BC, silver was used by the ancient Greeks to produce the first silver coins around 700 BC and still today in many countries silver is used as a circulating coinage. Silver is a white, lustrous metallic element and is usually found combined with other elements in ores and minerals.
Who produces it?
In ancient times, silver was easy to find, with many deposits located on or near the earth’s surface. Today, the majority of silver comes from Mexico, Peru, Australia, China and the United States where it is mined in conjunction with zinc, copper and lead.
What is it used for?
Because silver conducts heat and electricity better than any other metal, its primary application is as an industrial commodity. Photographic materials account for over half of its demand followed by conductors and contacts for the electronics industry. Surprisingly, only a small percentage, less than 3 per cent, is used for jewellery.
Soybean
What is it?
The soybean is a member of the oilseed family and is the common name for the leguminous plant and its seed. An ancient food in the Far East, it has a high protein content that has made it a popular food source throughout the world. The seeds are usually light yellow in colour, contained typically three to a pod with the plants themselves generally reaching maturity around 140 days after planting.
Who produces it?
The United States accounts for nearly 40 per cent of total world production with Brazil producing a further 20 per cent plus. Argentina is another major source of soybeans, closely followed by China, although as with most commodities nowadays China consumes considerably more soybeans than it produces.
What is it used for?
To produce a varied and diverse number of food products. Soy-based
products are particularly popular with vegetarians because of their
high non-meat protein content and also with consumers of non-dairy
products such as soy milk, soy baby formula, soy cheese and soy nut
butter.
Soybean meal
What is it?
Soybean meal is produced through the processing of soybeans, which are separated into both meal and soybean oil. This process is known in the industry as the ‘soybean crush’. The conventional ‘crush’ model states that one bushel of soybeans, weighing approximately 60 pounds, will produce after processing: 11 pounds of oil, 44 pounds of minimum content protein meal, 3 pounds of hulls and 1 pound of waste. Meal represents about 35 per cent of the weight of raw soybeans, and pro-
cessors aim to produce a conditioned product with a minimum protein content of 48 per cent, a minimum fat content of 0.5 per cent, a maxi-
mum moisture content of 12 per cent and a maximum fibre content of
3.5 per cent.
Who produces it?
The world’s largest producers of soybean meal are the United States, which is responsible for 25 per cent of production, closely followed by Brazil, China and the European Union.
What is it used for?
The majority of soybean meal is used as a feed for poultry where it accounts for approximately two-thirds of the world’s high-protein animal feed. The remaining meal is further processed to produce soy flour and isolated soy protein.
Soybean oil
What is it?
It is the natural oil extracted from whole soybeans as a result of the ‘soybean crush’ process. The conventional ‘crush’ model states that one bushel of soybeans, weighing approximately 60 pounds, will pro-duce after processing: 11 pounds of oil, 44 pounds of minimum content
protein meal, 3 pounds of hulls and 1 pound of waste. The oil content of each crop is directly correlated to the amount of sunshine and the temperatures during the soybean pod-filling stage. Typically, nearly 20 per cent of a soybean’s weight can be extracted as oil.
Who produces it?
The United States accounts for over a quarter of world soybean oil
production. Brazil is also a significant producer responsible for nearly
20 per cent, with the European Union accounting for a further 8 per
cent.
What is it used for?
Being high in polyunsaturated fat and cholesterol free, soybean oil is used in a number of edible products from margarine to cooking and salad oils. It is also used in a number of inedible products such as resins, plastics, paints and varnishes.
Sugar
What is it?
Sugar is a carbohydrate compound. It is a white crystalline organic substance also known as sucrose. Whilst it is found in most plants, it occurs with the highest concentration in sugar beets and sugar cane. The former is grown in cooler climates whilst sugar cane prospers in the tropical regions between the Tropics of Cancer and Capricorn where it benefits from the warmer and more humid conditions. Although the sugar contained in both is identical, sugar beet is an annual grown from seed whilst sugar cane is a perennial plant grown from cuttings of the stalk and provides around 75 per cent of all sugar produced.
Who produces it?
Well over a hundred countries produce sugar, with Brazil currently
the largest. Other major producers include the European Union and
India.
What is it used for?
Primarily as a taste additive to foodstuffs and as a source of energy
both for humans and in the composition of fuel derivatives such as
ethanol.
Tin
What is it?
Tin is a soft and pliable metallic element with a high crystalline struc-
ture. Silver-white in appearance, it has been in use for over 5,000 years. During the Roman Empire, Cornwall was responsible for the majority of tin production and continued to be a leading source of the metal until the late 19th century. Nowadays, tin deposits are generally small and are often recovered as a by-product of mining lead and tungsten.
Who produces it?
Currently Indonesia is the largest miner of tin, responsible for over a
third of world production. Not far behind is China, which produces
nearly 25 per cent, and Peru, which accounts for a further 20 per cent.
The world’s largest producers of smelted tin are China, Indonesia and
Malaysia. Although a large user of tin, the United States does not mine
a single ounce of the metal and, apart from recycling scrap, it has to
import the rest.
What is it used for?
Tin is primarily used in the manufacture of coatings for steel containers used to preserve food and beverages. It is also used in electroplating, plastic, ceramics and solder alloys. As tin is relatively low in toxicity, modern research is now focused on incorporating tin into a number of applications as a lead replacement.
Unleaded gasoline
What is it?
Gasoline is a mixture of hundreds of lighter liquid hydrocarbons and is primarily used to fuel the internal-combustion engine. It is a product refined from crude oil with refineries able to turn more than half of every barrel of crude into gasoline. The gasoline is then blended with ethanol (an alcohol-based product made from corn, wheat, barley and sugar), to produce a fuel with less harmful exhaust emissions.
Who produces it?
Refineries of varying size and capacity exist all over the world for the purpose of converting crude oil into gasoline and other petroleumbased products.
What is it used for?
Its primary use is as a fuel for the internal-combustion engine most
commonly found in automobiles, articulated transporters and motor-
cycles.
Wheat
What is it?
Originally a wild grass, wheat has been grown and cultivated by humans since prehistoric times. Now technically regarded as a cereal grass, it is responsible for supplying about 20 per cent of the food calories to the world’s population.
Who produces it?
The European Union, thanks in part to heavy central government subsidies, is the world’s largest producer of wheat, closely followed by China, India, Russia and the United States. Once again, for the supply/demand argument of this book, China, despite being the world’s second-largest producer, actually consumes more wheat than it produces!
What is it used for?
Wheat is primarily used to produce flour but also has other applications including the making of oil, gluten, bedding, brewing and distilling alcohol and as a feed for livestock.
Zinc
What is it?
A bluish-white metallic element, zinc is never found in its pure state but rather as an oxide, sulphide, carbonate or silicate. It is also found in many minerals such as smithsonite, franklinite, sphalerite, hemimorphite and zincite. Zinc is used as an alloy with copper to make brass and also as an alloy with magnesium and aluminium.
Who produces it?
The world’s largest producer of zinc is China, which is responsible for nearly 25 per cent of world smelter production. Canada, Japan and Australia are the other significant producers.
What is it used for?
It is used as a protective coating for other metals such as steel and iron. Zinc is also used in the manufacture of certain battery cells used in cameras, watches and other electronic equipment and, additionally, in medical applications primarily as an antiseptic.
The CRB Index (The Reuters/Jefferies CRB Futures Index)
The CRB Index offers commodity exposure in a similar way to how a stock market index provides exposure to a broad spectrum of capital weighted stocks and shares. It is calculated to produce a broad representation of the average overall trend in commodity markets, and the Commodity Research Bureau constantly monitors the component commodities to ensure the index provides as accurate a representation of price movements as possible. Following its ninth re-weighting in July 2005, the Reuters/Jefferies CRB Index currently comprises the following 19 commodities:
aluminium cocoa live cattle coffee natural gas copper nickel corn orange juice
cotton silver crude oil soybeans gold sugar heating oil unleaded gas lean hogs
wheat
The CRB Index began life in 1957 and is now recognized as the main
barometer of overall commodity trends. It serves as an excellent price
measure for macroeconomic analysis. It provides an efficient and
cost-effective option for those seeking to gain a simple exposure to
commodities as an asset class. The only potential drawback is a fixed
minimum weighting of 33 per cent for the energy sector. Whilst this
is a lower weighting than the Goldman Sachs Index discussed later,
such a weighting can make the CRB more of an energy proxy than was
previously the case. However, it is still a viable alternative for those
investors who have neither the time nor the expertise to deal with
individual commodities.
The DJ-AIGCI (The Dow Jones-AIG Commodity Index)
The components of the Dow Jones-AIG Index are annually re-weighted based upon the procedures set forth in the DJ-AIGCI Handbook, which states the composition of the index is ‘dependent on a combination of factors related to liquidity and US dollar-weighted production data over the most recently available five years’. It attempts, as all the other commodity indices attempt as well, to represent as accurately as possible the importance of a diversified group of commodities and their economic significance. The Dow Jones-AIG Commodity Index currently comprises the following 20 commodities:
aluminium live cattle cocoa natural gas coffee nickel copper silver
corn soybeans cotton soybean oil crude oil sugar gold unleaded gas heating oil wheat
lean hogs zinc
Despite the differences in its method of weighting, this index also
carries a heavy energy sector component, with the combined energy
commodities representing more than a third of its total performance.
However, it is still a viable alternative for those investors who have
neither the time nor the expertise to deal with the individual commodity
markets.
The GSCI (The Goldman Sachs Commodity Index)
The components of the Goldman Sachs Index are weighted based upon the world production figures of each respective commodity. They state that ‘the quantity of each commodity in the index is determined by the average quantity of production in the last five years’. Goldman Sachs feel it’s better to construct their index in this way because it assigns the correct weighting in relation to the proportion of the amount that each commodity flows through the economy. Using this method to determine the composition of the index generally means a stronger weighting towards the energy sector and, as at 30 June 2005, the current weightings detailed on the Goldman Sachs Commodity Index website show that the energy sector is responsible for a massive 75 per cent of the performance of the entire index. This can be a double-edged sword because, if the energy commodities have a strong performance, as is currently the case, this index will perform better than any other commodity proxy. However, should the energy sector underperform, then an investment in the Goldman Sachs Index will lag behind a similar investment in the other commodity-based indices. The Goldman Sachs Commodity Index currently comprises the following 24 commodities:
aluminium lead Brent crude oil lean hogs cocoa live cattle coffee natural gas
copper nickel corn red wheat cotton silver crude oil soybeans
feeder cattle sugar gas oil unleaded gas heating oil zinc
Similarly to the other commodity indices, the Goldman Sachs Commodity Index provides an efficient and cost-effective option for those seeking to gain a simple exposure to commodities as an asset class. The only reservation I have with the GSCI is its over-concentration of exposure to the energy sector, which makes this index more of an energy proxy than a commodity proxy. However, it can still be a viable alternative for those investors who do not wish to deal with the individual commodity markets.
Ignore them at your peril
Aluminium
What is it?
Aluminium is the most abundant metallic element found in the world. The ancient Greeks and Romans used salts of this metal as dyeing mordants and for dressing wounds. Since it was first discovered, aluminium has been extremely difficult to separate from rock and it is still the world’s most difficult metal to recover despite being the most common. First isolated in 1825, it wasn’t until 1886 that the first practical process for producing this silvery, lightweight metal was discovered and, today, electrolytic reduction is still the primary method.
Who produces it?
The world’s largest producers of aluminium are China, Russia, the United States and Canada.
What is it used for?
Aluminium’s excellent strength-to-weight ratio makes it very popular in the construction of automobiles, boat hulls, railway carriages and aircraft. In addition, because of its high heat conductivity, it is used to make the pistons of the internal combustion engine as well as cooking equipment. Aluminium is also used in low-temperature nuclear reactors owing to the fact that it absorbs very few neutrons.
Cocoa
What is it?
Cocoa is the name given to the powder derived from the seeds of the cacao tree, a tree that can take over five years to reach maturity but then live for another 45 years or more. Labelled by the Spanish over 500 years ago as ‘the food of the gods’, it still remains a commodity in strong demand. Essentially, cocoa comprises 40 per cent fat, 20 per cent protein and 40 per cent carbohydrate and also contains the stimulant theobromine, an alkaloid related to caffeine.
Who produces it?
Nearly half of the world’s production is accounted for by the Ivory Coast with two other African nations, Ghana and Nigeria, supplying a further 20 per cent. Outside of Africa, the main producers are Brazil, Malaysia, Indonesia and the Dominican Republic.
What is it used for?
Originally used by the Aztecs as a drink, nowadays nearly two-thirds of cocoa bean production is used to make chocolate and chocolate-based products. It’s still, in my humble opinion, ‘the food of the gods’.
Coffee
What is it?
As a cash commodity it is the second most valuable in the world. The coffee tree is actually a tropical evergreen shrub but it has the potential to grow to 100 feet tall. It grows in the regions between the Tropics of Cancer and Capricorn, where it requires and receives year-round warm temperatures combined with a plentiful amount of rainfall. Coffee is classified into two types of beans: arabica, which is the most widely produced representing nearly 70 per cent of world production, and robusta, which is grown at lower altitudes and has a stronger flavour.
Who produces it?
Behind the obvious leader in world production, Brazil, you might be surprised to learn that the second-biggest coffee grower is Vietnam whose recent production numbers have knocked Colombia into third place. Indonesia is also another significant producer.
What is it used for?
Although wine was actually the first drink to be produced from coffee, we are now all familiar with the warm beverage made from the roasted coffee bean, be it a latte, cappuccino, mocha or espresso.
Copper
What is it?
Dating back over 10,000 years, copper is humankind’s oldest metal,
with its name derived from the Mediterranean island of Cyprus,
which was originally the primary source of the metal. Copper is one
of the most widely used industrial metals because of its many varied
qualities. It is an excellent conductor of electricity, has strong corrosion-
resistant properties and is ‘biostatic’, which means that bacteria cannot
grow on its surface, making it very attractive for hygienic applications
such as food processing and air-conditioning equipment. In addition,
it is also used to produce the alloys bronze (a copper-tin alloy) and
brass (a copper-zinc alloy), both of which are actually stronger than
the pure metal itself.
Who produces it?
Chile is the world’s largest producer of copper and responsible for over a third of its supply, with the United States, Indonesia and Australia also accounting for significant output.
What is it used for?
Nearly three-quarters of copper demand relates to electrical products, particularly in relation to building and construction.
Corn
What is it?
Corn is a native grain of the American continents with fossils of its pollen found under Mexico City dating back over 80,000 years. A member of the grass family, it is a hardy plant capable of being grown at a wide variety of altitudes from sea level up to 12,000 feet, and it can also grow in areas with little natural water right up to tropical climates with extensive annual rainfall.
Who produces it?
The United States accounts for over 40 per cent of world corn production with China contributing a further 20 per cent. The next largest producers are Brazil and the European Union. Particularly important for the supply/demand argument of this book is the fact that China, despite being the world’s second-largest producer, actually consumes more corn than it produces!
What is it used for?
Predominately as a feed for livestock. Other uses for corn include gasoline additives, adhesives, cooking oil, sweeteners, margarine and food for humans.
Cotton
What is it?
Used by humans for many thousands of years and in particular by the ancient civilizations of China, India and Egypt, cotton is a vegetable fibre grown naturally from small trees and shrubs. It requires stable conditions of sunshine and water during its growth season and then a dry period for harvesting, which can make it extremely vulnerable to changes in weather patterns.
Who produces it?
The world’s largest cotton producers, namely China, India, Pakistan and the United States, are also the world’s largest consumers, which can lead to very tight supply/demand margins during periods of poor crop production.
What is it used for?
It is used in a wide range of products from clothing and linen to medical supplies.
Crude oil
What is it?
Crude oil, also known as ‘black gold’ to many commodity players, was formed many millions of years ago from the decayed remains of tiny aquatic life. Believed to have medicinal properties by many ancient civilizations, it was also used as an adhesive for the building of ships and the making of weapons and jewellery. The pyramids were held together by it, as were the great walls of Babylon. Until the invention of the kerosene lamp in 1854, most oil discoveries made by prospectors drilling for water or brine were met with dismay. The Industrial Revolution and the subsequent advances made during the 20th century changed this perception of oil for ever. Today, it is the single-largest product in world trade.
Who produces it?
The world’s largest producers of oil are Saudi Arabia, Russia, Norway, the United States, Iran, China, Mexico, Venezuela and Indonesia although, as widely documented, the United States, China and Indonesia all now consume more oil than they produce!
What is it used for?
Various grades of crude oil from the heavy ‘sour ’ crude to the lighter
‘sweet’ crude have different applications dependent upon the capacity
of each respective refinery. For example, sweet crude is preferred by
refiners in the production of diesel fuel, jet fuel, gasoline and heating
oil.
Gold
What is it?
Mined by the Egyptians over 4,000 years ago, gold has been coveted for centuries for its unique blend of beauty and rarity. The first gold coins date back to the 6th century BC, when they were produced upon the command of King Croesus of Lydia. It is a yellow, dense metallic element with a high lustre and is an inactive substance, unaffected by heat, air, moisture and most solvents. Because of this virtual indestructibility, all the gold that has ever been mined is still in circulation around the world in one form or another.
Who produces it?
It is mined on every continent except Antarctica, where mining is banned. South Africa is the largest producing nation, closely followed by the United States, Australia, China, Russia and Canada.
What is it used for?
Apart from the obvious cosmetic uses such as jewellery and decorative gold leaf, it is a vital industrial commodity, where its prime application is in electronics because of its excellent qualities as a conductor of heat and electricity. Another important industrial demand comes from dentistry, where gold has been used for nearly 3,000 years.
Heating oil
What is it?
Heating oil is a petroleum-based product that represents approximately a quarter of the refining output from a barrel of crude oil.
Who produces it?
The main consumer of heating oil, namely the United States, produces 85 per cent of its own requirement and imports the remainder from Canada, Venezuela and the Virgin Islands.
What is it used for?
As the name suggests, it is primarily used for providing fuel to heat properties.
Lead
What is it? d
Lead was one of the first metals known to humankind. It is a dense, bluish-grey and highly toxic metallic element. Originally used in paints, plumbing and face powders and as a preservative in wine, many civilizations, including the Roman Empire, were unaware of its toxic effect, which resulted in vast numbers of their citizens being slowly poisoned by its use in everyday applications. Lead is usually found in ore with copper, silver and zinc but more than 50 per cent of the lead currently in use comes from recycling.
Who produces it?
China and the United States combined are responsible for nearly half of the world’s lead smelter production, with Germany and the United Kingdom also smelting a notable percentage.
What is it used for?
Owing to its high density and nuclear properties, lead is used extensively in protective shielding for radioactive materials such as X-ray apparatus. It is also used in the construction industry and in the manufacture of electric cables and storage batteries.
Lean hogs (I do not participate in this market) What are they?
‘Hogs’ is a US term for pigs. They are generally bred twice a year in a continuous cycle. The gestation period is three and a half months, producing an average litter of 9-10 piglets, and the time period from birth to slaughter is usually around six months.
Who produces them?
China is the largest producer of pork, followed by the European Union and then the United States. For the supply/demand argument of this book, as well as being the biggest producer of pork China is also the world’s biggest consumer.
What are they used for?
The meat is primarily used as a food for humans. Following slaughter, an average carcass produces 85 pounds of lean meat, of which 21 per cent is ham, 20 per cent is loin, 14 per cent is belly and 3 per cent is spare ribs, with the remainder providing sundry carnivore products. The skin is often used to produce suede for clothing and footwear.
Live cattle (I do not participate in this market) What are they?
Live cattle form part of the beef industry. Most ranchers manage their herds to produce new crops of calves every spring following a gestation period of nine months. Calves are weaned from their mothers after approximately six months and then spend the next 10 months foraging on summer grass or winter wheat until their weight reaches around 600 pounds. The cattle are then sent to a feedlot where they add a further 600 pounds and are ready for slaughter.
Who produces them?
The world’s largest producer of beef is the United States, followed by Brazil, the European Union and China.
What are they used for?
The meat is primarily used as a food for humans and its consumption has recently enjoyed an increase following the popularity of high-protein diets such as the Atkins. The animal skin is used in the supply of leather for the manufacture of clothing and footwear.
Lumber
What is it?
Basically lumber is wood. It is produced from both hardwood, which comes from deciduous trees with broad leaves, and softwood, which comes from cone-bearing trees. Humankind has used wood for tools, building and energy since prehistoric times, and despite advances in the building and construction industry demand for this raw material remains as strong as ever.
Who produces it?
Wood is grown and utilized throughout the world, with the largest producers being the United States, Canada and Russia.
What is it used for?
Higher-quality wood is used for furniture, panelling, flooring and other decorative pieces whilst the lower grades are used for all manner of industrial applications, in particular home building.
Natural gas
What is it?
Natural gas is a colourless and odourless fossil fuel when in its natural form and is a mixture of many hydrocarbon gases including methane, propane and butane. Over 2,500 years ago, the Chinese harnessed the power of natural gas energy when they directed it through bamboo-shoot pipes and then burnt it to boil sea water to create fresh water
Who produces it?
Russia and the United States are responsible for nearly two-thirds of the world’s natural gas production, with Canada the other significant producer.
What is it used for?
Being a far cheaper source of energy than electricity, natural gas is
widely used in residential properties for both heating and cooking.
Large industry is also a major consumer for the same economic
reasons.
Nickel
What is it?
Nickel is a hard, ductile metal and slightly silvery in appearance. It is found in all soil and also on the ocean floor and in meteorites. Its uses can be traced back as far as 3500 BC, when bronzes from what is now Syria had a nickel content. The Chinese also minted coins from this transition metal over 2,000 years ago. It is a good conductor of electricity and heat and is often combined with other metals, such as iron, copper, zinc and chromium, to form alloys.
Who produces it?
Russia, Australia, Canada and Indonesia are the world’s largest miners of nickel.
What is it used for?
Nickel is primarily used in the production of corrosion-resistant alloys such as stainless steel. It is also employed as a replacement for silver in coins and in electronic circuitry, and nickel-plating techniques are uti-
lized on rolled steel strip, helicopter rotor blades and turbine blades.
Orange juice
What is it?
Apart from drinking orange juice, the other exposure you may have
had to this market is if you remember watching the hit film Trading
Places starring Eddie Murphy, Dan Ackroyd and Jamie Lee Curtis
where the final sequences heavily featured the orange juice futures pit
in New York. The orange tree is semi-tropical and its fruit, the orange,
is technically a kind of berry. There are three varieties of oranges: the
sweet orange, the mandarin orange (also known as a tangerine) and
the sour orange.
Who produces it?
Brazil is the largest producer, responsible for over a third of the world’s oranges, with the United States and Mexico combining to produce another 30 per cent plus.
What is it used for?
Sweet oranges are primarily used for the production of orange juice, a healthy drink rich in vitamin C. Sour oranges are predominately used in the manufacture of marmalade and also as an ingredient in some liqueurs. Orange oil is a by-product obtained from the peel prior to juice extraction and is used in a variety of products from cleaning agents through to flavourings and perfumes.
Platinum What is it?
Often referred to as ‘the noble metal’, it is one of the world’s rarest commodities. To illustrate, if all the platinum ever mined in the world was collected together, it wouldn’t fill an average-size living room. In addition to being limited in supply it is also extremely hard to produce, requiring the mining of between 8 and 10 tons of ore to produce just one pure ounce of platinum. It is a greyish-white, chemically inert metallic element that weighs almost twice as much as gold and has a greater value. It is also considered to be ‘the metal of the future’ because of its importance in various environmentally friendly applications.
Who produces it?
South Africa accounts for nearly 75 per cent of world supply with Russia, Canada and the United States the other principal producers.
What is it used for?
Platinum is highly prized by the jewellery industry, which accounts
for just over half its consumption. The remaining demand comes from
a variety of applications from fibre optic cables and infrared detectors
through to anti-cancer drugs. However, the largest industrial use for
platinum comes from the manufacture of automobile catalytic con-
verters, devices fitted to vehicles and designed to convert harmful
exhaust emissions such as oxides of nitrogen into water and other
harmless substances.
Silver
What is it?
Mined in Asia Minor since before 2500 BC, silver was used by the ancient Greeks to produce the first silver coins around 700 BC and still today in many countries silver is used as a circulating coinage. Silver is a white, lustrous metallic element and is usually found combined with other elements in ores and minerals.
Who produces it?
In ancient times, silver was easy to find, with many deposits located on or near the earth’s surface. Today, the majority of silver comes from Mexico, Peru, Australia, China and the United States where it is mined in conjunction with zinc, copper and lead.
What is it used for?
Because silver conducts heat and electricity better than any other metal, its primary application is as an industrial commodity. Photographic materials account for over half of its demand followed by conductors and contacts for the electronics industry. Surprisingly, only a small percentage, less than 3 per cent, is used for jewellery.
Soybean
What is it?
The soybean is a member of the oilseed family and is the common name for the leguminous plant and its seed. An ancient food in the Far East, it has a high protein content that has made it a popular food source throughout the world. The seeds are usually light yellow in colour, contained typically three to a pod with the plants themselves generally reaching maturity around 140 days after planting.
Who produces it?
The United States accounts for nearly 40 per cent of total world production with Brazil producing a further 20 per cent plus. Argentina is another major source of soybeans, closely followed by China, although as with most commodities nowadays China consumes considerably more soybeans than it produces.
What is it used for?
To produce a varied and diverse number of food products. Soy-based
products are particularly popular with vegetarians because of their
high non-meat protein content and also with consumers of non-dairy
products such as soy milk, soy baby formula, soy cheese and soy nut
butter.
Soybean meal
What is it?
Soybean meal is produced through the processing of soybeans, which are separated into both meal and soybean oil. This process is known in the industry as the ‘soybean crush’. The conventional ‘crush’ model states that one bushel of soybeans, weighing approximately 60 pounds, will produce after processing: 11 pounds of oil, 44 pounds of minimum content protein meal, 3 pounds of hulls and 1 pound of waste. Meal represents about 35 per cent of the weight of raw soybeans, and pro-
cessors aim to produce a conditioned product with a minimum protein content of 48 per cent, a minimum fat content of 0.5 per cent, a maxi-
mum moisture content of 12 per cent and a maximum fibre content of
3.5 per cent.
Who produces it?
The world’s largest producers of soybean meal are the United States, which is responsible for 25 per cent of production, closely followed by Brazil, China and the European Union.
What is it used for?
The majority of soybean meal is used as a feed for poultry where it accounts for approximately two-thirds of the world’s high-protein animal feed. The remaining meal is further processed to produce soy flour and isolated soy protein.
Soybean oil
What is it?
It is the natural oil extracted from whole soybeans as a result of the ‘soybean crush’ process. The conventional ‘crush’ model states that one bushel of soybeans, weighing approximately 60 pounds, will pro-duce after processing: 11 pounds of oil, 44 pounds of minimum content
protein meal, 3 pounds of hulls and 1 pound of waste. The oil content of each crop is directly correlated to the amount of sunshine and the temperatures during the soybean pod-filling stage. Typically, nearly 20 per cent of a soybean’s weight can be extracted as oil.
Who produces it?
The United States accounts for over a quarter of world soybean oil
production. Brazil is also a significant producer responsible for nearly
20 per cent, with the European Union accounting for a further 8 per
cent.
What is it used for?
Being high in polyunsaturated fat and cholesterol free, soybean oil is used in a number of edible products from margarine to cooking and salad oils. It is also used in a number of inedible products such as resins, plastics, paints and varnishes.
Sugar
What is it?
Sugar is a carbohydrate compound. It is a white crystalline organic substance also known as sucrose. Whilst it is found in most plants, it occurs with the highest concentration in sugar beets and sugar cane. The former is grown in cooler climates whilst sugar cane prospers in the tropical regions between the Tropics of Cancer and Capricorn where it benefits from the warmer and more humid conditions. Although the sugar contained in both is identical, sugar beet is an annual grown from seed whilst sugar cane is a perennial plant grown from cuttings of the stalk and provides around 75 per cent of all sugar produced.
Who produces it?
Well over a hundred countries produce sugar, with Brazil currently
the largest. Other major producers include the European Union and
India.
What is it used for?
Primarily as a taste additive to foodstuffs and as a source of energy
both for humans and in the composition of fuel derivatives such as
ethanol.
Tin
What is it?
Tin is a soft and pliable metallic element with a high crystalline struc-
ture. Silver-white in appearance, it has been in use for over 5,000 years. During the Roman Empire, Cornwall was responsible for the majority of tin production and continued to be a leading source of the metal until the late 19th century. Nowadays, tin deposits are generally small and are often recovered as a by-product of mining lead and tungsten.
Who produces it?
Currently Indonesia is the largest miner of tin, responsible for over a
third of world production. Not far behind is China, which produces
nearly 25 per cent, and Peru, which accounts for a further 20 per cent.
The world’s largest producers of smelted tin are China, Indonesia and
Malaysia. Although a large user of tin, the United States does not mine
a single ounce of the metal and, apart from recycling scrap, it has to
import the rest.
What is it used for?
Tin is primarily used in the manufacture of coatings for steel containers used to preserve food and beverages. It is also used in electroplating, plastic, ceramics and solder alloys. As tin is relatively low in toxicity, modern research is now focused on incorporating tin into a number of applications as a lead replacement.
Unleaded gasoline
What is it?
Gasoline is a mixture of hundreds of lighter liquid hydrocarbons and is primarily used to fuel the internal-combustion engine. It is a product refined from crude oil with refineries able to turn more than half of every barrel of crude into gasoline. The gasoline is then blended with ethanol (an alcohol-based product made from corn, wheat, barley and sugar), to produce a fuel with less harmful exhaust emissions.
Who produces it?
Refineries of varying size and capacity exist all over the world for the purpose of converting crude oil into gasoline and other petroleumbased products.
What is it used for?
Its primary use is as a fuel for the internal-combustion engine most
commonly found in automobiles, articulated transporters and motor-
cycles.
Wheat
What is it?
Originally a wild grass, wheat has been grown and cultivated by humans since prehistoric times. Now technically regarded as a cereal grass, it is responsible for supplying about 20 per cent of the food calories to the world’s population.
Who produces it?
The European Union, thanks in part to heavy central government subsidies, is the world’s largest producer of wheat, closely followed by China, India, Russia and the United States. Once again, for the supply/demand argument of this book, China, despite being the world’s second-largest producer, actually consumes more wheat than it produces!
What is it used for?
Wheat is primarily used to produce flour but also has other applications including the making of oil, gluten, bedding, brewing and distilling alcohol and as a feed for livestock.
Zinc
What is it?
A bluish-white metallic element, zinc is never found in its pure state but rather as an oxide, sulphide, carbonate or silicate. It is also found in many minerals such as smithsonite, franklinite, sphalerite, hemimorphite and zincite. Zinc is used as an alloy with copper to make brass and also as an alloy with magnesium and aluminium.
Who produces it?
The world’s largest producer of zinc is China, which is responsible for nearly 25 per cent of world smelter production. Canada, Japan and Australia are the other significant producers.
What is it used for?
It is used as a protective coating for other metals such as steel and iron. Zinc is also used in the manufacture of certain battery cells used in cameras, watches and other electronic equipment and, additionally, in medical applications primarily as an antiseptic.
The CRB Index (The Reuters/Jefferies CRB Futures Index)
The CRB Index offers commodity exposure in a similar way to how a stock market index provides exposure to a broad spectrum of capital weighted stocks and shares. It is calculated to produce a broad representation of the average overall trend in commodity markets, and the Commodity Research Bureau constantly monitors the component commodities to ensure the index provides as accurate a representation of price movements as possible. Following its ninth re-weighting in July 2005, the Reuters/Jefferies CRB Index currently comprises the following 19 commodities:
aluminium cocoa live cattle coffee natural gas copper nickel corn orange juice
cotton silver crude oil soybeans gold sugar heating oil unleaded gas lean hogs
wheat
The CRB Index began life in 1957 and is now recognized as the main
barometer of overall commodity trends. It serves as an excellent price
measure for macroeconomic analysis. It provides an efficient and
cost-effective option for those seeking to gain a simple exposure to
commodities as an asset class. The only potential drawback is a fixed
minimum weighting of 33 per cent for the energy sector. Whilst this
is a lower weighting than the Goldman Sachs Index discussed later,
such a weighting can make the CRB more of an energy proxy than was
previously the case. However, it is still a viable alternative for those
investors who have neither the time nor the expertise to deal with
individual commodities.
The DJ-AIGCI (The Dow Jones-AIG Commodity Index)
The components of the Dow Jones-AIG Index are annually re-weighted based upon the procedures set forth in the DJ-AIGCI Handbook, which states the composition of the index is ‘dependent on a combination of factors related to liquidity and US dollar-weighted production data over the most recently available five years’. It attempts, as all the other commodity indices attempt as well, to represent as accurately as possible the importance of a diversified group of commodities and their economic significance. The Dow Jones-AIG Commodity Index currently comprises the following 20 commodities:
aluminium live cattle cocoa natural gas coffee nickel copper silver
corn soybeans cotton soybean oil crude oil sugar gold unleaded gas heating oil wheat
lean hogs zinc
Despite the differences in its method of weighting, this index also
carries a heavy energy sector component, with the combined energy
commodities representing more than a third of its total performance.
However, it is still a viable alternative for those investors who have
neither the time nor the expertise to deal with the individual commodity
markets.
The GSCI (The Goldman Sachs Commodity Index)
The components of the Goldman Sachs Index are weighted based upon the world production figures of each respective commodity. They state that ‘the quantity of each commodity in the index is determined by the average quantity of production in the last five years’. Goldman Sachs feel it’s better to construct their index in this way because it assigns the correct weighting in relation to the proportion of the amount that each commodity flows through the economy. Using this method to determine the composition of the index generally means a stronger weighting towards the energy sector and, as at 30 June 2005, the current weightings detailed on the Goldman Sachs Commodity Index website show that the energy sector is responsible for a massive 75 per cent of the performance of the entire index. This can be a double-edged sword because, if the energy commodities have a strong performance, as is currently the case, this index will perform better than any other commodity proxy. However, should the energy sector underperform, then an investment in the Goldman Sachs Index will lag behind a similar investment in the other commodity-based indices. The Goldman Sachs Commodity Index currently comprises the following 24 commodities:
aluminium lead Brent crude oil lean hogs cocoa live cattle coffee natural gas
copper nickel corn red wheat cotton silver crude oil soybeans
feeder cattle sugar gas oil unleaded gas heating oil zinc
Similarly to the other commodity indices, the Goldman Sachs Commodity Index provides an efficient and cost-effective option for those seeking to gain a simple exposure to commodities as an asset class. The only reservation I have with the GSCI is its over-concentration of exposure to the energy sector, which makes this index more of an energy proxy than a commodity proxy. However, it can still be a viable alternative for those investors who do not wish to deal with the individual commodity markets.
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