Morningstar Advisor - April/May 2013 - (Page 26)

In Practice the war where distribution is concerned, a fact that shouldn’t be lost on advisors who are heralding the arrival of no-transaction-fee ETF programs. Free Beta Much ink has been spilled over ETFs’ inexorable push toward a 0% expense ratio, with some observers going so far as to suggest the day will come when ETF investors actually get paid to invest. What’s not to like about something for nothing, right? Well, it depends on one’s definition of nothing. If an ETF provider can economize investing through scale or a business model that is simply less expensive to operate, then it’s hard to quarrel with whatever savings get passed along to investors. But it pays to read the fine print, for nothing might actually be something that’s been waived or obscured away. For example, an ETF might rely on “securities lending” to defray operating costs. If you’re unfamiliar, securities lending is the practice of lending portfolio securities to a borrower, such as a short-seller, and then reinvesting the cash collateral. Securities lenders can use this net reinvestment income to blunt costs, lowering a fund’s expense ratio in the process. Managed prudently, securities lending is a laudable way to reduce fund operating costs. But the operative term is prudently, as securities lending is not riskless—lenders court counterparty risk (e.g., the securities borrower could default) as well as reinvestment risk (e.g., the lender could reinvest collateral in securities that lose value). Many lenders learned these lessons the hard way during the financial crisis, when their counterparties went under or their collateral reinvestments tanked. But memories run short, and the price battle being waged in ETFs is especially fierce. In this climate, some ETF providers lack the economies of scale or operational efficiencies to compete on cost alone, and they could lean more heavily on securities lending to close 26 Morningstar Advisor April/May 2013 the gap. The starker the cost disadvantage, the stronger the temptation will be to stretch by, say, lending portfolio securities more indiscriminately, seeking less collateral coverage, or plowing that collateral into lower-rated or longer-dated securities. Free Liquidity ETFs have been hailed as one of the signal investing innovations of the past few decades, and rightly so. They’ve made it simpler and cheaper to build portfolios than ever before while placing tools and techniques that were formerly the province of institutions within reach for advisors and retail investors. But to hear some proponents tell it, ETFs haven’t just made investing easier—they’ve helped to liquefy areas like the over-the-counter bond market that have stubbornly resisted modernization. Where an investor might formerly have struggled to transact in certain types of bonds such as high yield, they now have a ready means of doing so—bond ETFs, which act as a more-transparent mechanism for price discovery. for liquidity, the steeper the cost is likely to run. To illustrate, the exhibit on the next page plots the rolling five-day returns of the S&P 500 Index against changes in iShares iBoxx $ High Yield Corporate Bond ETF’s HYG percentage premium or discount to NAV. (In other words, we took the ETF’s percentage premium or discount to NAV on day 5 of each rolling period and subtracted it from its premium or discount on day 1 of that period; an expanding premium or narrowing discount is expressed as a positive while a narrowing premium or expanding discount appears as a negative.) As the chart shows, the stronger the S&P’s performance over a five-day period, the likelier it was that the ETF’s premium to NAV expanded (or its discount narrowed); conversely, the weaker its performance, the likelier that the ETF’s discount to NAV widened (or its premium narrowed). Is that liquidity free, though? The short answer is—maybe. It’s true that fixed-income ETFs in areas prone to illiquidity, such as corporate bonds, have continued to trade and price even amid market tumult. This has provided a valuable outlet to traders leery about getting hung-up in individual bond positions that they couldn’t exit at a fair price, or questioning their ability to adroitly enter a fast-moving over-the-counter market. What’s that got to do with liquidity? Let’s suppose that investors would be likelier to rebalance from stocks to bonds after a strong run for equities, and do the opposite when stocks tank. What the chart implies is that investors would have to pay a bit more to rebalance into, and out of, high-yield bonds using the ETF. That is, at the time they’re rebalancing into the ETF, it’s likelier to be trading at a widening premium to NAV; and when they’re rebalancing out of the ETF, it’s likelier to be trading at a widening discount. When investors are buying higher or selling lower in this manner, they are paying a tax of sorts. One could argue that it is the cost of liquidity in these instances. The catch, though, is that the more you need this liquidity, the likelier it is you’ll have to pay something for it. Indeed, popular high-yield ETFs have tended to trade at widening discounts to NAV amid heavy selling pressure, at slight premiums to NAV under normal conditions, and at widening premiums when demand spikes. All things being equal, an investor demanding liquidity is likely to buy in at a modest premium to NAV and sell at a discount. The more-frenzied the desire It’s not just ETFs that seem to dangle the prospect of free liquidity. The same can be said of practically any other product that trades daily, including traditional mutual funds. In these cases, investors pay for the privilege of being able to trade on a given day, if in oblique ways. For example, funds can suffer a “drag” from cash-equivalents that managers might keep on hand to fund redemptions. Even less obvious are the compromises that managers might make in the name of liquidity,

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013

Morningstar Advisor - April/May 2013
Contents
Contributors
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot

Morningstar Advisor - April/May 2013