Tag: ETF

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Making sense of ETF Liquidity

In my last post, I discussed ETF liquidity risk. After the post, a subscriber to ETFMathGuy asked me to talk more about this risk and how it relates to the wide variety of commission-free ETFs now available.

Bid-ask Spreads

Bid-ask spreads are an excellent way to measure liquidity. Less liquid ETFs generally have higher bid-ask spreads. But, the liquidity of the securities held by the ETF also affects bid-ask spreads. The image below shows the distribution of bid-ask spreads for Fidelity commission-free ETFs, which I updated from my April 2019 post.

Bid-ask spread of Fidelity Commission-Free ETFs, as of 9/22/2019. Source: ETF.com, Fidelity.com
Bid-ask spread of Fidelity Commission-Free ETFs, as of 9/22/2019. Source: ETF.com, Fidelity.com

Minimizing costs

As we see from these results, there is a wide variation of bid-ask spreads. So, about half have spreads under 0.1%, and about 80% under 0.3%. For ETFs traded commission-free, these spreads are likely the largest contributor to cost of ownership. To reduce this cost, an investor can either buy-and-hold for extended periods, or choose ETFs with lower bid-ask spreads. Investors should also avoid trading ETFs close to the market open and close. Higher volatility over a typical trading day can often occur close to the market’s open and close, and can produce higher bid-ask spreads.

What about ETF liquidity during high market volatility?

It is very likely that, during periods of high market volatility, bid-ask spreads will grow. This growth is simply the result of finding a balance between supply and demand. Or, in the case of ETFs, this balance occurs when an ETF seller finds a buyer. Remember that, due to liquidity risk, we can expect a return premium over risk-free investments. If market volatility is a concern, investors should seek lower volatility investments (e.g. bonds over stocks), and/or seek lower volatility in their portfolio through diversification.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Is there a bubble in ETFs?

The “hero” of the movie “The Big Short”, Michael Burry, has made some claims recently about a bubble in ETFs and market risks. Here, I discuss his concerns, and provide an alternate perspective.

Price discovery

One of the risks Michael Burry identifies is so-called price discovery. He claims that index funds have removed price discovery from the equity markets. I must disagree with this claim. For example, when an investor buys an S&P 500 index ETF, they are agreeing to pay the seller some price. This transaction is an implicit agreement on the value of the underlying securities. So, this is the very definition of price discovery, where supply and demand are in equilibrium.

” Simply put, it is where a buyer and a seller agree on a price and a transaction occurs. “

Definition of Price Discovery, Investopedia.

Liquidity Risk

Michael Burry also identifies liquidity risk, which occurs when an investor has trouble selling an investment at a desirable price. Liquidity risk is very real. ETF investors often realize this risk during significant market corrections through larger bid-ask spreads.

“…liquidity risk stems from the lack of marketability of an investment that can’t be bought or sold quickly enough to prevent or minimize a loss.

Definition of Liquidity Risk, Investopedia

While I agree that there is liquidity risk in ETFs, there is also liquidity risk in just about any financial investment. For instance, homeowners often face liquidity risk. So, you may wish to sell you home next month to move for a new job, but may not able to find a buyer willing to pay your asking price. In stock and bond ETFs, liquidity risk also occurs during times of market corrections. But, this risk occurs whether you own the individual stock, bond, or a fund that contains them. Taking this risk is part of the risk-reward payoff. That is, by taking additional risk, the investor realizes the possibility of higher returns.

Conclusions about a bubble in ETFs and market risks

So, how should an individual investor treat this opinion? Michal Burry’s solution is to be “…  100% focused on stock-picking.” My choice is to stick with ETFs, thanks to their simplicity and efficiency. Markets corrections will occur, so it’s not a matter of if, but when they occur. If, as an investor, you are not comfortable with these market risk, perhaps you should re-evaluate your risk tolerance and move to lower risk investments.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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September portfolios and year-to-date returns

The September 2019 optimal portfolios are now available to subscribers of ETFMathGuy. So, please log in and select your discount broker to see the effect of current market conditions on our optimal portfolios. In this post, we discuss the year-to-date returns of my personal account using the ETFMathGuy portfolios.

Year-to-date returns

Although there are still four months remaining in the year, I thought this would be a good time to talk about my year-to-date returns. I have personally been using the moderate risk level portfolios in my Fidelity brokerage account since the beginning of the year. Monthly returns, based on the balance in my account, appear below.

Monthly returns using commission-free Fidelity ETFs and the moderate ETFMathGuy risk level.
Monthly returns using commission-free Fidelity ETFs and the moderate ETFMathGuy risk level.

To better understand the returns in my account that maximizes return for a portfolio with volatility half-way between stocks and bonds, I created the next table. Here, you can see that the ETFMathGuy portfolio return so far in 2019 is 14.1%, with a monthly volatility of 2.1%. To one decimal place, the same volatility is seen if an investor had simply maintained a 50% stock and 50% bond fund, re-balanced each month. But, the 50/50 portfolio would have seen a return of only 13.7%

ETFMathGuy portfolio returns are higher than a 50/50 stock/bond portfolio, with the same volatility.
ETFMathGuy portfolio returns are higher than a 50/50 stock/bond portfolio, with the same volatility.

Key takeaways

The ETFMathGuy portfolios appear to be behaving as expected. That is, they have about the same amount of volatility as their benchmark. However, I realized an additional return of about 0.4% in my brokerage account. For a $100,000 portfolio, that is an additional gain of about $400. I will revisit my portfolio’s performance again at the end of the year, so please stay tuned!

The future of ETFMathGuy

For the near future, I will continue to provide the optimal portfolios without a fee. But, in the meantime, I decided to begin accepting donations, if you are so inclined. Please find the donate button at the bottom of the “Join Us” page. For your convenience, it also appears below.

Thanks for supporting ETFMathGuy!

Thank you all for your interest and support in 2019. I hope you all had a wonderful labor day weekend!

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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ETF Investments and inverted yield curves

In this post, I discuss a very popular topic in the financial news recently. The term “inverted yield curve” has come up quite a bit. Many consider it as a good indicator of a recession. So here, I will review the fundamentals on what a yield curve is. Then, I’ll comment on its relevance to ETF investors.

The Yield Curve

The yield curve visualizes U.S. treasury bond yields at various times to maturity. As of August 20, 2019, the yield curve looked like this.

Yield curve on August 20, 2019. source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield
Yield curve on August 20, 2019. source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

I’ve highlighted with asterisks (*) the yield on the two and ten year treasuries. So, these bond maturities had yields of 1.50% and 1.55%. These two maturities are often picked to represent short-term vs. long-term investments in U.S. treasury bonds. That spread, or difference in yields, is 0.05% as of August 20, 2019. Of course, if we chose “short-term” as 1 year, then indeed we would have an inverted yield curve with a spread of -0.17%. In any case, the two-to-ten year spread is very small, as compared to what has been seen so far in 2019.

Spread between two and ten year U.S. treasury bonds. source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2019
Spread between two and ten year U.S. treasury bonds. source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2019

What does a smaller (or negative) spread mean?

The general argument is that demand for longer term bonds is growing as investors flee the volatility of the stock market. This flight to bonds, or preferably bond ETFs, does seem to be prudent, particularly for investors with high concentrations of stock investments seeking to better manage stock market risk. So, I would argue that, if you have a well diversified portfolio of stocks and bonds, one can largely ignore all this discussion of the inverted yield curve. Instead, investors should focus on their own risk tolerance and long-term goals, as all markets correct themselves from time to time.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Taxation and your ETF investments

Taxation of your ETF investments is an important consideration. As we discussed in our previous post ETF Tax Efficiency vs. Mutual Funds, ETFs are quite tax efficient. Here, we summarize taxation of your ETF investments when held in a taxable account.

ETF taxation occurs in two ways. First, taxes occur when an ETF issues a dividend. Also, taxes occur when an investors sells their ETF for a gain (or loss). So, let’s first look at the preferred (lower) level of taxation available for ETFs.

ETF taxation of qualified dividends and long-term capital gains

ETFs issue two types of dividends, called qualified and non-qualified. As shown below, ETF investors prefer taxation of qualified dividends, due to their lower capital gains rates. Many stock-based ETFs issue these types of dividends. For example, the iShares core S&P 500 index ETF (ticker: IVV) currently distributes a qualified dividend yield of 2.05%. Investors who buy an ETF and sell it at least one year later also realize these preferred rates.

Tax rates for qualified dividends and long-term capital gains. source: https://taxfoundation.org/2019-tax-brackets/
Tax rates for qualified dividends and long-term capital gains.
source: https://taxfoundation.org/2019-tax-brackets/

ETF taxation as ordinary income

Unfortunately, ETFs can also be taxed at the higher rate of ordinary income. The tables below shows the current rates and income brackets for unmarried, married, and head of household tax payers.

Tax rates for non-qualified dividends and short-term capital gains. source: https://taxfoundation.org/2019-tax-brackets/
Tax rates for non-qualified dividends and short-term capital gains.
source: https://taxfoundation.org/2019-tax-brackets/

ETF investors face these taxes when either the ETF issues a non-qualified dividend, or is bought and sold in less than one year. Most bond-based ETFs issue non-qualified dividends. For example, the iShares Core U.S. Aggregate Bond ETF (ticker: AGG) generates non-qualified dividends, currently with a yield to maturity of 2.52%.

Don’t let the “tail wag the dog”

While taxation is an important aspect of ETF investing, it should not be the sole consideration. Indeed, Federal taxes could be minimized if one only needs the interest payments from municipal bond ETFs, like the iShares National Muni Bond ETF (ticker: MUB). But, a diversified portfolio should have a variety of asset classes. Instead, consider holding your portfolio of ETFs in a retirement account like a traditional or Roth IRA.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Stocks and Bonds in an ETF portfolio over the long-term

Stocks and bonds carry many benefits when held over the long term. In this post, I highlight a few aspects that are important to individual investors.

Two of the largest stock and bond ETFs analyzed each month by ETFMathGuy follow the tickers symbols IVV and AGG. IVV tracks the S&P 500 index, which consists of large U.S. companies. The top 10 holdings of IVV appear below.

Top 10 holdings of the iShares Core S&P 500 ETF. Source: etf.com/ivv
Top 10 holdings of the iShares Core S&P 500 ETF. Source: etf.com/ivv

The ticker symbol AGG tracks the Bloomberg Barclays U.S. Aggregate Bond Index. As we discussed in our previous post on the “Fundamentals of Fixed Income ETFs“, quality and maturity are two important components. The quality component of this ETF is largely influenced by its 40% of holdings of U.S. government bonds, and over 20% of mortgage backed securities. Top sector holdings appear below.

Top 10 sector holdings of the iShares Core U.S. Aggregate Bond ETF . Source: etf.com/agg
Top 10 sector holdings of the iShares Core U.S. Aggregate Bond ETF . Source: etf.com/agg

The bonds in AGG have an average maturity of about 8 years. Consequently, interest rate changes generally affect its price more than similar bond ETFs with shorter maturities.

Long term returns of stocks and bonds

The fundamental information about stock and bond ETFs is important, but doesn’t really address long-term investment performance. For that, consider the following chart that shows the total return of $100,000 invested in either the stock (green) or bond (blue) ETFs mentioned previously.

Total return of $100,00 invested in IVV (green) and AGG (blue) from January 5, 2004 to July 19, 2019. source: ETFReplay.com
Total return of $100,00 invested in IVV (green) and AGG (blue) from January 5, 2004 to July 19, 2019. source: ETFReplay.com

As this chart shows, much better returns are possible with stocks, provided investors are willing to accept the higher volatility. Annual growth rate of the stock ETF (IVV) is more than double (8.7% versus 4.0%) than the bond ETF (AGG). But, the volatility of the stock ETF is nearly four times (4X) larger than the volatility of the bond ETF.

Asset allocation basics

So, what is the correct allocation between stocks and bonds using ETFs? Generally speaking, investors seeking less risk will seek more bonds and less stock exposure. One simple rule of thumb is the “120-age” formula for stocks. So, a 30-year old investor would be 90% in stocks and 10% in bonds. Similarly, an 80-year old investor would be 40% stocks and 60% bonds. A more conservative approach is the “100-age” formula for stocks. In any case, investment risk typically increases with a higher allocation to stocks, and decreases with a higher allocation to bonds.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Fundamentals of Fixed Income ETFs

A recent Wall Street Journal article nicely summarized the fundamentals that define fixed income ETFs. Understanding these fundamentals can be very helpful in using them in a portfolio seeking the stability of bonds.

Quality, maturity and pricing of Bond ETFs

Two fundamental components that define a fixed income ETF are credit quality and maturity. Remember that fixed income ETFs are a collection of individual bonds. Also, a bond is a loan with fixed payments. That is why bonds are often referred to as “fixed income” investments. Credit rating firms, like Moody’s or Standard & Poor’s, evaluate the riskiness of the loans. Maturity measures the time until the original loan amount is due.

So, there is a strong relationship between a bond’s yield and these two fundamental components. Generally speaking, when a bond is first created, yields are higher under either (i) a lower credit rating or (ii) longer maturity. Once a bond is issued and makes its way into a bond ETF, the price of the bond ETF can then change. But, the underlying bonds continue to issue a stream of constant payments. The only significant exception occurs when the corporation making the bond payments enters bankruptcy protection.

Consequently, prices tend to decrease when demand is low, and investors prefer riskier assets. Conversely, prices of fixed income ETFs generally go up when investors seek less risky assets.  Yields are then inversely related to bond prices, so higher prices lead to lower yields.

What else can affect a bond’s price?

Interest rates can also affect bond prices. Short term rates set by the federal funds rate appear in the image below. As this chart shows, short term rates continue to climb steadily. But, these rates remain below typical levels seen in the past 20 years.

Federal funds rate for the past 20 years.
Federal funds rate for the past 20 years.

So, are bonds a bad investment as short-term rates go up?

This is an important question with no easy answer. But, few would argue that a diversified portfolio benefits from having some bond investments. So, the question should be “what part of the bond market is most suitable to your goals? ” Given there are bond ETFs covering a wide range of maturities and riskiness, there is no shortage of fixed income ETFs for investors to pick from. To this end, we encourage you to subscribe to ETFMathGuy to see how we use a wide variety of commission-free bond ETFs in efficient portfolios.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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July 2019 optimal portfolios are now available and discussed in terms of recent and long-term market trends

The July 2019 optimal portfolios are now available to subscribers of ETFMathGuy. So, please log in and select your discount broker. In this post, we will also discuss more about risk and return in an optimal ETF portfolio.

As we mentioned in our last post, there are benefits to having more ETFs to choose from during the portfolio construction process. We showed the potential to increase expected returns. In this post, we highlight another important element – risk.

Risk and Return

Risk and return are two fundamental issue that are important to consider when investing in an ETF portfolio. The chart below shows risk (horizontal axis) and return (vertical axis). Here, we define risk as the annual volatility, measured by the standard deviation of daily returns. We evaluate risk and return using a multi-year sample period selected from our rigorous backtesting process. As this chart shows, the optimal portfolios reside at risk levels between the bond market (ticker: AGG) and stock market (ticker:IVV). And, these portfolios are efficient, since they were selected to maximize the expected return.

Risk (Volatility) and Expected Return in the July 2019 optimal portfolios. Notice that at each risk level (conservative, moderate and aggressive), different ETFs offered by different discount brokers leads to different expected returns.
Risk (Volatility) and Expected Return in the July 2019 optimal portfolios. Notice that at each risk level (conservative, moderate and aggressive), different ETFs offered by different discount brokers leads to different expected returns.

As this chart shows, cash can be nearly risk-less, based on volatility, but offers returns that may not exceed long-term inflation. Bonds can offer more of a potential return, but with added risk. Even more return is possible from the stock market for those willing to accept additional risk.

What about the last 6 months?

Indeed, it is true that the first half of 2019 has been very good for both stocks and bonds. Based on a recent Wall Street Journal article, “… S&P 500 finished Friday up 17% this year, marking its best first half since 1997 “. According to the site ETFreplay.com, and including dividends, the stock and bond market are up 18.3% and 5.8%, respectively, this year. Will this trend continue? I personally doubt anyone really knows, as I believe that markets are generally very efficient. A better question may be “What level of risk” or “How much exposure” do you want your investments to have in various parts of the market. To end this post, I’ll leave you with one (of many) famous quotes by Warren Biuffet.

“The stock market is a device to transfer money from the impatient to the patient.”

Warren Buffett

We hope you found this post educational!

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Opportunities from more commission-free ETFs

Earlier this month, Fidelity followed through on its promise made earlier in the year. They now offers over 500 commission-free ETFs. This increase puts them in 2nd place for most commission-free ETFs offered by the five discount brokers analyzed each month by ETFMathGuy. The leader is still Vanguard, with approximately 1,800. Our chart below shows the update for Fidelity’s offering, where the Vanguard count only represents Vanguard ETFs. (We will be updating our Vanguard database soon.)

Vanguard* count only includes Vanguard ETFs. Vanguard now offers approximately 1,800 ETFs commission-free.
Vanguard* count only includes Vanguard ETFs. Vanguard now offers approximately 1,800 ETFs commission-free.

What is the benefit of more commission-free ETFs in a portfolio?

The most obvious benefit is the opportunity to access portions of the market not previously available. I demonstrated this benefit in previously published research entitled “ETF trading strategies to enhance client wealth maximization“. Here at ETFMathGuy, we have seen these opportunities first hand in our optimal portfolios. Each month, we’ve developed portfolios based on the current number of ETFs offered by each discount broker. We have also calculated the expected return associated with these portfolios, and there appears to be a potential opportunity. When constructing portfolios with more ETFs available, we see in the figure below that expected returns generally improve. Note that the pair of dots next to the portfolios are the result of excluding commission-free municipal bonds when generating a portfolio suitable for an IRA.

Expected return of ETFMathGuy optimal portfolios tend to rise with more commission-free ETFs available

More commission-fee ETFs may not always be beneficial

This figure shows that having more options to invest can improve the likelihood of generating higher returns. But, the additional ETFs must be sufficiently different those that are already offered. They must also have the potential to generate higher returns. Ameritrade seems to be accomplishing the most with their approximately 300 ETFs. Conversely, ETrade offers many more ETFs than the 59 offered by Vanguard, but doesn’t appear to increase expected returns by much in the portfolios constructed by ETFMathGuy .

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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June 2019 Optimal Portfolios are Now Available to ETFMathGuy subscribers

The June 2019 optimal portfolios are now available to subscribers of ETFMathGuy. So, just log in and select your discount broker.

You can now view the June 2019 optimal portfolios for the five discount brokers analyzed by ETFMathGuy. These portfolios cover nearly 1,500 ETFs currently offered commission-free from Ameritrade, ETrade, Fidelity, Schwab and Vanguard.

In all cases, we applied our rigorous portfolio construction process to produce the current portfolios. So, we encourage you to browse through these portfolios to review the following characteristics:

  • Allocation of bond versus stock ETFs in the optimal portfolio
  • Turnover from the previous month or months
  • The effect of risk level on the overall portfolio risk statistics
  • The increase in expected return as risk level increases

We hope you find these portfolios educational!

Where are the ESG funds in the 2019 optimal portfolios?

In our mid-April post, we updated the database used by ETFMathGuy to include the expanded list of commission-free ETFs offered by five discount brokers. We also mentioned one of the most popular themes to hit the ETF landscape, called Environmental, Social and Governance (ESG) investing. For example, Vanguard offers two of these ESG funds.

These two ETFs carry an expense ratio of 0.12% and 0.15%, respectively, consistent with Vanguard’s low-cost philosophy. So, why aren’t these funds appearing in the current portfolios developed by ETFMathGuy?

The short answer is that our portfolio construction process requires a sufficient return history. Based on our backtesting results, we identified an optimal sample period of several years. Unfortunately, the two Vanguard ETFs noted above have only existed since September 18, 2018, or about the last 8 and a half months. Consequently, this history is simply too short for our optimization model to generate portfolios that satisfy investor return expectations.

So, is ESG investing worthwhile?

This is an excellent question! In fact, based on a recent Wall Street Journal article, other experts in the industry shared our concern about a short return history.

“Many of these ESG ETFs are relatively young and have not had a chance to prove if they can demonstrate strong performance”

Todd Rosenbluth, senior director of ETF and mutual-fund research at CFRA

What does this mean for you? Well, if you are an investor focused on using your beliefs to guide your investment decisions, you may find this short history acceptable. However, here at ETFMathGuy, we prefer to make evidence-based decisions. So, we look forward to analyzing longer return histories that may show how ESG funds could be part of an optimal portfolio.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios. June 2019 optimal portfolios are now available.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.