InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
AUGUST 9 , 2017
Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues. Material may not be reproduced, forwarded or shared without express permission.
We return to “Investing and the Markets” in the next few issues of IntelDigest. In the last three weeks, we have run a series of articles from the IntelDigest archive; those articles … originally published in April/May … addressed investment in specific sectors. Today, we begin a series analyzing market trends for the rest of 2017 and into 2018.
Market “Melt Up”
In recent interviews, veteran market strategist Ed Yardeni, of Yardeni Research, has lent support to the thesis that the stock market is more likely to keep rising through the rest of this year. Yardeni noted that the recent record highs for the Dow Jones, Nasdaq, and S&P 500 indices were not driven by a surge in valuation multiples. Rather, he described a “melt-up in earnings” … a bullish sign for the remainder of the year.
“The fundamentals are just cranking along at a decent pace here. Earnings are doing remarkably well given that the economic data looks kind of slow. But, somehow or another, companies are generating good revenues and good earnings. I think that’s because the global economy is doing reasonably well,” said Yardeni on the CNBC Futures Now program.
Although the three major indices are taking a breather this week after surging in July, all are likely to resume an upward trend after Labor Day. We wrote in our April 26 issue:
“As we expect 2018-19 to feature both a Credit Default Crisis and a cyclical Recession, we think that these last few months of the expansion bring us the best opportunity for significant investment gains for quite a while.”
So, with Stop Losses on our portfolio tightened up, we expect to ride the last few months of the Bull Market.
Individual Stocks vs Stock Funds
The remainder of this letter will be devoted to Exchange Traded Funds (ETFs), which are low-cost, “passive” investment funds which simply track particular benchmark indices.
The number of publicly-traded companies … represented by individual stocks … has contracted significantly in the last two decades. In 1997, there were nearly 7,500 publicly-traded stocks; today, there are fewer than 3,600. In addition, many companies have bought back millions of shares of stock since the market downturn in 2008.
One explanation for the market run-up of the last eight years: a diminished supply of stocks available for purchase, and investor demand for equities because ultra-low interest rates ravaged the fixed-income markets.
Exchange Traded Funds
By contrast, the number of exchange traded funds (ETFs) has grown to almost 5,000 … greater than the number of publicly-traded stocks … and continues to increase.
ETFs represent an important investment tool for all investors, but especially those looking for an easy way to invest in a particular geographic region, market, sector, etc. The amount of assets under management (AUM) held in ETFs now exceeds $3.4 Trillion, a 17-fold increase since 2003.
ETFs are simple to understand, and appeal to investors who may have been disappointed by the relatively high fees and underperformance of “active” funds, where fund managers select stocks to include in the fund. ETF sponsors can make the case: why pay more in fees to underperform when you can track the benchmark for nearly free?
Considerations in Choosing ETFs
In choosing an ETF investment, you must carefully consider the cost, liquidity, and makeup of the fund. There is a great deal of overlap in exchange traded funds. Different funds may track the same underlying index. And, as mentioned above, there are actually more funds than there are publicly-traded stocks being tracked!
Most important … be sure to do your homework and understand exactly what the fund does. What companies comprise the underlying basket of securities? Does the fund seek to replicate a standard benchmark index, such as the S&P 500? Or, does it follow a very specific sector, such as cybersecurity or cloud computing companies?
What costs are associated with the investment? ETFs charge a fixed-percentage annual running cost to shareholders, referred to as the “expense ratio.” ETFs typically charge less than 0.50% of AUM, compared to actively-managed funds which may charge more than twice that rate.
ETF sponsors can usually afford to bring the expense ratio even lower because of economies of scale. As an ETF gathers more assets under management, costs as a proportion of the overall fund size decrease. Because the fund is simply tracking an underlying group of stocks, there are negligible transaction costs.
In addition, greater competition in the fund industry puts downward pressure on expense ratios. Investors are ever more cognizant of the diminishing effects of fees on their return. If you are looking at two near-identical ETFs which track the same index, which one would you choose? The fund with the lower expense ratio will win out more often than not.
But, keep in mind that different underlying ETF assets come with different associated expense ratios. If an ETF holds a wide range of emerging market stocks, the expense ratio would be higher than a fund tracking a standard benchmark index. It is more expensive for an asset manager to replicate a basket of stocks across multiple exchanges, and the expense ratio reflects that.
The Vanguard funds are generally recognized as cost-effective ETFs.
Finally, one must be concerned with the liquidity of a potential ETF investment. Liquidity is the ease with which you can buy and sell a security in the market without affecting its underlying price. Some ETFs can suffer from a lack of liquidity.
Examine the financial statements of any fund in which you have interest. A fund with Billions of Dollars in assets under management (AUM) usually will have no liquidity problem. A fund with considerably less AUM is more risky.
Also, examine the underlying securities in the fund. A basket of large-cap equities in developed markets is safer and more liquid than an ETF holding small companies in less stable sectors or geographical regions.
If you choose to buy a relatively illiquid ETF, please be sure to use “limit” orders. When placing an order to buy or sell, specify the maximum purchase price (or minimum selling price) that you are willing to accept.