Special ETF-CEF Functions and Factors. Marc Gerstein February 2015

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1 Special ETF-CEF Functions and Factors By Marc Gerstein February 2015

2 Strictly speaking, ETFs (Exchange Traded Funds) and CEFs (Closed-end Mutual Funds) are corporations. Hence these, like any other corporation whose shares are publicly traded, have financial statements (that in these cases follow specialized formats adapted to the particular aspects of their businesses, but this is no odder than what we experience with banks and insurance companies, etc.). So theoretically, ETFs and CEFs could be included in the same screening/buy/sell rules and ranking systems we use for other stocks. And in fact, there are fundamental databases that do include them for that very reason. But seriously, if you are considering an investment in ishares S&P 500 ETF (SPY), do you care that net investment income for the fiscal year ended 9/30/14 was $3.1 billion, up 10.7% from the 2.8 billion earned in the prior fiscal year or that the net investment margin was 95.3%, down from 95.8% in the prior year? How about the fact that the company was debt free? Does that make SPY less risky than banks, utilities or media companies that typically carry far more debt? Does the preceding paragraph seem pretty ridiculous? Of course it does! We invest or don t invest in SPY for one reason and one reason only: because of our desire or lack of desire to include in our portfolios exposure to the performance of the S&P 500 index. Our concern is focused on the investment portfolio. It therefore makes no sense to include these funds in our stock models. How absurd would it be if you built a 15-stock low-risk high-quality model and found that 13 of the recommended stocks turn out to be funds, which got there thanks to high margins and debt-free balance sheets! How much worse would it be if 11 of those funds were actually very risky, perhaps due to exposure to junk bonds, a high-risk less0-developed equity market, or a triple-leveraged short position in the Russell 2000! (Conventional fundamental modeling cannot detect the relevant risks all of which are tied to what s in the portfolios.) Hence we separate ETFs and CEFs, and limit modeling to relevant data based mainly on price and volume data (i.e. technical and statistical analysis). There are just a few exceptions: You can model fundamentally based on dividend information and yield You can model extensively on the basis of taxonomy (classification) You can model CEFs based on NAV/Premiums/Discounts This document will focus on (i) ETF/CEF taxonomy functions, and (ii) on CEF NAV/Premium/Discount factors. 2

Opening a New ETF or CEF screen Essentially, all you do is open the new-screen menu and click on ETF Screen or CEF Screen, instead of stock screen: That s all you have to do.

3 Opening a New ETF or CEF screen Essentially, all you do is open the new-screen menu and click on ETF Screen or CEF Screen, instead of stock screen: That s all you have to do. It is, however, important to note that you do have to choose one or the other, an ETF Screen or a CEF Screen. That s because the datasets are different, very slightly different but different nonetheless. 1. The Taxonomy functions are the same for ETFs and CEFs subject to one exception: a. If you opt to create a CEF fund screen, you should not use the ETFFamily function. Doing so would reduce your result set to zero. That s because in our database, CEF s are identified by identifying the family as Closed-end Fund. 2. There are some factors that are relevant only to CEFs (and which would, in an ETF screen, drive the result set to zero); those that allow you to work with differences between the fund s net asset value per share and stockmarket price (i.e., premiums and discounts). ETF/CEF Taxonomy Functions How annoying is it to go to a fund screener and find that you can screen on Equities or Fixed Income, but that you can t distinguish between large- or smallcap equities. How annoying is it to go to find that you can screen on funds specializing in small-cap growth stocks, small-cap value stocks, mid-cap growth stocks, etc. but that you can t screen on value in general, small cap in general, small and mid cap but not large, all kinds of value funds, etc. This should resonate with anyone who has tried to screen for funds. Some platforms force you to define your fund universe world in very general terms. Others force you to get very, often overly, specific. Portfolio123 is different. You can be as general as you want. You can be as specific as you want. You can be as generic as you want. You can be as idiosyncratic as you want. Summing up, you can define your ETF/CEF world however you want. 3

4 In the menu interface, this is accomplished using the TAXONOMY collection of ETF/CEF functions. If you click on the + sign, you ll see the following set of choices (remember that everything can be used for CEFs even though the label says ETF). ETFAssetClass ETFCountry ETFFamily (Remember: don t use ETFFamily for CEFs) ETFMethod ETFRegion ETFSector ETFSize ETFStyle The choices within each taxonomy group, along with their acronyms, are specified in the Full descriptions. Generally, though, here is what s included in each. Asset Class Country Equities, Currencies, Commodities, Fixed Income, Mixed Assets (which have become more popular lately, as some new ETFs try to imitate hedge funds), and Alternative (which had one ETF that folded, but we re still keeping the category to accommodate the increasing creativity of ETF sponsors) You can choose among individual countries or multi-country. Family (ETFs only) Method Region ishares, PowerShares, ProShares, Direxion, Rydex, SPDR, Vanguard, Wisdom Tree, etc., etc., etc. Standard Long (once upon a time, this was the only method in use by ETFs), Standard Short, Leveraged Long, Leveraged Short, Hedged, Quant Model (PowerShares Dynamic XTFs and those that followed), Special Weights (Wisdom Tree, and those that followed), which, nowadays, are being referring to by many as smart beta ) Asia, BRIC-Chindia (Brazil, Russia India and China, or just China and India), Developed, Emerging, Europe, Global (note that many 4

5 of these ETFs have big stakes in the U.S.), Latin America, Mideast- Africa, North America, Pacific ex Japan Sector We have the usual ones you d expect for equities: Consumer, Energy, Financial, Healthcare, Housing, Industrials, Materials, Real Estate, Resources (General), Services, Technology, Telecomm, Transportation and Utilities We also have some you might not expect: Agriculture, Alternative Energy, Infrastructure, Social (for socially conscious ETFs), Special Theme (this where we see a lot of creative ETFs), Precious Metals, Timber and Water. For fixed income, we have Municipal and Taxable. We also have General Sector for when you want to eliminate sectorspecialist ETFs. Size We have Large-Mega Cap, Mid Cap, and Small-Micro Cap. You can specify General if you want ETFs/CEFs that don t specialize. Style For those who specifically want to exclude specialist ETFs/CEFs, we have General. For Equity ETFs, we have Equity Income, Growth, or Value For fixed Income, we have General Fixed Income, High Yield, Short-term, Intermediate-term or Long-Term You don t always have to use these groupings. When you start a new ETF/CEF screen, your default universe consists of All ETFs or All CEFs. Use the groupings functions only to the extent you want to exclude certain kinds of funds. And this, by the way, is something you should always include doing. For example, modeling sand testing on a comprehensive universe that includes long, short leveraged long and leveraged short ETFs may not produce meaningful or satisfying results. 5

6 There are two ways to work with groupings, the basic functions or the set functions. If you want include or exclude just one item from any particular collection, here are some examples: ETFAssetClass = equity ETFassetClass!= equity (Note that!= means not equal to) ETFMethod = stanlong If you want to work with some items from a particular collection, but not necessarily all, use the set functions. ETFMethodSet(stanshort, levshort)=true ETFRegionSet(BRIC,Chindia,Pacific)=true ETFMethodSet(levlong,levshort,stanshort)=false You can mix and match very creatively by using screens containing several groupings functions. For example, the following set of rules will give you a list of non-u.s. ETFs that specialize in equities or currencies. ETFAssetClassSet(equity,curr) = true ETFCountry!=usa ETFRegion!=global The following example will identify agriculture ETFs, whether they focus on agribusiness equities or commodity futures. ETFAssetClassSet(equity,commod)=true ETFSector=agric Often, you ll you can build many ETF screens using only the TAXONOMY functions in the manner illustrated above. Then, choose only the top funds based on a quick-sort or a ranking system (a ranking system you create or a pre-set Portfolio123 ranking system). Finally, assuming you have some extremely idiosyncratic ways you d like to define the world of ETFs/CEFs and that even these functions don t allow you to fine-tune as tightly as you wish. In that case, you could create custom list using tickers you hand select. 6

7 CEF NAV/Premium/Discount Factors In many respects, Closed-end funds (CEFs) and ETFs (exchange-traded funds) look alike. In contrast to open-ended mutual funds, where you directly buy a share in investment the portfolio (strictly speaking, you don t buy or sell but contribute or withdraw/redeem funds to or from the portfolio), CEF and ETF shareholders do not put money into the portfolio. Instead, they buy or sell shares of a corporation whose sole business is to own and maintain the portfolio. As a matter of custom, these shares trade with reference to asset value, the pershare value of the portfolio. (Actually share prices of any corporation could be priced with reference to asset value but for business corporations, assets cannot be valued with anywhere near the precision that is routine for funds). And while the portfolio for an open-ended fund would continually grow or shrink (aside from market movements) as investors contribute or withdraw money, the portfolios of ETFs and CEFS are fixed: Unless the fund buys back and retires shares or does a public offering of new equity, the portfolio is sort-of fixed; the dollar amount rises or falls based only on market factors. So it seems that ETFs and CEFs are identical. At first glance, it looks like they are. There s really just one difference. It involves a seldom-discussed and often-wordy piece of highly technical legal boilerplate in ETF registration statements. But it has a huge impact on the way the respective kinds of shares trade. This legal point can best be introduced by noting that for CEFs, there is no mandate that they be priced at or anywhere near per-share asset value. This is the same as it is with all publicly traded corporate shares. That CEFs do tend to be priced within hailing distance of per-share net asset value is a matter of custom, or more specifically, investment community supply and demand. Sometimes, the share price and NAV (net asset value per share) will be very close, or nearly identical. But often, there will be noticeable differences. Price can be below NAV (meaning that the shares trade at a discount), or price can be above NAV (meaning shares trade at a premium). Discounts and premiums can be important aspects of an investment case for or against a particular CEF. Investors tend to be willing to pay premiums if the CEF offers appealing but otherwise unobtainable exposure to particular asset classes. In the past, for example, when CEFs were the only way for the typical U.S. investor to gain exposure to then-hot developing country equity markets, premiums, often up to around 20%, were commonplace. In the usual course of events, however (i.e. ex the presence of unusual circumstances), the presence of a premium is considered bearish. Why pay $12 a 7

8 share for assets worth $10 a share? On the other hand, discounts, especially larger discounts, are typically deemed bullish. (For example, paying $8 a share for assets worth $10 per share seems irresistible. When CEF shares trade at a noteworthy discount, there are four possible scenarios: 1. The shares maintain more of less the same discount in the future, this being a neutral CEF scenario in which the appeal of the shares will be tied solely to the appeal of the portfolio. 2. The discount will widen. This bearish scenario, which would cause the stock to underperform the portfolio, would usually occur if, in the future, investors become more bearish on the assets emphasized in the portfolio. 3. The discount will eventually narrow, as investors take note of the discount and as supply/demand gradually pushes the stock price closer to NAV. This is the standard bullish CEF scenario. 4. Finally, we have the CEF special-situation scenario. Here, a noteworthy discount persists. It seems unwarranted by the sentiment toward the assets in the portfolio but does not seem to be getting corrected by the forces of supply and demand. This can lead to a decision by fund management (either a voluntary decision or one prompted by an activist shareholder and/or a general proxy fight) to formally convert the entity to an open end fund. If that happens, then by law, the shares would have to be priced at NAV, thus conferring a windfall (as the discount vanishes) on those who held before the market reacted to news of a planned conversion. Because discounts/premiums figure so prominently in the CEF investment landscape, CEF screening includes relevant factors, which you can find under FUNDAMENTALS>>RATIOS & STATISTICS >>VALUATION (items relating to NAV and NAV Discount, which can be positive or in the case of a premiums, negative), and FUNDAMENTALS>>RATIOS & STATISTICS >>GROWTH RATES (items relating to changes in NAV). In theory, everything said about premiums and discounts could also apply to ETFs. As a practical matter, however, that is rare. ETF registration statements include provisions that allow institutional investors to assemble baskets of assets that match those of the portfolio and tender them to the ETFs in exchange for newly-issued ETF shares, or to tender ETF shares to the fund and receive, in return, the equivalent portfolio securities. To the casual observer, these institutional share creation/destruction exchange privileges may seem pointless. Actually, though, they are at the heart of the main difference between CEFs and ETFs. If meaningful premiums/discounts appear for ETF share prices, institutions can and do take advantage of their exchange privileges to, in essence, arbitrage them back to zero (subject to tracking error that is typically too small for anybody to bother about). So in a way, we might consider ETFs a modern innovation that corrects pricing inefficiencies often present among CEFs. 8

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