Any time a fund invests in something more esoteric than exchange-listed stocks from a developed country or widely traded high-quality bonds, the potential for something to go wrong increases. We saw this happen in December when the Third Avenue Focused Credit Fund—a mutual fund—suddenly shut its doors in response to junk bond losses. Last week new problems emerged in fund land, this time involving a popular gold exchange-traded fund.
BlackRock’s iShares unit was caught off guard by demand for its Gold Trust ETF (IAU). The company had more requests for creation units (blocks of 50,000 shares) than it could handle. IShares literally hit the limits of its ability to issue new shares. Simply put, there were more requests for shares than there were shares outstanding or could be created. As a result, iShares had to stop issuing creation units until it filed new paperwork with the Securities and Exchange Commission. (ETFs issue and redeem shares by trading with institutional traders using creation units, either baskets of the securities or commodities those creation units represent or, in some cases, monetary amounts equivalent to the value of the creation units.)
If this has you saying “Huh?!,” then welcome to the back-end side of the ETF industry. While the perception is that ETFs can scale up or down in response to demand by issuing or redeeming shares, things don’t always go as planned. More importantly, just because an ETF is supposed to be adjusted to its net asset value by market forces on an intraday basis, this is not always the case. The iShares website says that there were 55 days last quarter when IAU traded above or below its net asset value by a margin of greater than 0.5%. Not big discounts or premiums as neither exceeded 2%, but an indication that investors weren’t always getting a dollar’s worth of the underlying gold trust for every dollar they spent on the ETF.
The technicality of share issuance may sound like a minor issue. While I don’t want to blow it out of proportion because it was likely due to a mistake on the part of someone at iShares, it does show that not everything is always calm below the water’s surface. The predicament iShares found itself in is a good reminder that you should always understand what your fund invests in and the possibilities that its strategy may lead to unintended consequences. For example, the regulations regarding commodity ETF share issuance is different than it is for ETFs investing in equities. (According to Bloomberg, IAU is registered as an exchange-traded commodity and not a traditional exchange-traded fund.)
A bigger issue is the underlying assets themselves. For example, IAU and the SPDR Gold Trust (GLD) invest in trusts. These trusts hold gold. Among the risks listed in IAU’s prospectus are lower-than-expected-quality gold being delivered to the trust or the trust’s gold being lost. Even if these are low-probability risks, they highlight the fact that physical assets underline these ETFs. All of the risks and hassles of dealing with a physical asset accompany these ETFs as well. For example, unlike shares of stocks that can be held and exchanged in electronic form, gold has be to stored somewhere and moved if it’s bought or sold.
Though I’m picking on the iShares gold fund, other funds have caused bigger headaches for investors. For example, a 1-for-10 reverse split was announced this week for VelocityShares 3x Long Crude Oil ETN (UWTI). This exchange-traded note was designed to deliver three times the return of the S&P GSCI Crude Oil Index. Reverse splits (which replace cheaper-priced shares with fewer higher-priced shares) only occur when the share price has dropped too far and there isn’t an expectation of a significant rebound in the near future. According to a Barron’s blog post yesterday, the ETN is “down 32% so far this year, even though crude oil prices have rocketed nearly 40% from their lows last month.” The disparity of returns is known as tracking error—ignore it and you won't like the impact it will have on your portfolio.
There are diversification arguments to be made for looking beyond the traditional mixture of stocks and high-quality bonds. The danger lies when an investor jumps in without having any idea of the threats that may lie beneath. Junk bonds, commodities, master limited partnerships, futures, variable rate annuities and anything that counts as an “alternative investment” all come with risks that may not be apparent on first glance. Those unaware of what is potentially lurking under the bed can find themselves dealing with unwanted headaches and unanticipated losses. This is why it’s best to start simple and tread carefully before moving on to more esoteric assets, funds and strategies.
- ETFs and ETNs: Knowing What You Own – Among the things you should pay attention to is the liquidity of the underlying assets and how much the fund’s returns differ from the asset class.
- Investing in Gold – There are other ways to invest in gold besides using an ETF.
- Have You Ever Been Surprised by a Mutual Fund or ETF’s Performance? – Tell us on the AAII.com Discussion Boards.
My colleague Wayne Thorp will speak to our Dallas/Fort Worth Chapter on Wednesday and our Houston chapter on Saturday.
Right on the heels of fourth-quarter earnings season ending, we’ll start to see results from the first quarter’s early reports. Oracle Corp. (ORCL) will report on Tuesday, FedEx Corp. (FDX) will report on Wednesday and Adobe Systems (ADBE), Cintas Corp. (CTAS) and Lennar Corp. (LEN) will report on Thursday. All of these companies are in the S&P 500.
The Federal Open Market Committee (FOMC) will hold a two-day meeting starting on Tuesday. The meeting statement and updated forecasts from committee members will be released Wednesday at 2:00 p.m. ET. Fed Chair Janet Yellen will hold her quarterly press conference starting at 2:30. The CME’s 30-day Fed fund futures are currently pricing in a 98.1% chance of a quarter-point rate hike.
Elsewhere on the economic calendar, the February Producer Price Index (PPI), February retail sales, the March Empire State manufacturing survey, January business inventories and the National Association of Home Builders’ March housing index will be released on Tuesday. Wednesday will feature the February Consumer Price Index, February housing starts and building permits and February industrial production and capacity utilization. The March Philadelphia Fed survey and the January Job Openings and Labor Turnover (JOLTS) Survey will be released on Thursday. Friday will feature the University of Michigan’s preliminary consumer sentiment survey.
The Treasury Department will auction $11 billion of inflation-adjusted Treasuries (TIPS) on Thursday.
Friday will be a quadruple witching day, meaning both options and futures contracts will expire.
Thursday is St. Patrick’s Day; be sure to wear something green!
- Using Bonds Instead of Stocks for Portfolio Income
- Choosing the Right Portfolio Allocation Approach for You
- Social Security Strategies for Couples
Optimism among individual investors is at its highest level in five months, according to the latest AAII Sentiment Survey. Pessimism fell to a new low for the year, while neutral sentiment is modestly lower.
Bullish sentiment, expectations that stock prices will rise over the next six months, jumped by 5.3 percentage points to 37.4%. Optimism was last higher on November 5, 2015 (39.0%). The increase was not large enough, however, to prevent bullish sentiment from staying below its historical average of 39.0% for the 18th consecutive week and the 51st out of the past 53 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, edged down 0.5 percentage points to 38.3%. This is the sixth consecutive week and the 58th time in the past 62 weeks with a neutral sentiment reading above its historical average of 31.0%.
Bearish sentiment, expectations that stock prices will fall over the next six months, fell 4.9 percentage points to 24.4%. Pessimism was last lower on December 31, 2015 (23.6%). This is the first time bearish sentiment has been below its historical average of 30.0% on consecutive weeks since a three-week stretch between November 26 and December 10, 2015.
We’re continuing to see the pendulum swing towards the optimistic side. Since February 11, 2015, bullish sentiment has risen by a cumulative 18.2 percentage points and bearish sentiment has fallen by a cumulative 24.3 percentage points. As noted above, however, optimism is still below its historical average.
The improvement in expectations about the short-term direction of the stock market corresponds with the ongoing rebound in the major indexes. Though some individual investors are encouraged by the market’s rebound, sustained economic growth and still comparatively low energy prices, others fret about the pace of economic growth in the U.S., the pace of economic growth in China, tensions in the Middle East, the rate of earnings growth and prevailing valuations. Frustration with Washington politics also continues to be expressed.
This week’s special question asked AAII members how, if at all, oil prices are impacting their outlook for the stock market in general. Responses were varied. Slightly more than one out of four respondents (27%) said oil prices were not impacting their outlook for the stock market. Approximately 20% view oil and stock prices as being correlated. Several of these respondents said oil prices are hurting stocks or at least causing volatility. Nearly 15% believe low oil prices are a positive for the economy, and therefore the stock market. About 8% say low oil prices are a negative for stocks. Some of these respondents fret about energy company bankruptcies hurting the credit markets. Almost 10% of respondents gave a forecast for oil, with slightly more anticipating crude prices to rise than expect oil prices to be fairly stable.
Here is a sampling of the responses:
- “I am a long-term investor. I know that oil prices will stabilize and then go back up.”
- “I still think lower oil prices are good for the U.S. economy overall.”
- “Cheap oil stresses high-yield debt and restrains capital spending. That is a negative for stocks.”
- “I think that the stock market is almost directly following the price of oil.”
- “Oil will gradually rise, stabilizing the stock market.”
Bullish: 37.4%, up 5.3 points
Neutral: 38.3%, down 0.5 points
Bearish: 24.4%, down 4.9 points
Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Local Chapter Meetings
March 3, 2016 Buffett on How Earnings and Assets Can Be Misstated
February 25, 2016 The Factors to Include on Your Retirement Readiness Checklist
February 18, 2016 Where the NASDAQ Is Less Likely to Close At
February 11, 2016 Fees on Mutual Funds Could Get Cheaper
