Power investing with basket securities : the investor's guide to exchange-traded funds PDF
Preview Power investing with basket securities : the investor's guide to exchange-traded funds
POWER INVESTING wwiitthh BASKET SECURITIES THE INV ESTOR’S GUID E T O E XCHANGE- TRADED FU NDS JM2546_frame_FM Page 2 Monday, November 26, 2001 11:27 AM PETER W . MADLEM, CFA LARR Y D. EDW ARDS, CFA POWER INVESTING wwiitthh BASKET SECURITIES THE INV ESTOR’S GUID E T O E XCHANGE- TRADED FU NDS ST. LUCIE PRESS A CRC Press Company Boca Raton London New York Washington, D.C. CRC Press Taylor & Francis Group 6000 Broken Sound Parkway NW, Suite 300 Boca Raton, FL 33487-2742 © 2002 by Taylor & Francis Group, LLC CRC Press is an imprint of Taylor & Francis Group, an Informa business No claim to original U.S. Government works Version Date: 20120710 International Standard Book Number-13: 978-1-4200-2630-6 (eBook - PDF) This book contains information obtained from authentic and highly regarded sources. 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For permission to photocopy or use material electronically from this work, please access www.copy- right.com (http://www.copyright.com/) or contact the Copyright Clearance Center, Inc. (CCC), 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400. CCC is a not-for-profit organization that pro- vides licenses and registration for a variety of users. For organizations that have been granted a pho- tocopy license by the CCC, a separate system of payment has been arranged. Trademark Notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. Visit the Taylor & Francis Web site at http://www.taylorandfrancis.com and the CRC Press Web site at http://www.crcpress.com JM2546_frame_FM Page 5 Monday, November 26, 2001 11:27 AM Preface Power Investing with Basket Securities, The Investor’s Guide to Exchange-Traded Funds, represents the second volume in the Power Investing series of books. Several years ago, when the publisher originally suggested the idea, there was some hesitancy regarding the series title. Power seemed, well, a bit robust as a title theme. However, upon consulting the dictionary, the primary definition was found to be, “the ability or capacity to act or perform effectively.” Who can quarrel with that? After all, that is exactly what the series is intended to do, impart to readers the ability and capacity to perform effectively with their investments. Each volume presents an investment strategy or approach that empowers the investor, whether professional or individual, with proven and innovative approaches to improve performance in the convoluted and confounding world that makes up the financial marketplace. This book is about basket securities and how investors can use them. Spiders, Sectors, Holders, ETFs, iShares, Vipers, and Qubes, are all acronyms for members of this relatively new class of financial products. Most investors know them as exchange-traded funds, or ETFs. However, not all basket securities are exchange- traded funds, in the strictest sense. The fundamental concept of a basket is any grouping or combination of financial assets that underlie the value of a single exchange-traded security. Many, but not all, are based on indices, or subsectors of indices. In addition, most are structured as securities issued by unit investment trusts or mutual funds, but not all. The term “basket security” covers a broader spectrum of useful securities than just index fund products issued by registered investment companies. Most baskets are designed to track specific indices or subgroups. Others select specified portfolios within an industry group such as telecommunications and phar- maceuticals. Because they are basically passive portfolios, baskets incur lower expenses than actively managed mutual funds. Moreover, they typically entail a lesser tax burden, since the underlying stocks are generally traded when an index needs to be rebalanced. Like stocks, you can buy baskets on margin and trade them anytime the market is open. Baskets also are easy to short because they are exempt from the uptick rule, which forbids the selling of a stock short in a declining market. Baskets can be used to manage portfolio risk through hedging. Professional traders can swap shares of a basket security for the underlying stocks, or vice versa. This form of arbitrage keeps basket security prices very close to their net asset value, which means they can track an index better than a closed-end mutual fund. This book describes the origins of basket securities and reviews their beneficial features and structures. It covers the broad array of currently available basket securities, and suggests the likelihood of others on the horizon. Most importantly, the book presents some strategies for their successful and powerful applications in managing portfolios. JM2546_frame_FM Page 6 Monday, November 26, 2001 11:27 AM Those who can benefit from reading and using this book include investors who have made asset allocation decisions as to their overall financial assets, and are now considering how to achieve an appropriate level of diversification in the equity portion of their portfolios. The authors hope that this book will be useful to its readers in accomplishing such diversification, and perhaps in providing some further insights into the portfolio management process. JM2546_frame_FM Page 7 Monday, November 26, 2001 11:27 AM About the Authors Both authors are currently portfolio managers with the Trust Investment Services Division of Santa Barbara Bank & Trust, located in Santa Barbara, CA. Their professional backgrounds, while significantly different, share much in common. Peter W. Madlem, CFA, has nearly 20 years of diverse investment experience. In the mid-1980s he cofounded two publishing and investment advisory firms specializing in closed-end funds and REITs. His market and financial comments have appeared in The Wall Street Journal, Investor’s Business Daily, Kiplinger’s, and Money Magazine. A published author and composer, Madlem has written six investment-related books and his musical compositions have been performed at the Sydney Opera House, the National Cathedral in Washington, D.C., and London’s Wigmore Hall, and have been recorded on Sony/Classical and Sonora records. Madlem earned a Master’s degree from the University of California, Santa Barbara. He lives with his wife, Katherine, and two children in Carpinteria, CA. Larry D. Edwards, CFA, has more than 30 years of broad experience in the investment management industry. In addition to being an experienced portfolio manager, he served as President of Leland O’Brien Rubinstein Associ- ates Incorporated (LOR) and its subsidiary, SuperShare Services Corporation from 1984 to 1988. In these capaci- ties, Edwards had an integral role in the creation of “The SuperTrust” and its various securities that are described in Chapter 1 and Appendix B. One of these securities, the Index Trust SuperUnit, was the first successful U.S. exchange-traded basket security, preceding the introduc- tion of the Spider by about 3 months. Prior to joining LOR as president, Edwards was chief investment officer for Western Asset Management Company. He began his professional career with Scud- der Stevens and Clark Inc. A graduate of Occidental College and the Stanford Graduate School of Business, Edwards and his wife, Janice, reside in the Santa Ynez Valley. At Santa Barbara Bank & Trust, Madlem and Edwards, together with their associates, are developing creative applications for basket securities, some of which are described in this book. JM2546_frame_FM Page 8 Monday, November 26, 2001 11:27 AM JM2546_frame_FM Page 9 Monday, November 26, 2001 11:27 AM Introduction Tremendously versatile, basket securities have the potential to change the way money is managed. They are similar to index funds but trade like stocks, so they enjoy the advantages of both worlds. Baskets provide a way to obtain the diversification of, say, the Standard & Poor’s 500 Stock Index in a single security that can be bought and sold during market hours just like any other stock. Unlike regular mutual fund shares, which calculate their net asset values at the end of each trading day, baskets trade continually on a stock exchange, where their prices can change from trade to trade. This book provides the proper definition of the basket security, a brief exploration of their true history, and simple yet powerful ways to exploit their advantages. To that end the book is organized into three broad sections containing nine chapters, and three appendices. Section I contains Chapters 1 through 3. The first chapter reviews the origin of basket securities, as we know them today. The need for baskets became clear during the stock market “Crash” of October 1987. It took 5 years to develop one that worked and that had a sound regulatory structure. In Chapter 2, some of the primary structural characteristics and related benefits of baskets are reviewed, using the “Spider,” or SPDR, as a model. These innovative securities can provide instant diversification, price efficiency, tax efficiency, liquidity, and cost efficiency. When used as part of equity portfolios, they can reduce the likelihood of bombshells and, over time, assure freshness. Chapter 3 surveys the major participants in the basket securities business and those firms that are sponsors or managers. Many of the currently available baskets have come to market only recently. Section II, encompassing Chapters 4 through 7, represents the applied portion of the book. Chapter 4 explores simple, yet effective, ways basket securities can be used in asset management strategies, including trading the market, building a diver- sified core, or creating a “thousand stock portfolio.” Chapter 5 presents a more technical look at trading strategies using basket securities, including using baskets together with individual securities, the application of momentum screens, and how to utilize straightforward and useful charting tech- niques. A sample basket portfolio strategy, the Basket Case Portfolio, is introduced. Chapter 6 acknowledges the ongoing debate between active and passive man- agement and suggests a portfolio management approach to blending them. Based on a comparison between the capitalization-weighted and equal-weighted S&P 500 returns, two variants are introduced to ascertain whether active or passive investment is more likely to succeed. Next, a method for determining the appro- priate blend of the diversified core indices using an iterative historical value at risk computation is presented.
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