ETFs Gone Wild: New Listings and What You Need to Know Before Investing
February has already seen the launch of 14 new ETFs, with several of the products representing relatively new slices of the investment landscape.
But as always, you should proceed with caution and keep the mantra of "buyer beware" in the forefront of your mind. Let’s take a look at three of the recent offerings and what you need to know before investing.
Private Equity Funds
There is already a private equity ETF, PowerShares Global Listed Private Equity Portfolio (NYSEARCAPSP) which was launched in October 2006. Shockingly it actually preceded the IPO of Blackstone (NYSE:BX) eight months later. Blackstone’s IPO was rightfully met with skepticism. Behind the irony of a PE firm going public (yes a permanent source of capital is nice), it did in fact mark a top as the shrewd partners were cashing out of a very overheated market.
So it is with that jaundiced eye we must greet last week’s announcement that two new private equity ETFs are set to launch. The ProShares Global Listed Private Equity ETF (NYSEARCA:PEX), which invests in 30 PE firms that have at least 80% of their assets invested in private companies, and Market Vectors BDC Income (NYSEARCA:BIZD), a fund that invests in 25 business development names.
The timing of this launch seems most auspicious considering that mergers and buyouts are a “hot” sector right now as historically low interest rates are a boon for private equity firms that are highly dependent on borrowing money and taking on debt to finance deals. Basically PE firms can now borrow money for next to nothing, which means they don’t need to lever up as much to achieve the same return on equity. That’s nice for the partners and investors in specific PE funds, but what does that mean to shareholders of these ETFs?
Unlike the traditional unlisted private equity investments, which usually have high minimum investment amounts, are illiquid, and usually lock up your investment for some period of time, private equity ETFs provide investors with liquid exposure to the private equity asset class without minimum investment requirements, amounting to immediate exposure to a diversified private equity portfolio.
Be aware these funds come with relatively high expense ratios ranging from 2.32% to 2.56% annually and are layered with a reimbursement fee and acquired funds fees. Also, there could be issues of not only losing out on some of the return as the typical 2/20 fees get skimmed prior to bottom line earnings, but also double taxation. This is something that should be looked at with your financial advisor before making a big commitment to these ETFs.
For my money I would just as soon buy into the handful of publicly traded private equity firms such as the aforementioned Blackstone or KKR (NYSE:KKR). They have a lower cost and both have performed well, up some 30%-33% for the year to date, though it should be noted they are still down some 30% from their IPO prices. By comparison, PSP is only up 15% YTD and is down some 50% from its IPO price. This is a reflection of the fact that most indexes, or funds of funds, will have a lower beta than the component parts, but can perform equally poorly in a bear market when there is increased correlation.
But be aware -- BX and KKR also come with some quirks: You hold “units” rather than shares, which has tax implications in that you are taxed on your allocable share of the firms’ income regardless of whether cash distributions were made in the form of dividends to you.
High and Low Volatility ETFs
There has been a surge in ETFs that are constructed based on the volatility of individual components. Invesco PowerShares has a first-mover status in this category with its May 2011 introduction of the PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV). The firm expanded that lineup in recent weeks with mid cap and small cap offerings that also follow S&P indexes. State Street SPDRs brought out its first two ETFs targeting low volatility stocks with last week’s introduction of large cap and small cap funds based on Russell indexes. Some of the recent listings include the following:
PowerShares S&P MidCap Low Volatility Portfolio (NYSEARCA:XMLV) was launched on Feb. 15, 2013 with a 0.25% expense ratio. It will track an index composed of 80 of the 400 medium-capitalization securities from the S&P MidCap 400 Index (INDEXNYSEGIS:MID) with the lowest realized volatility over the past 12 months. S&P weights constituents by the inverse of each security’s volatility with quarterly reconstitution and rebalancing. Sectors receiving allocations in excess of 5% are financials (51.3%), utilities (23.9%), technology (7.2%), and materials (5.6%).
SPDR Russell 2000 Low Volatility ETF (NYSEARCA:SMLV) was launched on Feb. 21, 2013 and has a 0.25% expense ratio. It will track an index that currently has 164 securities, and a maximum of 400, selected from the Russell 2000 Small Cap Stock Index (INDEXRUSSELL:RUT). Security selection aims to deliver focused exposure to low volatility securities, while minimizing exposure to other factors. Reconstitution of the underlying index occurs monthly to maintain its focus on low volatility. Sectors receiving the largest initial allocations include financials (31.1%), utilities (16.7%), industrials (15.0%), consumer discretionary (10.1%), and technology (9.9%). SMLV is expected to yield 2.3%.
These ETFs are expected to be rebalanced quarterly. But as we have witnessed a lot can happen in three months; for example, PowerShares Midcap with 51% weighting in financials could be vulnerable, and very volatile, to any new financial crisis here or abroad.
Coming in from another angle is the new US Equity High Volatility Put Write Index Fund (NYSEARCA:HVPW) from ALPS is only the latest ETF that explicitly uses options in its strategy. This could be the boldest and most explicit derivatives-based income play in an ETF wrapper to date.
The fund explicitly aims for a 1.5% distribution every 60 days. That’s roughly 9 percent a year if things go well—a pretty enticing goal in today’s next-to-nothing yield environment but it comes with a fairly high risk.
HVPW “writes” put options on each of 20 stocks that are sporting the highest implied volatility. It sells puts that are 15% out-of the-money (OTM) and have some 60 days until expiration. Investors who buy these OTM options would exercise them if the stock’s price falls below that strike price within the 60-day term of the option.
Hence the fund is on the hook for each of its 20 names for the difference in price below a roughly 15% drop. If the stocks stay above the strike price until expiration, you collect the premium sold. These puts are all sold naked, meaning the losses on individual stock, should it blow up, could easily wipe out the incremental gains of the other holding. And in the case of a broad market sell it could be catastrophic. One mitigating factor is that the fund will hold 101% cash as collateral, meaning it is not employing leverage. But so far there is no track record and only scant historical data on how such a fund would have performed.
If you are looking for income I would suggest going for funds that try to mimic the CBOE Buywrite Index (INDEXCBOE:BXM) which is a covered call strategy of the SPDR S&P 500 ETF Trust (SPY) such as Powershares S&P 500 Buywrite (NYSEARCA:PBP) or those based on the PutWrite Index (^PUT) which sells. These have a proven track record and provide income with a lower beta than being long the underlying index.
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