Thursday, August 5, 2010

Gastineau, The Exchange-Traded Funds Manual

Since the ETF world has been changing so rapidly, a second edition of The Exchange-Traded Funds Manual (Wiley, 2010) was definitely in order. Gary L. Gastineau provides a comprehensive analysis of ETFs with enough actionable tips to make it not only a reference book but also a trading guidebook.

He addresses run-of-the-mill concerns of ETF investors such as taxation as well as more controversial issues such as the return patterns of leveraged ETFs. He describes how ETF trading is different from stock trading and why it is easy to borrow ETF shares—“if you want to borrow enough of them.” (p. 239)

In this post I’m going to confine my focus to a topic that has been written about ad nauseum, indexing. Fortunately Gastineau has a different take: he argues against the often eulogized transparency of index ETFs. The problem is that “if your funds reveal their trading plans in advance, that trading transparency is certain to reduce your returns.” (p. 102) Most so-called passive index funds feel compelled to adjust their composition as indexes rebalance and thereby incur a cost penalty. It’s more profitable to trade against the index changes instead of with them. Gastineau claims that “the value that can be added by astute trading around a single reconstitution trade in a large index fund portfolio will often exceed $1,000,000 per incident.” (p. 108)

Gastineau suggests that silent (nontransparent) indexes can help mitigate the transaction costs associated with transparent index funds. Admittedly, the SEC requires transparency, so a silent index fund couldn’t be marketed as an index fund at all; it would have to be called something else. What would a silent index look like? It “can be based on the same kinds of rules as a rules-based benchmark index—but the specific silent index rules should not be published. The rules have to be sufficiently obscure to protect the fund from speculators attempting to front-run trades by the fund portfolio manager. The rebalancing date(s) of the fund and the capitalization range might be randomized from year to year. Of course, the rebalancing dates and capitalization range would not be disclosed.” (p. 125) The fund manager of whatever the silent index fund is called would also be able to engage in full-function active management.

Naturally, Gastineau develops this idea in more depth, analyzing some of its drawbacks as well as its strengths. I have no space to follow it any further, but I found it an imaginative, contrarian response to the problem of transparency in index funds.

All in all, The Exchange-Traded Funds Manual should be required reading for all financial advisors and fund managers. The individual investor should also find enough meat in it to make it a worthwhile read.

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