Wednesday, August 31, 2016

Abner, The ETF Handbook, 2d ed.

Since David J. Abner wrote the first edition of The ETF Handbook: How to Value and Trade Exchange-Traded Funds in 2010, the ETF industry has more than doubled, with new users continuing to incorporate ETFs into their trading strategies but not always knowing just how they work. A second edition of this book was definitely in order.

Abner’s handbook is directed primarily at institutional investors. The retail investor who owns, let’s say, a few hundred shares of SPY, TLT, and GLD does not need the kind of detailed information provided here.

Abner divides his book into three parts. The first part introduces the structures of ETFs, the methodologies underlying these products, and the ways of bringing them to the marketplace. The second part addresses trading, with special emphasis on volume and liquidity. In the third part Abner discusses the mechanics of calculating the fair value of the products.

Rather than going into the weeds of trade execution, however important it may be for institutions placing large trades (in fact, Abner writes that “the information in [the chapter on execution] alone should make owning this book mandatory for every trader and execution flow staff member who handles orders in exchange-listed funds”), I’ll focus on a topic that bedevils both retail and institutional investors: leveraged products.

Leveraged ETFs are structured to satisfy traders with short-term positions. At the close of every trading day leveraged ETFs have to be reset to 100% exposure, “which means the leveraged funds are truing up their exposure and trading in the close daily.” This also means that “the leverage performance applies only to day-over-day price movements, not to the basis at which you entered into the trade. … [O]ver time, the compounding of this reset can potentially cause the performance of the fund versus its underlying benchmark to diverge.” Consider, for instance, the extreme case in which the index rises 10% a day for ten days. It will have a ten-day cumulative change of 159%. A 2X ETF, however, will have a cumulative change of 519%. Because of the increasing price, the daily gains “are driving the value higher at a faster pace.” If the index declines 10% a day for ten days, its cumulative change will be -65%; the 2X ETF, -89%. It loses progressively less in notional points every day. In a rangebound, volatile market, up 10% then down 10% for ten days, the cumulative change for the index will be -4.90%; for the ETF, -18.46%. The returns of leveraged ETFs are, as can be seen, highly path dependent.

Abner’s book is both comprehensive and comprehensible, and he writes from experience. Earlier in his career he built and managed ETF sales and trading businesses at BNP Paribas and Bear Stearns. He currently leads the European business for WisdomTree Asset Management, an ETF issuer. No professional should enter the ETF world without taking advantage of his experience, analysis, and sound advice.

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