Got to the bottom of a few financial questions I didn’t understand.
This post is organized in a way that I’d first introduce the problem, and then I gonna explain all the necessary background information before get to the actual problems. If a reader just wants to get a quick understanding, search in YouTube for a 5 min video would be easier!
If index fund prevails 96% of active managed funds and it will eventually multi fold after decades, why not use leveraged ETF, like TQQQ? How leveraged ETF works?
https://www.etf.com/etf-education-center/ is a great place to understand ETF and all its knowledge.
If you read the previous two blog posts here and here. You will find investing in passive ETF might be is the best strategy for 99% of the population.
So if investing in ETF is always a win, why not use leverage to get 3x the ETF gain? Before that:
- What is ETF, how ETF works?
- How SPY matches S&P 500 index?
- What is leveraged ETF, how leveraged ETF works?
What is ETF?
ETF is short for “exchange traded fund”, it is a fund that can be traded on an exchange like a stock. ETFs give you a way to buy and sell a basket of assets without having to buy all the components individually.
ETF fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors.
What is Market Maker?
A market maker (MM) is a firm or individual who is actively quotes two-sided markets in a security, providing bids and offers (known as asks) along with the market size of each.
For instance, a market maker in XYZ stock may provide a quote of $10.00-$10.05, 100x500. This means that they bid (they will buy) 100 shares for $10.00 and also offer (they will sell) 500 shares at $10.05. Other market participants may then buy (lift the offer) from the MM at $10.05 or sell to them (hit the bid) at $10.00. Market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread.
Market makers may also make trades for their own accounts, which are known as principal trades.
What is Authorized Participant?
Authorized participants (AP) are one of the major parties at the center of the creation and redemption for ETF. An AP may be a market maker. They provide a large portion of liquidity in the ETF market by obtaining the underlying assets required to create a fund. When there is a shortage of shares in the market, AP creates more. Conversely, the authorized participant will reduce shares in circulation when supply falls short or demand.
Authorized participants are responsible for acquiring the securities that the ETF wants to hold. If that is the S&P 500 index, they will purchase all its constituents in the same weight and deliver them to the sponsor. In return, authorized participants receive a block of equally valued shares called a creation unit. Issuers can use the services of one or more authorized participants for a fund.
The exchange takes place on a one-for-one, fair-value basis. The AP delivers a certain amount of underlying securities and receives the exact same value in ETF shares, priced based on their net asset value (NAV), not the market value at which the ETF happens to be trading.
Multiple authorized participants help improve the liquidity of a particular ETF. The threat of competition tends to keep the fund trading close to its fair value. More importantly, additional authorized participants encourage a better functioning market. When one party ceases to act as an authorized participant, other ones will see the product as a profitable opportunity and offer the creation/redemption technology. At the same time, the impacted authorized participant has the option to address any internal issues and resume primary market activities.
What is the Creation/Redemption Mechanism
A very good YouTube video that explains how AP holds ETF to fair value and why ETFs are low cost.
The creation/redemption process is important for ETFs in a number of ways. For one, it’s what keeps ETF share prices trading in line with the fund’s underlying NAV.
Because an ETF trades like a stock, its price will fluctuate during the trading day, due to simple supply and demand. If many investors want to buy an ETF, for instance, the ETF’s share price might rise above the value of its underlying securities.
When this happens, the AP can jump in to intervene. Recognizing the “overpriced” ETF, the AP might buy up the underlying shares that compose the ETF and then sell ETF shares on the open market. This should help drive the ETF’s share price back toward fair value, while the AP earns a basically risk-free arbitrage profit.
Likewise, if the ETF starts trading at a discount to the securities it holds, the AP can snap up 50,000 shares of that ETF on the cheap and redeem them for the underlying securities, which can be resold. By buying up the undervalued ETF shares, the AP drives the price of the ETF back toward fair value while once again making a nice profit.
This arbitrage process helps to keep an ETF’s price in line with the value of its underlying portfolio. With multiple APs watching most ETFs, ETF prices typically stay in line with the value of their underlying securities.
This is one of the critical ways in which ETFs differ from closed-end funds. With closed-end funds, no one can create or redeem shares. That’s why you often see closed-end funds trading at massive premiums or discounts to their NAV: There’s no arbitrage mechanism available to keep supply and demand pressures in check.
With ETFs, APs do most of the buying and selling. When APs sense demand for additional shares of an ETF — which manifests itself when the ETF share price trades at a premium to its NAV — they go into the market and create new shares. When the APs sense demand from investors looking to redeem — which manifests itself when the ETF share price trades at a discount — they process redemptions.
The AP pays all the trading costs and fees, and even pays an additional fee to the ETF provider to cover the paperwork involved in processing all the creation/redemption activity.
The beauty of the system is that the fund is shielded from these costs. Funds may still pay trading fees if they have portfolio turnover due to index changes or rebalances, but the fee for putting new money to work (or redeeming money from the fund) is typically paid by the AP. (Ultimately, investors entering or exiting the ETF pay these costs through the bid/ask spread.)
Regarding tax, ETFs do much better (for reference, the average emerging market ETF paid out 0.01 percent of its NAV as capital gains over the same stretch).
Why? For starters, because they’re index funds, most ETFs have very little turnover, and thus amass far fewer capital gains than an actively managed mutual fund would. But they’re also more tax efficient than index mutual funds, thanks to the magic of how new ETF shares are created and redeemed.
When a mutual fund investor asks for her money back, the mutual fund must sell securities to raise cash to meet that redemption. But when an individual investor wants to sell an ETF, he simply sells it to another investor like a stock. No muss, no fuss, no capital gains transaction for the ETF.
What happens when an AP redeems shares of an ETF with an issuer? Actually, it gets better. When APs redeems shares, the ETF issuer doesn’t typically rush out to sell stocks to pay the AP in cash. Rather, the issuer simply pays the AP “in kind” — delivering the underlying holdings of the ETF itself. No sale means no capital gains.
The ETF issuer can even pick and choose which shares to give to the AP — meaning the issuer can hand off the shares with the lowest possible tax basis. This leaves the ETF issuer with only shares purchased at or even above the current market price, thus reducing the fund’s tax burden and ultimately resulting in higher after-tax returns for investors.
Unit Investment Trust
A unit investment trust (UIT) is an investment company that offers a fixed portfolio, generally of stocks and bonds, as redeemable units to investors for a specific period of time. It is designed to provide capital appreciation and/or dividend income. Unit investment trusts, along with mutual funds and closed-end funds, are defined as investment companies.
How SPDR S&P 500® ETF (SPY) works?
If you read all the way through here, you should have understood how ETF index fund works. SPDR S&P 500® ETF is a unit investment trust. The Trust was created to provide investors with the opportunity to purchase a security representing a proportionate undivided interest in a portfolio of securities consisting of substantially all of the component common stocks, in substantially the same weighting, which comprise the Standard & Poor’s 500® Index (the “S&P 500® Index”).
Note SPY is different from SPX, SPX is just computed from the prices of the constituent companies and it has no market forces directly on it.
Michael Burry’s Concern of ETF
Burry’s bearish stance on index investing and ETFs center around the assumption that, after decades of net inflows to passive investing strategies, eventually the tides will turn, and outflows will cause issues.
Burry noted that 266 of the 500 stocks in S&P 500 had less than $150 million in trading volume that day.
“Trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was.”
How Leveraged ETF Works?
In general, leveraged ETFs promise to deliver a multiple of the underlying indices’ daily return (note the term daily). For the ProShares S&P 500 leveraged ETFs, these outsized return are accomplished using derivatives, mainly index swaps and futures, in addition to holding common stock.
As ETF Database explains:
For example, a 2x long S&P 500 ETF may use a combination of equities, futures and swaps to essentially double its exposure. A fund with $100 million in assets might invest $80 million in the underlying assets of the underlying benchmark, leaving $20 million in cash. A portion of this cash could be used to purchase S&P 500 futures contracts — exchange-traded derivatives that provided exposure to a benchmark without direct ownership. A futures contract is essentially a standardized contract between two parties that agree to buy (and sell) an underlying index at a future date at the market price.
In addition, a leveraged ETF may enter into an index swap agreement with a counter party to increase its exposure to the underlying index. Swaps are customized agreements between two counter parties to exchange two sets of cash flows over a specified period of time. In an equity index swap, one party generally pays cash equal to the total return on the underlying index, while the other pays a floating interest rate.
Disadvantage and Risk of Leveraged ETF
Leveraged ETFs have high expenses. One effect of this derivative usage, and the constant derivative rebalancing, is a high expense ratio. SSO has an expense ratio of 0.91% and its short twin SDS is at 0.89%, much higher than the S&P 500 ETF SPY of 0.09%. Such a high expense alone makes it poorly suitable as a long-term investment.
The high expense may be forgiven if its leveraged performance truly sings. However, long-term leveraged performance is a somewhat mixed bag.
Let’s use the 3x leveraged ETF for an example. If the tracked ETF dropped by 34%, the leveraged ETF is wiped out.
TQQQ is the 3X ETF that tracks the QQQ, which is an ETF that tracks the Nasdaq 100. SQQQ is the inverse of the TQQQ.
TQQQ strives to move 3X the QQQ on a DAILY basis, not a weekly or monthly basis. If QQQ and TQQQ are both prices at $1.00, then QQQ goes to $1.10, TQQ will go to $1.30.
If QQQ goes back to $1.00, this is where it gets confused with contango, which I believe has nothing to do with 3X ETFs.
$1 X 1.3 = $1.30.
$1.30 X .7 = $.91.
QQQ has returned to $1.00, but TQQQ has returned to $.91.
If QQQ trades sideways, both TQQQ and SQQQ will lose value.
However, QQQ has been trending up. That means that TQQQ has been trending up faster. The below chart is the QQQ and TQQQ on the same chart going back to 2013. Green is the QQQ, and red is the TQQQ.
Two popular 3X ETFs that are volatile, and trading sideways are the NUGT and DUST. In two years, NUGT is down 81.29% and DUST is down 98.42%. The black line is the underlying GDX, which is gold miners that are correlated to gold.
GDX is up 12.31% over the same period.
This is what happens when the underlying moves sideways.
I hope this helps explain the benefits and perils of 3X ETFs.
How does Federal Reserve Influence the Economy and Print Money?
We know when Federal Reserve drop interest rate, interest rate from commercial banks would also drop, thus stimulating the economy to save less and borrow more. But how this works end-to-end?
What is Federal Fund?
Federal Reserve funds are overnight loans banks use to meet the reserve requirement at the end of each day. The fed funds market is the total amount borrowed by all banks.
What is Federal Rate?
The interest rate banks borrow fed funds from each other is called Fed Fund Rate. A high fed funds rate means banks will lend less, because it costs more to borrow enough fed funds to meet the reserve requirement. A low fed rate means banks will lend more, which allows them to charge a lower interest rate.
What is Interest Rate on Excess Reserves?
The interest rate Fed pays banks for excess reserves. The interest rate on excess reserves (IOER rate) is determined by the Board of Governors and gives the Federal Reserve an additional tool for the conduct of monetary policy.
Federal rate and Interest rate on excess reserves closely matches each other, but not always.
How Fed Funds Market Works
Banks with reserves more than the requirements lend them to banks that fall short.
Company 1 wants to invest in new machines and gets a loan from its bank, Bank 1 (a bank with excess liquidity). The money is lent to the company but until Company 1 uses the money it stays in the company’s account with Bank 1. Bank 1 has an account at the central bank, where its excess liquidity is kept. The loan in itself hasn’t changed the excess liquidity of Bank 1. Now Company 1 buys the new machines from Company 2 and instructs Bank 1 to transfer the money to the bank of Company 2, Bank 2 (a bank with excess liquidity). Bank 2 also has an account at the central bank which receives the transfer from Bank 1. Company 1’s payment for the new machines leads to a decrease in the excess liquidity of Bank 1 and an increase in the excess liquidity of Bank 2. Overall, the loan and the purchase of machines do not alter the excess liquidity in the banking system. Lending has taken place and the loan has been used for an investment in the economy.
The fed funds market has been shrinking since 2008 since
- Federal Reserve increased its balance sheet to $4 trillion through QE. Fed bought U.S Treasuries and MBS from banks. That left banks lots of reserve on their balance sheet. https://fred.stlouisfed.org/series/EXCSRESNS
- Fed pays banks interest on excess reserves. Banks have less incentive to lend excess fed funds.
How Fed Affects Economy?
Fed sets the reserve requirement to control the amount of money available to lend, known as liquidity. Fed funds rate target is the interest charged for fed funds loans. Fed manages money supply to achieve healthy economic growth. Goal is to prevent high inflation. Secondary goal is to reduce unemployment to its natural level.
When the fed raises rates, banks are less able to borrow money to keep their reserves at the mandated level. As a result, they lend less money out. The money they do lend will be at a higher rate because they are borrowing money at a higher rate. Mortgage rate becomes more expensive consequently and homebuyers can only afford smaller loans and slows the housing industry.
How does Fed lower interest rate?
When FOMC wants to lower the rate, the Fed purchases securities from its member banks. It deposits credit onto the banks’ balance sheets, giving them more reserves than they need. It forces the banks to lower the fed funds rate so they can lend out extra funds to each other. Fed has many more tools other than interest rate.
How does Fed Print Money?
“Print money” is the Fed’s solution to spur borrowing, investing, and economic growth. It is known as “liquidity”.
Fed decides how much money gets made, both credit and paper currency. Till 2018, there was $1.7 trillion of notes in circulation and Fed spends almost $700 million a year to manage the currently (print, transport, destruction).
The other way of creating money is monetize the U.S debt. It keeps Treasury on its balance sheet. The Fed can remove Treasurys from circulation. Decreasing the supply of Treasurys make the remaining bonds more valuable. These higher-value Treasurys don’t have to pay as much in interest to get buyers. The lower yield drives down interest rate on the U.S debt and the government doesn’t have to spend as much to pay off its loans. That’s money it can use for other programs.
Understand the Federal Reserve Balance Sheet
Anything Fed has to pay money becomes the Fed’s asset. The Fed’s assets have mainly consisted of government securities and loans extended to member banks through the repo and discount window, till 2008, when it put $870 billion of toxic assets in its balance sheet.
How Interest Rate Changes Affect Banks?
Banks profit off of the marginal difference between the yield they generate with cache invested in short-term notes and the interest they pay out to customers. When rate rise, this spread increases, with extra income going straight to earnings.
Example:
For example, a brokerage has $1 billion in customer accounts. This money earns 1% interest for customers, but the bank earns 2% on this money by investing it in short-term notes. Therefore, the bank is yielding $20 million on its customers’ accounts but paying back only $10 million to customers.
If the central bank brings up rates by 1%, and the federal funds rate rises from 2% to 3%, the bank will be yielding $30 million on customer accounts. Of course, the payout to customers will still be $10 million. This is a powerful effect. Whenever economic data or comments from central bank officials hint at rate hikes, these types of stocks begin to rally first.
Another indirect way in which interest rate hikes increase profitability for the banking sector is the hikes tend to occur in environments in which economic growth is strong, and bond yields are rising. In these conditions, consumers and business demands for loans spike, which also augments earnings for banks.
References
- SPDR annual report: https://www.ssga.com/library-content/products/fund-docs/etfs/apac/au/ar/annual-report-au-en-spy.pdf
- Why don’t SPY and SPX track perfectly with each other: https://money.stackexchange.com/questions/54373/why-dont-spy-spx-and-the-e-mini-sp-500-track-perfectly-with-each-other
- What is The Creation/Redemption Mechanism: https://www.etf.com/etf-education-center/etf-basics/what-is-the-creationredemption-mechanism
- Unit Investment Trust UIT: https://www.investopedia.com/terms/u/uit.asp
- Authorized Participant: https://www.investopedia.com/terms/a/authorizedparticipant.asp
- The hidden pitfalls of being tempted by leverage: https://www.marketwatch.com/story/the-hidden-pitfalls-of-being-tempted-by-leverage-2013-08-01
- What is excess liquidity and why does it matter? https://www.ecb.europa.eu/explainers/tell-me-more/html/excess_liquidity.en.html
- Why is TQQQ or leveraged ETFs a bad idea: https://www.quora.com/Why-is-TQQQ-or-SPXL-or-leveraged-ETFs-a-bad-idea
- Why are ETFs so tax efficient: https://www.etf.com/etf-education-center/etf-basics/why-are-etfs-so-tax-efficient
- Who are authorize participants: https://www.etf.com/etf-education-center/etf-basics/who-are-authorized-participants