Archive for August, 2009
ETF Regulation Battle Bad for Investors
Commodities ETFs continue to steel themselves against an approaching army of regulators.
iShares S&P GSCI Commodity Indexed Trust has followed the example of United States Natural Gas and halted share-creation. As issuers and regulators prepare to clash, it is a third party, the individual investor, who stands to lose the most.
ETFs have offered unprecedented access to the commodities markets through the use of derivatives such as futures contracts and swaps. Where once only institutions could invest, individuals have gained access to “pure” commodities vehicles.
Regulators such as the Commodities Futures Trading Commission believe that these futures-based commodity ETFs have become too big for their britches and are looking to curb the funds with position limits.
The PowerShares DB Commodity Index Tracking Fund and the PowerShares DB Agriculture Fund have already been subject to changing regulation. On Aug. 20, the CFTC repealed an exemption that previously exempted these funds from position limits.
By limiting the number of futures contracts that a fund like UNG can own, regulators essentially give these fund issuers two choices.
The first and increasingly most popular option is to halt creation. If a fund can’t buy more futures and grow, it can simply stop issuing new shares. Creation of UNG was halted by force in July and extended by choice in August. UNG’s managers simply decided not to risk running in the path of a regulatory freight train.
GSG, the most recent fund to follow in UNG’s footsteps, joins the iPath Dow-Jones-AIG Natural Gas ETN(GAZ Quote) and the PowerShares DB Crude Oil Double Long ETN(DXO Quote) in halting share-creation.
The second choice, most likely to be used in conjunction with the first, is for ETF managers to come up with another strategy. Funds like UNG and GSG use futures contracts to achieve their investment objectives. If they can’t use futures, they can find something else.
UNG is already combining the first choice with the second and is selling futures contracts and buying swaps. These swaps are not regulated in the same way as futures contracts. Other products like GSG will likely be forced to follow suit if position limits on futures are put in place.
Neither one of these options, halted creation or on-the-fly restructuring, is good for investors. Creation plays a defining role in the ETF process. It is through the creation and redemption processes that ETFs actually track their underlying indices. A disruption in either one of these steps will cause a disconnect between the price of the fund and what it is worth.
Investors will suffer by paying huge premiums to buy shares of funds like UNG and GSG.
The implicit promise made to each ETF investor by the ETF industry is that the shares of a fund will track an underlying index. Halting creation means breaking this promise.
The consequences of on-the-fly restructuring could be even greater. Other derivatives markets make commodities futures look tame, and alternative strategies like swaps could put individual investors at even greater risk.
If regulators are truly worried about investors getting hurt by derivatives, they should consider the alternatives that these funds will use to achieve their objectives.
GSG may be the latest fund to protect itself from regulation, but it won’t be the last. ETF issuers have been alerted by regulators that the rules could be changed mid-game. When the music stops, it is investors who will be left standing.
Goldman Sachs Attention Unwanted
Goldman Sachs (GS) may rue the day it got into bed with the U.S. government, if trends in public opinion continue to develop.
From a Rolling Stone expose to political pundits and concerns about high-frequency trading, Goldman Sachs’ name keeps turning up.
Now, The Wall Street Journal is asking questions about its “trading huddle,” where analysts and traders discuss thoughts on the market and, in at least one case, offered meeting advice that differed from a published report.
On the surface, it doesn’t appear that Goldman did anything illegal, nor is there clear evidence of unethical behavior. The meetings were focused on short-term trading ideas, not long-term ones found in analyst reports. Furthermore, one might ask why an investor or trader would be a client of Goldman Sachs if it didn’t deliver an edge.
Nevertheless, FINRA and the SEC want to investigate the matter. It’s a good idea, if for nothing else than to clear the air, but it’s yet another case of the regulators acting after the public dissemination of information.
Government regulators and (formerly) quasi-government entities such as Fannie (FNM) and Freddie (FRE) were complicit in the financial crisis because their name was a stamp of approval; subprime debt gained legitimacy because Fannie and Freddie were buying it.
The SEC approved the rating agencies that gave triple-A ratings to garbage. And many investors are cavalier about who they invest with because they believe the SEC is watching their back. Madoff and R. Allen Stanford proved otherwise.
Instead of focusing on this specific incident, which doesn’t yet show evidence of clear wrongdoing, I’d ask why the Journal ran this story on the front page. And I believe the answer is that the public is not happy with financial institutions in general, and certainly not with firms that have benefited directly, such as JPMorgan(JPM), Citigroup (C), Bank of America (BAC) and AIG (AIG) (through cash infusions) or indirectly, in the case of Goldman Sachs (through the selective bankruptcy of the competition, and cash infusions that passed through other firms).
On top of that, the firms’ close ties to the federal government raise the ire of taxpayers miffed about huge deficits .
The end-result is likely to be tougher-than-expected regulations. As much as corporations are able to lobby Congress for favorable outcomes, they are almost powerless against widespread negative public opinion. Politicians who might normally favor less stringent changes will not step in front of a runaway train.
President Obama and the Democrats are already looking at large losses in 2010 due to their botched efforts at health care reform. Deficits, climate change, bailouts and the stimulus are all losers for the party heading into next year, as things stand today. Financial regulation could be an easy win because Republicans won’t want to be seen as defending financial institutions.
ETF investors need to consider potential new regulations as part of their long-term planning. Commodity and leveraged ETFs have come under attack and regulation could eventually change the way investors access these asset classes. Financial regulation will be even more far-reaching, affecting everything from insurance to mortgages. Public sentiment suggests the industry is about to land in the government’s crosshairs.
Regulatory agencies shouldn’t think they’re safe, either. Inter-agency turf wars are under way and the Federal Reserve seeks to expand its power, even at the expense of the SEC. But the Federal Reserve is also a target of the public. House and Senate bills calling for an audit of the central bank gain more and more co-sponsors over time, with the House already at an absolute majority.
The Great Depression saw the creation of regulatory agencies and expanded the powers of the Federal Reserve, but citizens considered government and business to be distinct entities. Voters aren’t as naive today, and the line between the two is as thin as ever. This time, reform may target government and business with the same intensity. The risk of collateral damage is high.
If Your GDP Outlook Is Dim, Try Pimco
Investors who expect the next several years of GDP growth will be anemic at best, with an underperforming stock market to match, will find Pimco Total Return(PTTDX) one of the best places to find positive returns. That also means it’s a good choice for investors looking to park their fixed income allocation.
On Aug. 18, Pimco adviser Richard Clarida said he expects 2% GDP growth in the U.S. with high unemployment for some time. In his August outlook, Bill Gross says that he expects much slower GDP growth in the future.
In the readjustment process, debts take a haircut via corporate defaults and home foreclosures, and equity P/Es are cut based upon increased risk and substantially lower growth expectations. A virtuous circle of expansion turns into a vicious cycle of recession or low-growth stagnation.
Anyone following Gross’ line of thinking knows what this means: Protect your capital and accept lower rates of return if it means reducing losses on assets. High-risk funds often carry high fees, but if Gross is correct, those funds will be unable to deliver high returns. In a lower return world, volatility will likely be lower as well, and high fees will chew up a greater percentage of investors’ assets.
In Gross’ August outlook, he says of mutual fund expenses, common sense would dictate that the industry as a whole cannot outperform the market because they are the market, and long-term statistics revealing negative alpha for the class of active managers confirms it. Yet, what a price investors are willing to pay!
Many of Pimco’s own funds charge fees in the neighborhood of 1%, with Pimco Total Return charging 0.75% and the A class (PTTAX) charging 0.90%. The R class (PTTRX) charges 0.45%, which is nice if you can get it in your retirement account. Another option is Harbor Bond(HABDX), which is advised by Gross but has only a 0.55% fee.
A yield of more than 5% makes the fund an attractive income source in a world of low yields, but it also delivers capital gains. PTTDX (returns will be slightly higher for PTTRX due to lower fees) gained 4.5% last year, when many bond funds finished down for the year. In the past 10-years, it gained an annualized 6.95% (through July 31), besting both its comparison benchmarks. The three- and five-year annualized returns were 8.24% and 6.10%, respectively. In the past year, it has gained 11.42%, which places PTTDX in the top 6% of all funds in its category, high quality intermediate term bonds. Year to date, PTTDX is up 9.28%, more than 5% better the benchmark.
High yields are out there, but the risks of default are high. Index funds with mortgage or corporate exposure could suffer losses if the economy remains weak. Protecting investor capital is job number one and Pimco Total Return has a proven track record.
Pimco TIPS the Competition
The Pimco 1-5 Year U.S. TIPS Index Fund(STPZ) has joined competitors like the Barclays TIPS Bond Fund(TIP) in offering investors protection from inflation.
While hard economic data has yet to support inflation fears, many investors are looking to get behind the eight ball. Investors have shown a growing interest in Treasury Inflation-Protected Securities (TIPS) and vehicles that provide exposure to them.
“At PIMCO, we agree with this shift in strategic focus,” the company noted in a recent release about the use of TIPS. “At our 2009 Secular Forum, in which we developed our longer-term three- to five-year outlook, one of our conclusions was that the domestic economy will likely have to deal with heightened inflation expectations, with the longer-term balance of inflation risk biased to the upside.”
America is aging and baby boomers are becoming increasingly concerned about getting by on a fixed income. These investors are especially concerned about the effects of inflation on their portfolios. Whether inflation fears take shape or not, PIMCO wants to be ready. It has identified the hunger for TIPs ETFs and wants part of the action.
STPZ joins the lineup beside an already-popular competitor. TIP has been one of the biggest success stories for iShares in 2009. TIP and the iBoxx $ Investment Grade Corporate Bond Fund(LQD) have been the biggest asset gatherers for iShares so far this year.
This isn’t the first shot that PIMCO’s fired across iShares’ bow. PIMCO’s initial fixed-income product, the 1-3 Year U.S. Treasury Index Fund(TUZ), is squarely aimed at iShares Barclays 1-3 Year Treasury Bond(SHY). Rather than reinventing the wheel, Pimco decided to make a cheaper one. TUZ has an expense ratio of 0.09% while SHY has expenses of 0.15%, according to Morningstar(MORN)
STPZ and TIP both have expense ratios of 0.20%, but Pimco’s offering is more focused. TIP is based on the Barclays Capital(BCS) U.S. Treasury Inflation-Protected Securities (TIPS) Index, which contains all TIPs securities with at least one year until maturity. STPZ tracks the more time-sensitive Merrill Lynch(BAC) 1-5 Year U.S. Inflation-Linked Treasury Index.
PIMCO has plans to launch two more TIPs ETFs in September. The Pimco 15+ Year U.S. TIPS Index Fund and PIMCO Broad U.S. TIPS Index Fund offer focused exposure to TIPs and capture the spirit of the ETF industry.
As the ETF industry has grown, ETF issuers have found increasing success with focused products. Rather than simply offering a commodity ETF, issuers offer individual metals and agricultural products. This same pattern is emerging with TIPs funds. TIP has raked in a huge amount of assets for iShares and other issuers are looking for ways to capitalize on the idea.
The STPZ fact sheet argues that a short maturity TIPS index had less interest rate risk and exhibited higher correlation to inflation and lower volatility than the index that TIP tracks.
The new PIMCO funds will take time to garner investor interest and build trading volume. During this period, the funds could be volatile. Investors who are sure of their inflation time horizon may want to consider STPZ now, while longer-term investors are better off sticking with TIP.
A New Short Treasury ETF Coming
Despite a growing controversy over the use of leveraged ETFs, ProShares has launched another inverse exchange-traded fund designed to short longer-term Treasuries.
The ProShares Short 20+ Year Treasury(TBF) is set to track the Barclays Capital U.S. 20+ Year Treasury Bond Index, an underlying index used for successful traditional funds.
Investors may be temped to believe that a “single” inverse Treasury fund like TBF would be less risky than other types of leveraged funds. The recent shakedown in the leveraged ETF business has taught investors otherwise. TBF, like other leveraged fund strategies, is a daily tracking ETF that is appropriate for sophisticated investors.
TBF will join four other ETFs in shorting longer-term Treasuries. ProShares currently offers UltraShort 7-10 Year Treasury(PST) and the UltraShort 20+ Year Treasury(TBT) funds. Both PST and TBT offer 200% short exposure versus the milder 100% short exposure set to be offered by TBF.
Rival leveraged fund issuer Direxion also offers a set of short Treasury funds. The Daily 10-Year Treasury Bear 3x Shares(TYO) and the Daily 30-Year Treasury Bear 3x Shares(TMV) offer even greater leverage than the ProShares strategies. TYO and TMV offer investors 300% short exposure to their underlying indexes.
ETFs do not necessarily have the qualities of the securities that they track. While the market for treasuries is typically highly liquid, there is no guarantee that TBF will garner enough investor attention to offer ample liquidity. It is likely that the leveraged used by TBF will also make this fund more volatile than the Treasuries it tracks.
Leveraged ETFs use instruments like futures and swaps to synthetically achieve their objectives. Rather than simply owning a basket of stocks or bonds, like many traditional ETFs, these funds amplify their indexes with derivatives. This results in complex strategies that are inappropriate for many retail investors.
TBF’s strategy isn’t based on shorting the 20+ year Treasury bond index, as the name of the ETF might suggest, but on owning instruments that provide a return that would be “like” shorting the index. This important difference impacts the risk and fees involved in investing in these non-traditional strategies.
While traditional and non-traditional ETFs might share the same underlying index, risks and fees can be dramatically different. The Barclays 20+ Year Treasury Bond Fund(TLT) utilizes the same index that TBF will offer the inverse of. TLT owns a basket of 20+ year Treasuries and charges a 0.15% fee. TBF will own a mix of underlying investments and will charge a 0.95% fee. It is not simply a difference of being “long” or being “short.”
Fees for leveraged ETFs are higher than traditional funds, no matter how many times you are doubling down. Both the 200% short existing ProShares Treasuries funds and Direxion’s two 300% short Treasuries funds have fees of 0.95%. Traditional funds like TLT, Barclays 1-3 Year Treasury Bond Fund(SHY) and Vanguard Total Bond Market(BND) ) offer expense ratios of 0.15% and 0.14%.
ProShares’ new Treasuries offering reflects two popular trends in the ETF industry. First, the fixed income ETF market is rapidly expanding. The two biggest asset gatherers so far in 2009 for ETF giant iShares are Barclays TIPS Bond Fund(TIP) and iBoxx $ Investment Grade Corporate Bond Fund(LQD).
The second development in the ETF marketplace has been the scrutiny of leveraged ETFs. After experiencing a rapid rise in popularity, leveraged funds have come under fire for their sales practices and strategies that make them unsuitable for many investors.
As leveraged ETFs grew in popularity, the amount of leverage that they offered increased dramatically. ProShares was a first-mover in the leveraged funds business, beginning with “single” 100% leveraged funds. Recent funds from rival Direxion now offer 300% leverage.
Leveraged ETFs are currently causing quite a stir among investors. Firms like UBS(UBS) and Ameriprise(AMP) are now refusing to sell the funds.
As the scrutiny intensifies, funds that offer greater leverage may be targeted more than “single” leveraged funds. By offering a “single” leveraged fund like TBF that utilizes a non-exotic index like the Barclays Capital U.S. 20+ Year Treasury Bond Index, ProShares seems to be erring on the side of caution.
Don Dion’s Weekly ETF Blog Wrap
AIG Climbing on Pure Emotion
Posted 8/21/09 10:10 a.m. EDT
AIG’s(AIG Quote) stock keeps marching to higher ground, and the company’s new CEO’s comments could keep it climbing.
After the stock popped 21% yesterday, bringing the total gain since Aug. 4 to 139%, new CEO Robert Benmosche said, “We believe we will be able to pay back the government, and we hope we will be able to do something for our shareholders as well.”
AIG received $182 billion from the U.S. government, but it is on the hook for only $80 billion. Asset sales should reduce the total to $55 billion. Even if AIG can return to prebubble levels of profitability, that would probably require directing 100% of profits to the government for at least a decade, and that assumes there are no capital needs between now and then.
AIG isn’t the only piece of junk shooting higher in recent weeks. Freddie Mac(FRE Quote) has gained 162% since Aug. 4, and Fannie Mae(FNM Quote) has climbed 93%. A combination of short-squeeze and short-term buying is pushing these shares higher because the broader financial ETFs have very tepid gains.
iShares Dow Jones U.S. Financials(IYF Quote) advanced 3.8% over this period, SPDR Financial(XLF Quote) climbed 4.8%, and SPDR KBW Bank(KBE Quote) added 7.4%.
Bullish and bearish investors should stick with the broader financial ETFs. While there’s plenty of opportunity in the volatility of AIG, it is a stock completely unhinged from the fundamentals and running on pure psychological forces.
UNG Investors Are Giving Away Money
Posted 8/19/09 9:41 a.m. EDT
The U.S. Natural Gas Fund (UNG Quote) has fallen 47.91% in 2009, and the suspension of share issuance and switch from futures to swaps does not speak well for UNG’s future. Furthermore, without its closing premium of near 13%, its return would be much closer to the 53% drop seen in iPath Natural Gas (GAZ Quote) — should the premium eventually evaporate, returns should fall in line with this fund.
UNG, the global behemoth of natural gas ETFs, decided to suspend the offering of new shares, based on fears of investment inhibition. UNG representatives expressed concern that expansion will lead to federal regulation of investment in natural gas futures.
This decision is of particular concern to the fund’s well-being, given the context of UNG’s recent SEC allowance. The fund has been given the rights to expand (gaining approval for the sale of up to 1 billion new units — a monumental capacity when considering UNG’s current size of roughly 500,000 shares). Fear of regulation has also caused the fund to sell futures and purchase swaps, exposing investors to counterparty risk.
Enterprising traders will find a way to profit from the massive premium on UNG. Already, UNG investors lose money due to exacerbated contango in the futures market. Buyers at these levels have the added bonus of giving away an extra 13%. Don’t join the herd.
France, Germany, Japan Emerge From Recession
Posted 8/18/2009 12:21 p.m. EDT
Germany, France and Japan succeeded in pulling themselves from the throes of recession in the second quarter of 2009.
While ETFs that track the whole of Europe (such as S&P Europe 350 Index Fund (IEV Quote) and PowerShares FTSE RAFI Europe (PEF Quote)) may see some gains, funds that track the individual markets of Germany and France (such as iShares MSCI Germany Index Fund (EWG Quote) and iShares MSCI France Index Fund (EWQ Quote)) may soon be ideal niche holdings for investors looking to bank on developed Europe. EWG is up almost 5% year to date for a period ending Aug. 17. EWQ is up more than 9% for the same period.
Reuters explained last week that the two nations succeeded in making positive growth at the end of the first half of 2009. Though far from stellar, the 0.3% growth from both France and Germany is a welcomed alternative to the previous negative quarters coming from the nations.
This news was a direct reversal of analysts’ predictions that both nations would contract by 0.3% for the quarter.
Additionally, on Tuesday Bloomberg reported that GDP was not the only boost coming from Germany. Investor confidence, measured by the ZEW Center for European Economic Research, shot up to 56.1 from 39.5 in July. This is the highest level seen in the nation since April 2006.
Unfortunately, even with the first-rate news coming from the two largest forces in Europe, the rest of the EU failed to post positive gains in the second quarter. The total eurozone contracted 0.1% in the second quarter as economies of nations such as Italy, Austria and the Netherlands continued to shrink.
On Monday, Japan followed Germany and France to become the third G7 nation to pull out of the recession. The nation posted 0.9% growth in the second quarter, marking the first time the nation has posted growth in five quarters. MSCI Japan Index Fund (EWJ Quote) should give investors a boost if the growth is sustainable. EWJ is currently up 3% year to date for a period ending Aug. 17.
Dion’s Weekly ETF Winners and Losers
Positive economic data lifted equities Tuesday through Friday, culminating with positive comments from Federal Reserve Chairman Ben Bernanke. Investors forgot about the Monday plunge in stocks triggered by a selloff in mainland Chinese equities as manufacturing and housing data were helpful, but it was Bernanke saying the U.S. economy was on the cusp of a recovery that juiced stocks on Friday.
Investors moved back into risk trades this week, and that meant outperformance from emerging markets, housing and oil. There was an eclectic mix, however, as both currency and country funds vied for the top spot.
iShares Turkey(TUR) +7.2%
WisdomTree Dreyfus South African Rand(SZR) +3.7%
TUR is one of the strongest funds we track in terms of long- and short-term momentum. Similarly situated ETFs were down over the previous week or had small gains, while TUR raced ahead. I don’t know whether that can last, but the fund seems impervious to the nervousness that suppressed the prices of Russia, China, India, Indonesia and Brazil ETFs.
SZR is one of the strongest currency funds since May. It corrected in the previous week, but this week’s return of the bull helped lift the currency. The rand is a high-risk currency that will be volatile in either direction.
iShares Dow Jones U.S. Home Construction(ITB) +3.5%
SPDR S&P Homebuilders(XHB) +3.2%
Housing data showed sales of existing homes increased more than 7% from June to July, and this sent the housing stocks higher. It was the largest month-to-month increase on record, though data only goes back to 1999. Again, homebuilding stocks saw the largest gains, so the homebuilder-heavy ITB bested the more retail-influenced XHB.
iPath Crude Oil ETN(OIL) +6.2%
PowerShares DB Oil(DBO) +3.2%
PowerShares Dynamic Oil & Gas Services(PXJ) +5.6%
OIL beat DBO this week, but DBO still leads over the past three months. A drawdown in U.S. inventories, in addition to general economic optimism, lifted oil prices this week.
Losers
The losers this week were a strange mix. Solar panel stocks, which typically rise with energy prices, tanked in a week when oil was a top performer. U.S. Natural Gas(UNG) holders must feel like a ride on the River Styx would be more fun as their shares bleed value. Lastly, financial preferreds, previously a strong rebounder in the rally, sank by a considerable amount.
Market Vectors Solar(KWT) -5.9%
Chinese panel maker Solarfun(SOLF) lost money in the second quarter and projected falling prices going forward, even with a pickup in demand. Overcapacity will become an issue for this sector eventually, sooner if demand fails to materialize. Overall, the dip in solar is bearish since it doesn’t confirm the rise in oil prices and at the least confirms that investors are becoming choosier about which “risk trades” they’re buying.
U.S. Natural Gas(UNG) – 9.1%
iPath Natural Gas ETN(GAZ) – 1.9%
These funds stopped issuing new shares and now trade at considerable premiums — 6.7% for GAZ and a whopping 14.2% for UNG. There are arbitrage strategies here as ETF investors give away free money to those savvy enough to profit from these discrepancies, and retail investors ought to avoid these shares entirely. These funds not only track the price of natural gas, but investor demand for funds that track natural gas. The premium could move independently of gas prices, or it could exacerbate swings as price rises attract investors and price drops induce selling.
PowerShares Financial Preferred(PGF) -7.8%
iShares S&P U.S. Preferred Stock Index(PFF) -2.2%
Preferred shares fell sharply on Thursday, but it was part of a bad week for these stocks. These funds are back to October levels, but they still have farther to go. A stall here would be bearish for the financial sector because they are considered a safer alternative to common stock.
Don’s Outlook 8/21/09
Ben Bernanke boosted the stock market today when he said the U.S. economy is on the verge of recovery. Investors focused on this sentence from his speech at a Fed conference in Jackson Hole, Wyoming, “After contracting sharply over the past year, economic activity appears to be leveling out, both in the United States and abroad, and the prospects for a return to growth in the near term appear good.”
Well timed housing data reinforced Bernanke’s comments. Existing homes sales in July increased at the fastest rate since 2007. Data only goes back to 1999, but the one-month 7.2 percent increase from June to July was the fastest on record. Housing stocks advanced sharply on the news and many reached new summer highs after topping out in early August. Broader markets were higher as well, with the S&P 500 Index up more than 1.5 percent.
Today’s news builds on positive data released earlier this week. Yesterday, the Conference Board said that its index of leading economic indicators increased for the fourth straight month. Credit markets, unemployment and workweek data pushed the leading indicators into positive territory.
The Empire Manufacturing index, measuring activity in New York, also paints a portrait of recovery. The number came in at 12, well above expectations of 3 and above last month’s -0.55 reading. Anything above zero indicates expansion. The Philly Fed index confirmed this improvement today with a 4.2 reading, well above -7.5 from July.
Seventeen states reported a decline in unemployment for July. Although only Vermont and Minnesota recorded meaningful declines, the stabilization across the country is a welcome improvement. Also encouraging are expansion plans from Caterpillar and Navistar, who are discussing a joint venture with a Chinese truck manufacturer. Many companies put expansion plans on hold, but their return is one of the surest signs of recovery.
I continue to believe that the market has begun the lengthy process of repairing itself after the financial crisis last fall. Therefore, I encourage investors to begin reinvesting any cash that they have kept on the sidelines, in keeping with your own risk tolerance levels.
Vietnam ETF: Way to Play Booming Nation
Vietnam is presenting a new investment opportunity for risk-tolerant investors. Despite a fall in exports, Vietnam’s economy continues to gain momentum, propelled by domestic growth.
The launch of a new Vietnam ETF — Market Vectors Vietnam(VNM) — by Van Eck Global’s Market Vectors group last week highlights the continued investor interest in this rapidly growing economy.
(Roger Nusbaum, a fellow contributor for TheStreet.com, reviewed the launch of VNM earlier this week and recommended a small position in the fund due to its well-balanced sector allocation.
While Vietnam’s business-friendly attitude and workforce continue to be compelling reasons to invest in this emerging market, more recent developments have given the Asian nation increased potential. A large government stimulus package is now helping to increase consumer demand, propel property prices and help businesses implement long-awaited plans.
Keirn O’Connor, managing director of the Vietnam-based SEAF Blue Waters Growth Fund (SEAF), has seen the impact of the government stimulus in the last few months. “Last year, after the end of the 2007 boom, we saw that many companies in Vietnam struggled due to decreased demand, increasing production costs and limited access to financing. This situation has slowly improved and now, especially in the last three to four months, companies are feeling optimistic again and reimplementing many of the growth plans that they had previously put on hold,” O’Connor noted.
While VNM invests in the 30 largest companies in and around Vietnam, the Blue Waters Growth Fund invests in small and medium-sized enterprises “underserved” by traditional sources of capital. The fund uses private equity and mezzanine structures, and is part of Small Enterprise Assistance Funds (SEAF), a global investment firm that invests in more than 30 countries around the world through an international network of 19 offices in Central and Eastern Europe, Latin America and Asia.
Investing in “emerging” and “frontier” markets through any fund exposes investors to a unique set of risks. “There is clearly significant long-term upside potential in the local stock markets. The flaw is the lack of liquidity, leading to drastic swings on the upside and on the downside,” O’Connor said.
Vietnam’s marketplace is still small, and foreigners can have difficulty investing because of capital controls. Even though VNM invests in just the largest companies in and around Vietnam, the local stock market is still very small, with just approximately 40 companies that have a market cap over $200 million.
The impact of foreign investment controls coupled with the small size of the market means that local liquidity levels can often determine market performance more than the profitability and growth of the companies themselves. “It often seems like local speculators are the driving force,” O’Connor noted.
Despite these challenges, investment vehicles like VNM and SEAF provide incredible opportunities for investors in this developing marketplace. Vietnam has many of the same advantages that have made China a powerhouse of growth over the past decade. Vietnam also benefits from the “China+1″ strategy. International manufacturers, who had been operating in China, are currently looking to open facilities in Vietnam both as a political hedge and an economic hedge, due to increasing production costs in China.
VNM rose nearly 1% in its first 5 days of trading, but has yet to attract significant interest in the form of trading volume. Investors should approach this fund cautiously, keeping an eye on liquidity.
Allocating a small portion of your portfolio to a Vietnam fund could be a profitable play for the long term. Vietnam now looks similar to China a decade ago. As O’Conner asked me, “Who doesn’t wish that they made a more significant investment in China in 1999?”
Fund Lessons From Peter Lynch
Last week I shared a profile of growth stock investor Warren Buffett of Berkshire Hathaway(BRK). The Oracle of Omaha made his mark in the investment world by identifying companies with strong business models that can generate long-term profits.
This week we’ll consider another growth investor who has made a significant mark in the investment world during the past several decades. He has his own approach to stock-picking and has influenced many of today’s most successful and promising fund managers.
At ten years old, Peter Lynch worked as a caddy at Brae Burn, an exclusive golf club outside Boston. There he met many leading executives and picked up his first stock tips. He continued to caddy through high school and college at Boston University, where the young man studied history, psychology and philosophy.
He bought his first stock, Flying Tiger Airlines at $7 a share as a sophomore in 1963. The stock did well — largely because the Vietnam War came along — and Peter made more than 500% on his investment over the next few years.
Peter’s caddying clients at the Brae Burn included D. George Sullivan, president of Fidelity Investments(FNF). Sullivan urged Lynch to apply for a summer internship at the company. Peter landed a spot and spent the summer after his college graduation at Fidelity. The firm put him to work researching companies.
Peter’s profits from Flying Tiger helped pay for his graduate work at the Wharton Business School. He spent two years as an artillery officer in the army and went to work for Fidelity upon his release. He spent five years as assistant research director, and in 1975, the firm made him director of research. In 1977, he took the reins of the Fidelity Magellan Fund(FMAGX).
The rest is history. The fund gained 29% annually and grew from $20 million in assets to $14 billion by the time Lynch retired from the fund in 1990 at the age of 46. If $10,000 was invested in the Magellan Fund at the start of Lynch’s tenure, it would have accumulated more than $288,000. That’s impressive, especially considering that the same amount invested in a fund that matched the gains of the S&P 500 over the same period would have grown to only about $65,000.
Lynch became a household name during the bull markets of the ’80s when his face appeared on countless magazine covers.
Lynch played a leading role in shaping the Fidelity approach to growth stock investing — a bottoms-up, research-intensive approach that has served Fidelity and its shareholders well during the past three decades. Lynch was a mentor to many of Fidelity’s leading fund managers, including some of the men and women who run the firm’s top funds today. Along the way, he’s also managed to co-author a couple of superb investment books, Beating the Street (1994) and One Up on Wall Street (2000).
Lynch has become associated with the idea that investors should buy what they know from their work and their everyday lives. In fact, Lynch himself identified some of his most successful stocks by investing in shares of firms that made products he spotted at the grocery store or the mall.
However, liking the product isn’t enough. Lynch once put together a list of attributes he looked for in a stock:
It sounds dull — or ridiculous. Growth stock investors traditionally gravitate toward glamorous industries and companies. Such companies often have little more than a story to sell and that makes them potentially dangerous. Lynch made his name investing in companies such as Bob Evans Farms(BOBE) and Pep Boys(PBY).
It does something boring or unpleasant or downright depressing. Lynch cited examples such as Crown Holdings(CCK), which makes cans and bottle caps, and Service Corporation International(SCI), which products for funeral homes.
It’s underfollowed. Lynch liked stocks that nobody else liked at the time. He was thrilled when he could find shares of a promising company ignored by Wall Street analysts and other mutual funds or investment firms. That sort of neglect meant there was still plenty of room for the stock price to increase — assuming the underlying company could deliver rising earnings over time.
It’s in a no-growth industry. Lynch was scared of high-growth industries. He believed that high-growth industries are hotbeds of competition — and everyone knows that competition makes it hard for a company to sustain superior earnings growth.
It’s got a niche. So what made Lynch a growth investor? For starters, he looked for companies that could deliver superior growth and he found them. He found many of his favorites among firms that occupied a particular market niche that was relatively easy to defend from competitors. For instance, he liked companies that owned rock pits.
Lynch also liked drug companies because their patents made them niche businesses. He also liked companies with brand names such as Coca-Cola(KO). The bottom line: it’s very hard to compete with a business that has a good niche.
People keep buying the company’s products. Lynch didn’t want to own a company that made the latest toy. He wanted a company that made drugs or soft drinks or cigarettes or razor blades.
It benefits from technology. Lynch typically avoided technology companies that had to compete with each other by lowering prices — but he liked companies that could benefit from those falling technology prices. If he heard about a new supermarket scanner, he might buy supermarkets rather than the company making the scanner.
Fortunately, you don’t have to be an investing genius yourself to reach your own investment goals. Instead, you can rely on the stock-picking skills of first-rate fund managers — many of whom have learned the lessons of Peter Lynch and other masters. That said, the more you know about investing, the more confidence you’ll have when you’re making judgments about your portfolio of funds or other investments.
