ETFs Explained

What is an Exchange Traded Fund (ETF)?


Exchange Traded funds (ETFs) are modern equivalent of index trackers. They are low cost, low fee investment vehicles that trade on an exchange like a stock, but replicate many attributes of mutual funds by holding a basket of securities.

Hudson James Investment Mangement use a variety of ETF strategies to maximize returns for clients using our proprietary stock timing strategies.

Michael Sapir, CEO of ProShares, was reported by Barron's as saying "The mistake is in viewing an ETF as an investing strategy, it's paramount that you understand the strategy." In other words, just attempting to “buy and hold” an ETF just to keep fees down isn’t enough. You have to understand the investment strategy in light of the macro fundamentals. In other words, you need to know the state of play in the world economy and how to read technical signals to optimize your exchange traded fund strategy.

HudsonJames Investment Managemnt will actively manage a basket of ETF’s for you to maximize returns. Our ‘Smart Money’ ETF strategy is returning 34% per year on average.

Why use ETFs?

A study has shown that less than 24% of active fund managers beat the index, so by employing ETF tactics, you are likely already ahead of the curve according to probabilities. HJIM uses an ETF momentum strategy to swing trade ETFs to optimize performance whilst minimizing risk and increasing returns. Our actively managed ETF strategies have consistently outperformed a static buy and hold approach using passive ETFs.

Why do index funds outperform actively-managed funds? Over long periods of time, index funds have had higher returns than their actively-managed counterparts for a number of reasons.

Lower Fees Due to Passive Index

Firstly, index funds, such as the best S&P 500 Index Funds, are intended to match the holdings (the underlying stocks of the 500 biggest companies in the USA) and the performance of a stock market benchmark, such as the S&P 500. Therefore, there is no need for the intense research and analysis required to actively seek stocks that may do better than others during a given time frame. This passive nature allows for less risk and lower expenses.

Removes Human Risk

Secondly, it removes the human element. This removes the human element as managers are subject to emotion, complacency and mistakes. This removes human risk and irrationality.

Lower Expense Ratios Compounded Over Time Makes it Difficult for Active Managers to Compete

Lastly, ETFs have low expense ratios. Many ETFs have low expenses around 0.2%, so an active manager charging 1.2% for example means he has to beat the ETF by 1% per year just to be even. Over a 5 or 10 year period, this becomes quite difficult to beat.

ETFs come in a variety of styles including passive or actively managed ETFs. Passively managed index ETFs usually aim to closely track their underlying index, whilst actively managed ETFs are typically managed with the objective of providing above-benchmark returns or with the objective of returning an income or maximizing growth.

Hudson James Investment Management actively manages passive ETFs to maximize growth and minimize risk. ETFs offer investors many benefits such as intraday liquidity and pricing, trading flexibility, transparency of holdings and potential tax advantages. Because ETFs trade like stocks, investors may be able to buy them on margin or sell them short, and have the added flexibility to use limit or stop-loss orders and, in many cases, use options strategies.

How do ETFs work?

Most Exchange Traded Funds (ETFs) are open-end investment companies that are registered under the Investment Company Act of 1940 and are subject to essentially the same rules and regulations as traditional mutual funds. They are investment vehicles in which investors own a proportional share of the pooled underlying securities. Unlike mutual funds, which issue shares in the fund directly to investors that can be redeemed directly back to the fund at the net asset value, or NAV, determined at the end of each trading day, ETFs trade throughout the day on exchanges at current market prices. ETF shares are issued or redeemed through an authorized participant in what is called a “creation or redemption.”

What is an ETF creation or redemption?

An ETF creation is the process by which authorized participants (APs), self-clearing broker-dealers who have signed an agreement with the ETF manager, deliver the securities or cash that constitute the creation basket of the ETF to the fund manager in exchange for units of the ETF.

Whereas an ETF redemption occurs when an AP delivers shares of an ETF to the fund manager in exchange for the individual securities or cash constituting the fund redemption basket. A creation or redemption basket contains the securities the ETF manager accepts or delivers in exchange for shares of the ETFs. Through creations, the net assets under management (AUM) of the ETF increase in response to demand for the shares, and through redemptions, AUM decline as supply outstrips demand. Creation and redemption transactions only occur at the NAV of the fund and can only be implemented in block unit sizes, which typically range from 50,000 to 100,000 ETF shares. Typically, an ETF manager has several APs that can create or redeem its ETFs.

Benefits of ETFs

Liquidity

Liquidity is essential in today’s markets and all of HJIM’s strategies are fully liquid and convertible to cash upon request with no lock-in period or fees upon exit.

In today’s environment, especially after the last financial crisis exploited holes in the stability of the financial system, most advanced portfolio models seek to maximize returns, minimize risks whilst providing the greatest amount of liquidity. All our ETF models are fully liquid and a client can exit and strategy free of charge and go to cash immediately upon request.

Liquidity in the Exchange Traded Funds (ETFs) market is derived from two sources: firstly, from the liquidity of the secondary market, where ETFs trade throughout the day at the prevailing market price; secondly, from the underlying liquidity of the securities that comprise the ETF portfolio, which can be accessed through new share issuance.

The number of outstanding shares of ETFs is highly flexible, unlike closed-end funds, which have a static amount of shares outstanding. This reduces the potential for ETF shares to trade at a premium or discount to NAV (Net Asset Value). An ETF can issue and redeem shares dependent on supply and demand. If demand rises for a particular ETF, a market participant can acquire new ETF shares from the ETF creator, which can trade on the open market. Likewise, if demand decreases, an authorized participant can accumulate a creation unit of ETF shares and redeem that unit for the underlying securities or potentially for cash. Large block trades can also be accommodated in this manner. Investors who buy and sell ETF shares on an exchange generally do so for cash settlement, and do not buy or sell shares directly from the ETF manager.

Pricing and Trading

Many clients prefer ETFs to mutual funds as they are fully liquid and the price is transparent.

The pricing of ETFs and holdings within HJIM’s investment strategies are shown live and clients can log in at any time to see the price of the ETFs that they hold.

Because the amount of shares of an ETF outstanding can fluctuate, the potential for a premium or discount to NAV may be reduced, since the supply of ETF shares can be adjusted to match the demand. For each ETF, there is an Intraday Indicative Value (IIV, or sometimes called INAV or Indicative Optimized Portfolio Value) published every 15 seconds during trading hours. The Intraday Indicative Value is published by a third party, and is an approximation of the current value of the underlying securities in the ETF.

Diversification

ETFs allow investors to gain exposure to an entire asset class with a single security, thereby avoiding the risks of owning individual stocks. ETFs own most or all of the securities that constitute an index. Exact portfolio holdings are disclosed on a daily basis which provides full transparency.

Focus

ETFs also provide focus. Often, portfolios are OVER diversified which negatively impacts returns. ETFs can focus on a specific asset class or index. HJIM’s ‘Smart Money’ ETF strategy for example uses ETFs which have a negative correlation to each other which means by ranking ETFs and holding those with strongest momentum will avoid over diversification.

Transparency

We value transparency at Hudson James Investment Management and all of our smart money  ETF investment strategies are fully transparent whilst our fees are shown live at any time.

ETFs are highly transparent as their holdings are disclosed on a daily basis. With ETFs, investors can understand the exact makeup of their portfolios at any given time. This may be a particularly important feature during periods of market dislocation, or when specific securities come under pressure as they have in recent crises.

Taxation of ETFs – ETF Tax Efficiency

Tax efficiency is a critical issue that is often overlooked by investors and by financial advisors. Delaying the taxation of appreciating assets significantly enhances after-tax returns over time. ETFs are among the most tax-efficient securities due to their low internal portfolio turnover (as most holdings are held for long periods of time) and ETFs unique method of creating and redeeming shares, which allows an ETF manager to continuously purge the lowest-basis tax lots from the portfolio. 

This allow HJIM to help you choose ETFs which are able to minimize, and in most cases avoid altogether, the taxable gain distributions that have created unwanted tax liabilities for investors in actively-managed mutual funds.

We may be able to help to reduce tax on capital gains with ETFs that use “in-kind” redemptions.

When an AP (Authorised Participant) exchanges ETF shares for its basket of underlying securities, this redemption may be an “in-kind” exchange of securities instead of cash which would avoid a taxable event.

As a result, when in-kind redemptions occur ETF shareholders may not incur capital gains due to other shareholders’ selling activities.

ETFs may allow for greater certainty of share price in planning transactions for tax purposes.

ETF market prices are visible throughout the day, potentially enabling more control and precision in tax management strategies, whereas mutual funds’ NAV’s (Net Asset Values) are not known until much later. As such, ETF investors can more easily determine which strategy would be the most beneficial to fit their circumstances.

For example, ETFs may be used in tax management as an efficient means of “harvesting” tax losses. When an investor sells a security or fund to realize a tax loss, he or she may be able to purchase a comparable, but not substantially identical, ETF in order to maintain a similar exposure while preserving the tax benefits of the loss.

We advise you seek independent tax advice if concerned about a particular tax-dependent strategy. HJIM’s main role is that of asset manager, but we can put you in touch with our international tax partners.

ETF Strategies that Provide You With an Income Stream

We can provide clients with an income stream via our ‘SMART INCOME’ ETF strategy using low cost fixed income ETFs.

We show you how to use fixed income ETFs within your portfolio. Discover more about understanding ETFs for investing with HJIM.

Fixed Income ETFs are innovative tools for today's markets, and more and more investors, financial advisors and institutional investors are finding out that HJIM’s fixed income model via our ‘SMART INCOME’ ETF strategy is a superior way of protecting client assets than just employing a simple “buy and hold” model.

We use low cost, low fee bond ETFs in an actively managed portfolio to deliver superior results. We rebalance bond ETFs on a monthly basis. We use our proprietary stock timing model to optimize performance, whilst reducing risk.