Deploying “Stopped Out” Money

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The use of sell stops and re-investing monies you have been stopped out of as the market resumes its upward trend, has been the hot topic of the past few weeks. Reader Paul had this to add:

A few questions regarding your tactics for reentering the market with “stopped out” money:

1. Typically, what kicks off your decision to start reentering the market?
2. Do you only enter into funds that have a 0.0 %DD?
3. Assuming the trend remains positive, do you give yourself a target deadline for reinvesting all of your “stopped out” money?

For one, a resumption of upward momentum will always make me realize that I have been whip-sawed and cause me to re-deploy the proceeds such as happened early this week.

Second, depending on your risk aversion, you could wait until the funds/ETFs, you’ve been stopped out of, take out their old highs before re-entering. Or, you could select different funds/ETFs along the lines as I profiled back in July in “Using The Benefit Of Hindsight.”

Third, I don’t give myself a deadline for re-investing stopped out money but, if I see a rally building early in the morning, such as we had last Monday, I try to get back in as quickly as I can.

Keep in mind that trying to find a new entry point is not an exact science. You never know for sure if you’re making the right move at the right time. The idea is to get back onboard quickly if the trend goes your way. This also means that you need to quickly accept the fact that the stop point may have turned into a whip-saw by not dwelling on it.

That’s the moment in time to look at the big picture and remember that you are using stop losses for a reason, which is to limit downside risk.

An Emerging-Markets Bubble?

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The WSJ featured an interesting viewpoint in “Are ETFs Causing an Emerging-Markets Bubble?” Here are a few highlights:

U.S. investors have pumped roughly $26 billion into emerging-markets funds so far this year. Of that, $15 billion came in through exchange-traded funds — portfolios that hold every stock in a market benchmark with utterly no regard to price.

Several hedge-fund managers and other active stockpickers have told me that this “mindless money” is distorting valuations and pumping up a potentially monstrous bubble.

At first blush, it is hard to imagine that they are wrong. As money pours into the ETFs, they must mechanically match their holdings to those in the emerging-market indexes. That forced buying drives up stock prices, attracting still more new money into the ETFs, spiraling stock prices even higher.

Even Gus Sauter, chief investment officer at Vanguard Group, one of the world’s largest managers of index funds and ETFs, is concerned. “Obviously it’s the last trade that determines the price of everything,” he says, “and there have been large flows [from ETFs into emerging markets], perhaps leading to a bit of a bubble.”

Mr. Sauter adds that several markets, such as Brazil and Peru, are up roughly 100% in 2009. “Either something has changed quite dramatically,” he deadpans, “or pricing has been dislocated from reality. And it’s probably a little bit of the latter.”
…

Thanks to obscure provisions of the U.S. Internal Revenue Code and the Investment Company Act of 1940, which governs how mutual funds are organized, ETFs can’t allow their assets to become over-concentrated in a handful of holdings. In general, they can’t keep more than 25% of their money in a single stock, and at least half of their assets must be in securities that each account for no more than 5% of total holdings.

Now that emerging markets have risen so far so fast, these tax requirements may compel some large ETFs to begin selling their biggest holdings. Ms. Ting says that her fund automatically sells some of its Petrobras holdings, currently 23% of assets, whenever they near the 25% threshold. They are replaced, she says, with “securities with similar risk factors.”
…

So what does all this mean for investors? ETFs probably haven’t caused a bubble, and they might even help a bit to prevent one from forming. But many will remain superconcentrated bets on very risky markets. If you invest in an ETF with most of its assets in a few stocks and think you have made a diversified bet, the real bubble is the one between your own ears.

As a general rule, I don’t think bubbles in any market pop over night. Sure, you may have the occasional Black Swan event, but even during last year’s market crash, prices started to head lower at a slow pace at first and accelerated later on.

Take a look at the EEM chart above. For those with sell stops in place, the initial market pullback provided plenty of opportunity to liquidate any positions. Even if you gave yourself more room and sold as the price crossed the trend line to the downside, you would have had no problem getting out.

As always, the key here is not to worry about wild speculations as to what might or might not happen to this market but to be prepared to exit when the trends reverse.

That alertness to changing conditions, more than anything else, will save your portfolio from a receiving a severe haircut and will help you emotionally to better deal with a declining market.

Disclosure: We currently have no positions in EEM.

A Lot Of Green

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From the moment the markets opened yesterday, it was up, up and away with the Dow hitting a new high for 2009.

Friday’s unemployment figure of 10.2% contributed in a perverse way to yesterday’s rally supporting the view that with such dire news, interest rates will have to stay low for some time to come, which bodes well for stocks.

Additional market support came from the G-20 via an agreement over the past weekend to keep the stimulus programs going. That’s all that was needed, and the major averages never looked back.

I took the opportunity early on yesterday morning to add some new positions, in essence replacing those that we were stopped out of during the last pullback. Of course, all sell stop points have been identified and will be executed when necessary.

While the stamina the market has shown is simply amazing, I have to wonder how long it can last. Since no one has the answer, we will simply follow the trend until the end when it bends.

Price Discrepancies

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While ETFS have many advantages over mutual funds, they have not been around long enough to address all issues that might affect their NAVs as Seeking Alpha reports in “Bond ETFs Suffer from Pricing Discrepancies:”

Exchange traded funds (ETFs) have many of the built-in advantages that mutual funds have, but there are also differences. In my view, the biggest difference is not the fact that ETFs trade throughout the day or even how ETF pricing works, but rather that ETFs have a very short operating history.

We use both mutual funds and ETFs so I am not at all negative about exchange traded funds, but I am aware that there will be growing pains as the ETF industry matures.

In this piece from the Wall Street Journal [registration may be required], we see problems arising in bond ETFs. Namely, that it is hard to price some of the underlying bonds in the various ETF portfolios accurately. Or, it may be difficult for a given ETF to replicate a bond index exactly because the index may hold some bonds that are not traded frequently.
…

…Share prices of many bond ETFs are drifting far from the value of their underlying holdings, which can create big trading costs for investors. Some of the funds are straying from their benchmarks, meaning investors aren’t getting the returns they expected.

…ETFs, typically cheap, straightforward products designed to act like index funds, generally track the performance of a benchmark for stocks, bonds or commodities. But they differ from traditional mutual funds because they trade throughout the day on an exchange.

Keeping ETF returns in line with the indexes has proven to be tough in the murky bond market…

…State Street Corp.’s SPDR Barclays Capital High Yield Bond ETF (JNK) fell nearly 1% in the 12 months ending Aug. 31, even while its benchmark gained 6%…

…The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), for example, traded at a 7% premium at one point in April, and traded within 0.5% of its NAV on only five days in the third quarter…

Such wide gaps aren’t generally supposed to appear in ETFs. Big investors can typically buy up the fund’s underlying holdings and swap them for ETF shares, arbitraging away any significant gaps between the ETF share price and NAV.

But bonds can be so tough to trade that large investors become reluctant to perform this function for fixed-income ETFs. Even when they do make the trades, they incur big trading costs that get factored into the price of the ETF shares…
…

Bond ETFs set the NAV based on estimates of the prices they would get if they sold their holdings. Meanwhile, most bond ETFs are bringing in new money now, so the dealers responsible for creating ETF shares need to constantly buy new securities. That takes place at the higher “offer” side. To compensate, dealers will price the ETF shares higher than NAV, resulting in the bias toward a premium.

If it’s a matter of buying and selling at inflated prices, it’s a wash. But sometimes, investors who bought at a premium end up selling at a discount. “If everybody is selling, it’s also a time where there may not be much liquidity in the bond market, and…funds will be trading at NAV or at a discount to NAV,” says Kenneth Volpert, a principal at Vanguard Group.

In fact, when investors fled corporate bonds last fall, many bond ETFs traded at meaningful discounts. This year, some $25 billion has gone into bond ETFs, a good portion of which is chasing big returns in high-yield bonds, which are notoriously difficult to trade in tough times. How would ETF prices handle that money being pulled out in a flash?…

So far, the discrepancies between a given ETF’s share price and its net asset value (NAV) seem to be manageable. As anyone who has ever purchased bonds knows, bond traders do a good job of exacting their pound of flesh, particularly for thinly-traded securities. So, the cost of putting together a portfolio that matches a given index would be very difficult and costly.

This last point is a good one though. If all the investors in a given ETF want to get out at the same time, raising cash may be an issue. And, if a given ETF has to raise a lot of cash quickly, it will probably get dinged a bit on those securities that it sells.

[Emphasis added]

While there is no good way to deal with this pricing issue, you might want to consider no load mutual funds if your mode of operation is to generate income.

However, in a zero interest rate environment, the risk in bonds, bond ETFs and bond mutual funds is clearly to the downside, especially if inflation rears its ugly head somewhere down the line.

While there is no perfect solution to deal with this issue, I would never hold any of these funds/ETFs without the use of a trailing sell stop.

When the tide turns and interest rates rise, you want to be one of the first heading for the exit doors before they become too crowded. A trailing sell stop may just be the vehicle to get you there before the masses wake up and follow suit.

Sunday Musings: Missing The Point

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A few days ago, I posted about Schwab’s venture into “Commission Free ETFs.”

While I think that this move is a great step in the right direction, most readers who commented missed my point entirely by being more concerned about venting petty grievances.

In case you don’t remember, back in 1992, Schwab was the innovator when they created the mutual fund market place, which allowed you to have one brokerage account and invest in thousands of mutual funds, many on a no transaction fee basis. It was an unheard concept, which caught on quickly and has since become the standard for any brokerage firm.

While Schwab for a number of years, due to internal policy and management changes, lost that leadership, I believe that they now have stepped up to the plate again by being the first to offer commission-free ETFs with very low annual fees.

To be clear, this is not meant to be a plug for Schwab on my part. I believe that if they can succeed with their efforts of offering a wide variety of commission-free ETFs over the next couple of years, they will have an impact on all competitors. It may lead to others having to follow in the same footsteps, which eventually may result in no commissions (or extremely low ones) at all brokerage houses.

Looking at the big picture, every investor will be served well by this potential outcome no matter where you prefer housing your assets.

How To Track Your Sell Stops

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A convenient and efficient way to track sell stops has been on many readers’ minds. Tom had this to say:

How can I get a fund or ETF price automatically downloaded into my personal investment spreadsheet?

Setting sell stops based on new highs, etc. requires finding the price and manually entering it in the spreadsheet everyday. When I don”t look every day, I know I miss something.

Is this possible without subscribing to some high priced electronic quote system, etc.? (Free is good!) It seems with the tracking you do, there must be an obvious way to do this that I overlook.

I have Schwab and Fidelity, but I have not found a way to do this from their websites. There must be some software, program, or website that will pick up this info and put it into a spread sheet on your PC.

For many years, I have used a simple way to get that task accomplished. I have set up “My Yahoo” as a personalized page to track daily news events. Part of that set up includes a listing of funds/ETfs that I currently own and follow on a daily basis.

The funds/ETFs are listed by ticker, date, price and change for the day as the table above shows. It also includes a feature that lets you export this list to a spreadsheet, neatly arranged in columns to be copied and pasted wherever you like.

In your spreadsheet, you could use Tab1 to paste in all data, as I do, and use Tab2 to have your current holdings listed and formatted. By linking the prices in Tab1 to Tab2, you only need to go though one copy and paste process and your holdings are instantly updated.

Afterwards, I simply view my column titled high price to see if it needs updating, which I do manually. This obviously only comes into play during a market rally when new highs have been made.

Here’s what my matrix looks like using an actual purchase and a sell stop that got triggered:



[Double click to enlarge]

The columns are pretty self explanatory. The “High” column needs to be updated when prices make new highs, while the “Action” column is programmed to alert me to any changes in the status. In other words, when the 7% sell stop level has been broken, the “Hold” switches to “Sell,” giving me an easy identifiable alert when looking at a large list of items.

While I use other custom data bases to track these sell stops for a large number of funds/ETFs, this spreadsheet along Yahoo’s export feature is simple and effective and requires minimum time on your part once it is set up.