All I Wanna Do Is Have Some Fun

Is Sheryl Crow to blame for the NETS’ demise?

In the first major ETF consolidation of the year, last week, Northern Trust officially liquidated all 17 members of its ETF family, the Northern Exchange-Traded Shares, or NETS. Simultaneously, the bank spent millions of dollars to sponsor a PGA tournament, the Northern Trust Open at the Riviera Country Club, and throw lavish star-studded parties around Los Angeles.

The Chicago bank paid to fly hundreds of clients and employees to the tournament, paid for their rooms at some of the city’s priciest hotels — the Beverly Wilshire, the Ritz Carlton and the Casa Del Mar — and shuttled its guests to the tournament in Mercedes.

According to L.A. gossip site TMZ.com, Wednesday, Northern Trust hosted a dinner with entertainment from the band Chicago. Thursday, dinner was held at a private hangar at the Santa Monica Airport followed by a concert from Earth Wind & Fire. Friday, the NETS were officially shut down. Saturday, Northern Trust took over the House of Blues, served salmon and filet mignon, and had Sheryl Crow serenade its guests. Female guests left with gift bags from Tiffany’s.

TMZ said Northern Trust paid Chicago $100,000 and the House of Blues $50,000. The other two bands declined to disclose their fees. Northern Trust also footed the bill for the entire tournament and part of the $6.3 million purse.

In light of the fact that Northern Trust took $1.6 billion from the government’s Troubled Asset Relief Program, or TARP, there’s plenty of outrage over this egregious display of wasteful spending, especially since Northern Trust laid off 4% of its workforce in December. But putting that aside, couldn’t this money have been used to save the NETS?

It takes between $250,000 and $650,000 to bring an ETF to the market. Let’s say $500,000 each, or $8.5 million, to launch 17 funds. Then assume another $500,000 in annual expenses to run the funds, or another $8.5 million a year to keep the NETS operation afloat. While we don’t have a total cost for the party, from the TMZ data, it’s not hard to imagine the whole thing costing around $8.5 million, essentially what it costs to keep the ETFs afloat for another year.

Is the death of an ETF or an ETF company worth mourning? In the grand scheme of things, probably not. Definitely not by its competitors, but the ETF industry is still small, with just about 25 companies. So, less competition and fewer good ideas are bad for investors and the industry in general.

Of course, the ETF industry did go through a huge growth spurt from 2006 to 2008 as companies in a gold-rush-type spirit pushed out funds based on any idea that came into their heads. There were some great ideas, such as the commodity- and currency-based exchange-traded vehicles, and some incredibly stupid ones. Amidst a falling stock market and declining economy, investors are less willing to take a risk on an offbeat idea. So, consolidation of the industry was not unexpected. In some cases, that’s a good thing.

Among the stupid ideas we’re well rid off, let me point you to the Focus Shares. As the housing bubble popped these geniuses came out with the ISE Homebuilders Index Fund. Their other brilliant ideas were the ISE-CCM Homeland Security Index Fund, which tracked companies that did work for the Department of Homeland Security, and the ISE-REVERE Wal-Mart Supplier Index, which followed companies that derive a large portion of their revenues from sales to Wal-Mart.

Others like the HealthShares or the Claymore/KLD Sudan Free Large-Cap Core Fund were clever portfolio ideas, but much too narrowly focused to attract a large audience, especially in times such as these.

But the NETS were different. They offered investors the first way to invest in the world’s main global stock indexes. Instead of investing in a little known MSCI index of a foreign market, the NETS gave investors the opportunity to invest in a country’s actual benchmark. The NETS tracked London’s FTSE-100, Germany’s DAX Index and France’s CAC-40 Index, among others. The NETS were also the first to offer U.S. investors exposure to the Irish, Israeli and Portuguese markets. Also, they were run by Steven Schoenfeld, the man who wrote the book on indexing. In addition to being an indexing expert, Schoenfeld helped build the iShares business in its early days.

The NETS were reported to have $33 million in assets under management and charged an expense ratio of 0.47%, bringing in $155,100 a year. So, they weren’t paying their way, but it doesn’t cost that much to keep them going. These were young funds that needed to find an audience. So, it seems shocking that after all the time and effort to bring an ETF to market, a firm would give up on them so fast? In a down market, investors aren’t in the mood to invest, but you want to have products ready and available the moment investors come back.

While the ETF industry experienced a record number of fund closings in 2008, most of those came out of independent ETF shops. However, Northern Trust is a huge Chicago-based investment bank. According to Barron’s Dimitra Defotis, while the nation’s prominent banks are suffering and asking for money from the U.S. government, Northern Trust has a far more promising outlook.

“Unless you think the world is going to disappear in the next five years, our position as the leading wealth manager in the United States should serve us well as the U.S. market recovers,” CEO Frederick H. Waddell told Barron’s “On the institutional side, we continue to win significant asset-management and servicing mandates around the world.”

Barron’s says Northern Trust’s balance sheet is better than most other banks, because it avoided housing finance. In addition, it’s gaining customers from overseas institutions. Finally, it’s fee income, which accounts for more than half its revenue, came in at $4.2 billion last year.

So, with about $8 billion in revenues and $1.6 billion of TARP money, it seems incredibly short sighted for Northern Trust to have closed down the ETFs. And after spending about $8.5 million for a golf tournament and parties, it really wasn’t a lot to keep them open. In fact, this wasteful spending of government money for bonuses and parties shows how this isn’t just obnoxious, but actually detrimental to these banks and their customers. It is truly taking cash out of the funds necessary to run these banks’ operations. Businesses are being shut down so top managers can party. It’s nauseating.

I think the NETS were good products and I’m sorry to see them go. Since these ETFs were based on a good idea, I’m sure some other company will create similar products. Still, while the Northern Trust head honchos sang, “All I Wanna Do is Have Some Fun”, the ETF industry and investors are singing another Sheryl Crow hit: “The First Cut is the Deepest.”

World Map of Financial Turmoil

For people who want their bad news in one large dose vs. many small doses, the Global Indices Map is like a world map of financial turmoil. This constantly updated global map from Google lists almost all the major stock market indices around the world and gives a feel for how the world markets are doing at any point in time. It’s a cool idea.

However, I already noticed the map is missing the S&P 500 index, which is considered by most market participants to be the true benchmark of the U.S. market.

On needs only to look at where investors are putting their money. The SPDR (SPY), the largest ETF in the world with $83.8 billion in assets, tracks the S&P 500, while the Dow Diamonds (DIA), which tracks the Dow Jones Industrial Average, holds only $7.76 billion.

U.S. Oil to Change Roll Policy

Aha! The Wall Street Journal obviously read my interview with John Hyland about its take on the U.S. Oil Fund’s (USO) influence on the futures market and is fighting back. Or did someone read my post and get to Hyland?

OK. I might be giving myself too much credit. But then again …

I’m not quite sure what to make of the fact that the day after I spoke with Hyland, the WSJ reported that the exchange-traded product with $3.4 billion in assets will abandon its practice of rolling its entire oil future position in one day. USO now says it will renew the expiring contracts over the course of four days.

The New York Mercantile Exchange says that last Tuesday USO held 19% of all the crude for April delivery. Meanwhile, the ICE Futures Europe exchange says the fund holds 30% of its April contracts.

The Journal says the size of the fund was affecting oil prices and hurting the fund’s investors. With the fund announcing what day it would roll, oil traders would front-run the fund by selling the front-month futures contract before that date. This would push the price down, hurting the fund’s investors. With oil for delivery currently higher than the spot price, USO would then need to pony up more to buy the second month contract.

WJS says “U.S. Oil paid anywhere from a $4 to $6.10-a-barrel premium when it sold March and bought April futures contracts, as robust oil supplies and weak demand pushed down near-term prices relative to outer months.” It also reported analysts at Goldman Sachs published a note saying long-term holdings in near-term commodity contracts are “not investable,” citing the large roll cost. According to WSJ, the USO’s share price had fallen 71% over the 52-weeks ending Wednesday.

USO said it will continue to hold the front-month contract, as that is the structure of the fund.

Survey Finds Nearly Half of Advisors Don’t Do Monthly Reviews

Rydex Investments, the sponsor of leveraged ETFs and the CurrencyShares, exchange-traded products that track foreign currencies, released its Advisor Benchmarketing Supplemental Survey this week. Here are some highlights:

· Most of the advisors (55%) surveyed review the ETF universe and their clients’ ETF holdings monthly.

That may be the majority, but is a little more than half really most advisors? Is this a positive statistic? Well, let’s flip it around. Nearly half (45%) of all advisors DON’T review the ETF universe and their clients’ ETF holdings monthly. So, the odds are nearly 50/50 that your advisor isn’t on top of things. That’s not what I want to hear. Let’s hope your advisor isn’t one of them.

· Open-ended mutual funds and ETFs will be a primary vehicle or product focus for 2009 for investments, according to 98% and 83% of advisors respectively.

That agrees with what I’ve been saying for months. In fact, I think ETFs will surpass mutual funds in the cash inflows for 2009.

· When selecting ETFs for their clients’ portfolios, investment objective and index exposure are the most important criteria, according to 60% of advisors surveyed. The second and third most important decision making criteria are fees (45%) and benchmark tracking accuracy (35%), respectively. It’s interesting to note that more than a third of advisors (38%) do not find Morningstar rankings (or rankings from other research providers) important as decision criteria for ETF investment.

It makes sense that you have to decide what you want before you look at fees. I’m curious to know why so many advisors don’t use the Morningstar rankings.

· Most (80%) of the advisors surveyed said that they are knowledgeable on the differences between ETNs and ETFs, with almost all of them declaring themselves ‘very knowledgeable’ on the tax consequence differences between ETNs and ETFs (97%). Only about a third (30%) are knowledgeable on tracking error differences between the two.

Tracking error is the difference in return between an index fund and the index it follows. This typically results from the costs required to create and hold a portfolio of securities. Index funds should shoot for a tracking error of less than 10 basis points. Since ETNs don’t hold securities, they don’t incur any costs to create or hold a portfolio. They are merely a promise by the issuing bank to pay the return of the index. Thus, a well run ETN should have no tracking error.

· When advisors research different ETF choices, more than half (55%) use the Morningstar ETF center, 40% use the Yahoo! Finance ETF Center and about one third (34%) use ETF provider sites.

For my list of the best sites for researching ETFs check out How to Decide Which ETFs Are Best for You.

· Despite the current economic situation, ETF assets grew to more than $725 billion globally by the end of 2008, according to consulting firm Strategic Insight, and are expected to continue growing in assets over the next few years.

According to the Investment Company Institute, the trade group for the mutual fund and ETF industries, in 2008 U.S. mutual fund assets fell 20% year-over-year to $9.6 trillion, while U.S. ETF assets slid 12.7% to $531.3 billion. I will address the growth in ETF assets in another posting, but that attests to the growth of ETFs outside the U.S.

Debating the WSJ’s Assessment of USO

In a continuation of yesterday’s post, It Takes Two (Months) to Contango, I want to focus a little more on the roll. The roll is what an investor, or speculator, in the futures market needs to do to keep their investment open and avoid taking delivery of the commodity in question. Remember, futures are an obligation to buy or sell a commodity at a certain price on the day the contract expires. If you don’t close the futures contract before it expires, you can expect a big truck to unload 1,000 barrels of oil on your lawn in a few days. Unless you’re running an oil refinery, this is not a good move.

Before expiration, investors betting on a commodity need to sell the contract for next month and buy the contract for the second month out. When the first month expires, the second month contract, becomes the new first month contract. Yesterday’s post dealt with the cost involved with the roll and how when the price of oil is rising, a trend called “contango,” you will earn less than the total movement in the spot price of the commodity. However, unless you want to take delivery, this is the closest way to play the spot price.

Last week I highlighted an article in the Wall Street Journal. It said the U.S. Oil Fund (USO), the exchange-traded product that is a pure play on the first month oil futures contract, is getting so large it’s affecting the oil market. The Journal writer Carolyn Cui says the $3.3 billion in assets held by USO accounts for 22% of the outstanding front-month contracts. According to Cui the fund is so large that on the day it moved from the March to the April contract, Feb. 6, it had a visible affect on the oil market.

I called John Hyland, the portfolio manager of the U.S. Oil Fund, to get his take on this. Hyland says you can’t blame a huge one-day move solely on USO without looking at the trend three days before the roll and three days after.

“The people who look just at the day we roll and say the spread was “X”, that doesn’t tell you anything,” says Hyland. “You have to look at the days leading up to and the days after. You might miss the trend going on if you just look at USO.”

For instance, if the three days before the roll, the spread on the contract was $1 and the day of the roll the spread jumped to $2, then you can say there was an affect.

According to Hyland, the three days before Feb. 6, when USO rolled over its contract, the spread between the March and April contracts were $3.99, $3.87 and $3.88. The day USO rolled it jumped to $4.55. However, the next day the spread grew to $4.76 and over the next few days jumped to $4.81, $5.24 and $6.06, eventually widening to $8.19.

“The spread is tending to move wider as you get into the middle of the month, as March gets closer to expiration. Is that USO’s doing? How are we doing it after our roll?” asks Hyland. “It looks to me that as we get closer to expiration, it’s more of an inventory issue. The people who say it must be USO are not really looking at everything.”

Inventories are rising. If demand for oil drops off a million barrels a day and OPEC produces the same amount of oil, then inventory goes up million barrels a day. A lot of oil in the tanks is not bullish for the March contract. With supply rising and inventories hitting 52-week highs, one would expect the oil price to weaken. If OPEC cuts production, the shortfall will be made up from the current inventory. As inventories get smaller, the front month contract will stop trading at a big discount to the contracts further out.

People are assuming inventories will not build up indefinitely. OPEC will have to reduce production, if for no other reason than they will run out of storage tanks. Since the cheapest place to store oil is in the ground before you pump it out, they will cut production. At that time, inventories will start to shrink.

Market Folly, the blog posting I ragged on yesterday, actually has an interesting slide presentation from the International Energy Agency from November called The Era of Cheap Oil is Over. It’s a good read for anyone investing in oil.

It Takes Two (Months) to Contango

Caveat emptor.

It’s Latin for buyer beware. There’s no doubt that a lot of people in this world want to make money off of selling you junk. In fact, that’s a pretty good assessment of the entire collateral debt obligation market. If buyers had paid a little bit more attention to what they were buying, we might not be in the financial mess destroying the country.

ETF companies aren’t selling junk, but investors still need to be aware of what they’re buying. Many ETFs are extremely sophisticated instruments. Investors may think they are buying one thing, when in fact they are buying another. The problem isn’t with the ETFs. These transparent instruments lay it all out in the prospectus and usually in the easy-to-read fact sheet on their Web sites. The problem is investors need to do their homework.

For example, Tradefast, an independent equity trader at a private investment fund, writes on the MarketFolly blog about how contango affects the crude oil ETFs. He says “three factors play a role in determining the performance of the United States Oil Fund (USO): 1) changes in the spot price of crude oil, 2) interest income on un-invested cash, and 3) the ‘roll yield’.”

Unlike the two gold ETFs, the StreetTracks Gold Trust (GLD) and iShares COMEX Gold Trust (IAU), which actually hold gold bullion, USO doesn’t hold the underlying commodity, barrels of oil. It owns oil futures contracts.

While the spot price of crude oil, the price it costs to buy a barrel of oil today for immediate delivery, may affect how investors buy or sell this exchange-traded vehicle, USO doesn’t track the spot price. It holds holds the front month futures contract, which is where oil traders expect the price of oil to sell for a month from now.

So, while the spot price will influence where investors expect the price of oil to be a month from now, they don’t necessarily move together. For example on Friday, anticipation that passage the economic stimulus package going through Congress would increase demand for oil, the price of the March crude futures contract for West Texas Intermediate crude oil jumped $3.53, or 10.4%, to $37.51 a barrel on the New York Mercantile Exchange. Meanwhile, the spot price closed Friday with a bid/ask spread of $37.60 to $37.65, according to the Australian Associated Press.

USO investors hoping to capture the spot market’s Friday gain were surprised to see the ETP actually fall 1.2%. That’s because the previous Friday the fund had rolled out of the March contract and bought the April contract to avoid taking delivery of the actual oil this Friday. So, while the March contract jumped 10%, the NYMEX April crude contract fell 0.47% to $41.97.

It’s the forward roll from the first month contract (March) to the second, and future first, month contract (April) that upsets MarketFolly. When the price of oil is rising, it’s in a trend called “contango”. This means that demand for oil in the future is greater than today, or that future supplies will be tighter. So, when you sell the first month contract, you have to pay up to buy the next month’s contract. It’s not a straight line up like in a stock. If you sell the March contract at $37.50 and buy the April at $41.97, you have to pay an additional $4.47 per contract. This additional cost eats into returns. Well, with a little bit of research, such as reading this story I wrote for SmartMoney.com when USO launched three years ago, he wouldn’t have been so surprised.

MarketFolly then realizes that “USO is not a direct play on the spot price of crude oil – it is, instead, a play on the spot price, forward prices, and the relationship between spot and forward (the slop of the futures curve).”

Because of this he says that USO is not a good way for investors to play the price of oil. For some reason, the FT Alphaville blog from the Financial Times agrees with this ridiculous assertion. Since investors can’t buy the spot price of oil without taking delivery, you have to buy futures to make any kind of play on the price of oil. So, all investors pay the roll, not just USO. If investors were buying futures and not the ETP they would have to make the same kind of trades USO makes, pay the same cost of the forward roll, plus the transaction costs.

What Tradefast fails to realize is “being in contango doesn’t means you lose money,” says John Hyland, the portfolio manager of USO. “Being in contango means you underperform the spot price. If the price of oil rises $100 again, even in a contango market you still make money. You just make less that the return in spot, say $90. They just focused on one half of the equation.”

Hyland says in the reverse scenario, backwardation, when the price of oil in the second future month is lower than the near month contract, the investor would outperform the spot price, but that doesn’t mean you make money. “Spot can fall 50% and you fall 40%. So you outperformed the spot price, but you still lost money.”

Setting the Record Straight

My friends at IndexUniverse have given me, my book and this blog a nice bit of press with today’s lead story. It’s a question and answer piece on my thoughts on the ETF industry.

Cramer Wants SEC to Ban SKF

James Cramer, the host of CNBC’s Mad Money and my former boss at TheStreet.com, was ranting and raving about the UltraShort Financials ProShares ETF (SKF). He says it doesn’t work, doesn’t help shareholders and hurts the market as a whole. He says the ETF only helps the brokers and hurts the market.

SKF is a highly risky investment and isn’t a long-term bet. It isn’t necessarily living up to its hype. But what’s wrong with having a product for traders? No one who reads the prospectus see ProShares recommending this for long-term investors.

Cramer hasn’t been doing very well by his viewers over the past year. As the market continued to crash he kept telling people to buy stocks instead of telling people to sell and go to cash or recommending bear funds. He also told people to hold Bear Stearns the week before it went under. He quotes a guy from Goldman who says it sucks. Well, let’s see, maybe that’s because every time people buy SKF it forces shares of Goldman lower.

Cramer says the SEC has to listen to him. You mean like the people who listened to him when he told them to hold Bear Stearns? I’m not putting to much faith into his opinion.

SSGA Launches Intermediate Bond Fund

State Street Global Advisors launched the SPDR Barclays Capital Intermediate Term Credit Bond ETF (ITR) Thursday on the NYSE Arca. It was SSGA’s third bond ETF this month. The fund’s will track an index that tracks the intermediate term (1-10 years) sector of the U.S. investment bond market.

USO Affects Futures Market

The U.S. Oil Fund (USO), an exchange-traded vehicle with $3.3 billion in assets, is getting so large it’s affecting the oil market, according to Carolyn Cui of The Wall Street Journal. Cui says “the sheer size of USO’s position, which accounts for about 22% of outstanding front-month contracts, is sending tremors through futures markets and contributed to oil’s dip below $40 a barrel in intraday trading Friday.” She says the volume of crude-oil futures on New York Mercantile Exchange was “nearly double the average volume posted so far this year.”

Most ETVs that track the oil market are commodity pools that hold futures contracts. While many investors think USO tracks the spot price of oil, it actually tracks the price of the future contract one month in the future. As the futures contract nears its expiration it must roll over the contract, that is sell the current contract and purchase the next month, or else take delivery of the oil. As oil prices sank from $145.29 a barrel in early July, the fund more than tripled in size, as investors predicted the price of oil would bounce. The National Stock Exchange says in December and January alone the fund received net cash inflows of $3.46 billion.

For more on USO see page 185 of ETFs for the Long Run.