The Dangers of Buying on Disasters

Charles Wallace wrote an intersting story for Daily Finance about the risks of buying ETFs on disaster news. He specifically looked at ETFs that focused on the Japanese and Egyptian equity markets.

Wallace quotes me in the article saying you shouldn’t put a lot of money into these kinds of ETFs and to make sure you’re diversified. However, a lot of my insights from our interview didn’t make it into the article, especially about the iShares MSCI Japan Index Fund (EWJ) and the main Egypt ETF, the Market Vectors Egypt Index (EGPT). Shares of Egyptian stocks, and hence the Egypt ETF were driven down by protests against President Hosni Mubarak.

Wallace wrote “Trading in the EGPT was brisk in the U.S., and the ETF moved consistently higher even though the stock market in Egypt was closed for more than a month. When the Egyptian Exchange reopened on Tuesday, stocks dropped 10% and EGPT opened at $15.86, a decline of 17% from its March 9 high.”

Anytime an ETF tracks a foreign country, especially one whose market is closed during U.S. trading hours, it can move on news that occurs after the foreign market closes. This typically puts the ETF’s price at a premium or discount to the underlying stocks in the portfolio. However, nearly every time, the movement of the ETF correctly predicts the movement of the local market when it finally opens the next day. So, these premiums or discounts last less than 24 hours. While there is some risk in these kinds of trades, the ETFs usually seem to be doing the price discovery for the closed local market.

However, when a market is closed like the Egyptian market was for a month, then the ETF begins to trade like a closed-end fund. That’s because the arbitrage mechanism that balances out the creation and redemption of the ETF’s shares is unable to work. At that point, the price discovery mechanism is dismantled and the ETF shares can trade dramatically far from the actual value of the underlying stocks in the portfolio. Without the arbs there to keep the share price closely linked to the underlying portfolio, it ceases to trade on fundamentals and becomes pure speculation.

Conclusion, if the ETF can no longer buy the underlying shares of the market it tracks, stay away. You are playing with fire and bound to get burned.

Funds Hold GM to the Bitter End

What does a company need to do to get kicked off of an index around here?

As of Friday, General Motors was still in the S&P 500 and the Dow Jones Industrial Average. If the indexes hold the stock until the company declares bankruptcy are the index funds and ETFs that track indexes with GM as a component obligated to hold it to the bitter end? Are they are allowed to sell it ahead of time or do they have to suck up the loss, even though everyone saw this coming from a mile away?

According to AOL Money & Finance, all of GM’s shares are now owned by large block holders. Institutions hold 36%, mutual funds, which includes ETFs, hold 62% and the rest with others like the executives. State Street Global Advisors hold the most GM shares of any institution, 26.9 million, or 4.37% of all the GM shares outstanding. Surprisingly, only 5.26 million of those shares reside in the SPDR Trust (SPY). Still that’s a big loss for one fund no matter how you slice it. Vanguard Group has the second most shares, 23.99 million, or 3.93% of the shares outstanding. However, four of its funds are in the top 10 holders, the Vanguard 500 Index (VFINX) has the most shares of any fund, 5.8 million. This is followed by Vanguard Mid-Cap Index Fund (VO), Vanguard Total Stock Market Index Fund (VTI) and Vanguard Institutional Index Fund. Barclays Global Investors, owner still of the iShares ETF family, comes in third with 17.8 million shares.

The shocking part is that according to Standard & Poor’s, a component of the S&P 500 needs to have a market cap of at least $3 billion. With 610 million shares outstanding, GM would have to trade at $5 to make that. But GM last saw $5 on its shares on Dec. 8, 2008, more than five months ago. It’s not like S&P doesn’t remove stocks from the index. It’s deleted nine companies already this year.

Peter Cohan knows how to evaluate a company. He’s amazing at looking under the hood and breaking apart a company’s financial statements to see the rotting husk of a business. At Daily Finance, he says the failure of GM matters because it shows of success can lead to failure and how now the U.S. can’t even fail right. Companies can’t shut down without government intervention. He adds that the U.S. system of economic growth, venture-backed innovation, has been nearly snuffed out and that is not good news.

Cohan also list the five big reasons why GM didn’t have to fail and squarely lays the blame at the feat of managers who were overly impressed with themselves for no good reason. The five reasons: 1) bad financial policies, 2) Uncompetitive vehicles, 3) ignoring competition, 4) failure to innovate, 5) managing the bubble. Ignoring the competition and failure to innovate are the worst crimes and that should justify Rick Wagoner’s firing pretty easily.