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18 May 2009
Ron’s Financial Newsletter: Issue #3
Basics about Stocks, Bonds, Mutual Funds, and ETFs
This issue continues to lay a foundation for understanding basic investing, with an emphasis on bonds
and Exchange Traded Funds (ETFs) since it appears that they are less well understood than stocks and
mutual funds. With the recent drop of stock prices, fixed income (bond) investing has gained attention as
a core part of an investor‟s portfolio, along with other ways to obtain yield, e.g., via stock dividends.
Why discuss ETFs? As you‟ll learn below, they are a growing asset class and are considered a
supplement to and an alternative to mutual fund investing, used by advisors and investors. What they are
and their pros and cons discussed below.
Goals for this issue:
1. Understand bonds, their status relative to stocks, their risks, how a bond’s price is
affected by interest rates, and how an investor may react to changing interest rates in
making buy/sell decisions about bonds.
2. Understand ETFs, their variety and flexibility, their risks, how they compare with mutual
funds, where to go for more information about them, and how to structure a portfolio build
Disclaimer: Nothing written in this or any other issue is intended to be construed as investment
advice. The intent is to be purely informative and informational.
I welcome your comments and questions on the content in this newsletter.
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Basics about Stocks, Bonds, Mutual Funds, and ETFs
An investment portfolio has a number of characteristics, two of which are the set of asset
classes represented and their distribution, i.e., percent allocation. In this issue, I‟d like to focus
on two asset classes that I believe are not widely understood by many investors, namely bonds
and exchange traded funds (ETFs), but first let‟s begin with a quick rundown of the basic asset
classes used by investors:
Common stock represents ownership in a corporation via shares. Shareholders, i.e.,
owners, expect their investment to rise or fall based on the fortunes of the corporation.
What makes investing so challenging today are the many exogenous (big word for
„external‟) factors that affect a company‟s fortunes, from the price of oil to access to
capital to government policy. Can one really know the „story‟ behind a company and
how all of these factors will affect its business? It‟s been getting harder.
A bond is a loan to a corporation. A bondholder is a creditor and expects an annual
payment (called a coupon or yield) for extending the loan. The bondholder also expects
to get his/her original investment (principal) returned in full at maturity, the date when the
holding period of the bond expires. Bonds may be issued with maturities from a year to
over 30 years. Shorter maturities are usually less risky than longer ones, and thus
normally pay lower coupons, or yields. The price of a bond can fluctuate.
A mutual fund is a portfolio of stocks, bonds, or a combination of stocks and bonds
(often called balanced funds). An actively managed fund has a manager though some
funds mimic an index, such as the S&P 500, and are not actively managed. Fund
managers may also hold an amount of cash, but by practice and prospectus, a fund
typically limits the percent of cash it may hold on the theory that if an investor buys a
fund for its theme (large cap*, small cap, technology, international), that is what the
investor expects to own. Mutual funds are priced based on net asset value (NAV), the
average market price of the assets being held.
[*cap: market capitalization, or the value of a company as represented by the dollar
value of all shares outstanding; cap = stock price * # of shares outstanding]
Like a mutual fund, an exchanged traded fund (ETF) is also a collection of stocks or
bonds, but, at present, there is no active management. It is a fixed and passive
collection of stocks or bonds and trades on the major stock exchanges.
Another category of asset, not generally well-known to the average investor, is closed
end funds. These are also collections of stocks or bonds similar to ETFs, but closed
ends are actively managed and trade on the major stock exchanges. Based on supply
and demand, they trade at a discount or premium to their underlying value. One
strategy is to take advantage of extremes in the discount and premium to time buys and
sells. To learn more about ETFs and closed ends, go to www.ETFconnect.com.
There are variations of classes of stock (common and preferred) and bonds (corporate,
convertible, high yield, government), but in the interest of space, we‟ll skip those variants here.
Of the five asset classes described, all but mutual funds issue a fixed number of *units*,
whether they are shares or bonds. Their price moves on supply and demand. On the other
hand, mutual funds are *open* in that they may issue an unlimited number of shares based on
the inflow of funds. When these shares are redeemed, the number of shares outstanding
diminishes. The value of the fund is driven by the values of the assets it holds, calculated each
day at the market‟s close, currently 4 pm EST. All fund trades are made at this close-of-day
I thought it might be instructive to see the change in price by asset class from 2000 to 2008
using the chart below from www.zealllc.com/. The chart is a bit of a „setup‟ since it begins when
the market last peaked in March, 2000. Nevertheless, it does show that there were better
investments than common stock in this period. You might ask: “Well, how does one invest in
commodities and other alternatives?” We‟ll see below using ETFs.
Also, for the first time since 1979, the S&P 500 did not show a gain in the current rolling 10 year
period, from 1999 through 2008, as found at
Bond Basics. When issued, bonds are priced at $1,000 (par) and come with a fixed coupon
rate defined in dollars per year, say $60. This means that a purchaser of this bond receives $60
a year in dividends, or 6% on the par value. Bond prices are quoted at 10% of par, so a $1,000
bond is quoted at $100. Quaint, no? A bond fluctuates in value with interest rates, and we‟ll
see why in a bit. If a bond is quoted at $85, that is equivalent to $850 on the original price.
Recall that the $60 coupon is fixed so the yield on this bond, after it has dropped in price, is
60/850, or 7.06%.
Here it gets interesting. Why would a bond drop in price? Here are two reasons. First, think of
a corporation in economic trouble. Come up with any? OK, let‟s use General Motors (GM).
Would you pay $1,000 for a GM bond? Likely not. At one point recently, they had been selling
for a range of between 20 to 30 cents on the dollar, or $200 to $300 per bond because investors
are not sure that the bond will be paid back at maturity. For this risk, investors are receiving a
high rate of return since, if the original coupon was $50 (or 5%), the return now would be
50/200, or 25% per year.
In addition to this high yield, if the bond matures and GM is solvent, the investor will receive the
full $1,000 par value, a handsome gain. Factoring this gain with the annual yield gives what is
called yield to maturity (YTM). If this bond matures in 4 years and is paid, the (capital) gain
would be $800 ($1,000 - $200), or 800/200, or 400%, or another 100% per year above the
dividend. In this market, this example is not far-fetched, but the risk involved is considerable. It
is not a recommendation, but one can buy such high yielding, low-rated bonds (called „junk‟ in
the trade) either individually or in a high yield mutual fund. Funds offer experienced
management and diversity, but do your research and know the risk you are taking and are able
and willing to take.
Let‟s continue, and please indulge me so that I can reinforce the relationship between interest
rates and bond price. Say you just bought a bond for $1,000 with a $60 coupon when the
market interest rate for bonds was 6%. What if market rates rise, say to 12%, as they did in the
late 1970s and early 1980s. A corporation decides to raise money and issues bonds. What
coupon rate will they have to pay to attract investors? It will be nearer to $120 rather than $60
since 120/1000 is 12%, the market rate.
With market rates rising to 12%, let‟s say you still own this older bond paying a $60 (fixed)
coupon, and you‟d like to sell it (before it matures). What will you be offered? $1,000? I doubt
it. How about $500 since 60/500 is now 12%. Lesson: When rates rise, bonds drop in value,
and vice versa. Had rates dropped, say to 3%, the market would drive the price of your bond to
about $2,000 since 60/2000 is 3%.
In the old days (pre-1970), when interest rates were more stable, bonds were a calm, tranquil
investment. Not so today. Sharp rate movements have made bond investing almost as volatile
as equity investing, making for significant potential gains and losses. However, recall that if one
holds a bond to maturity and the issuer (corporation) doesn‟t default, one can ignore all of the
variation in bond prices in between. This is the case when one owns individual bonds. Bonds
held in a mutual fund are less likely to be held to maturity since the fund manager is buying and
selling them all the time.
Bonds have been a great investment since the early 1980s, a period in which long-term rates
dropped from over 16% to under 3% in 2008. Since bonds drop in value when rates rise, one
does not want to own bonds in a rising interest rate environment. With the government about to
print many dollars, rates and inflation will tend to rise. When? Who knows, since we are
currently still in a deflationary global economy, but it‟s a trend that an investor needs to follow.
What has occurred in the bond market in 2008 is that safer bonds (governments) have dropped
in yield while riskier bonds (high yield corporate, aka junk bonds) have escalated in yield so that
the price spread between the two is now very large by historical standards, as shown in the
chart below. The question for an investor/advisor is: “Do low-rated bonds justify their risk? That
is, will default rates reflect current yields or will defaults be higher (let‟s not invest) or lower (let‟s
buy) than bond prices now imply?” Whether an investor or an advisor, one needs to answer this
question correctly if investing in high yield bonds.
Government Bonds. Bonds issued by the U.S. government are deemed the safest bonds one
can buy. However, these bonds also change in value with interest rates. They are usually
bought by conservative investors for their safety, but amazingly, in the 4th quarter of 2008, while
stocks were tumbling, US Treasury bonds rose over 22% in value because rates dropped so
precipitously as investors bought to seek safety. Bondholders 1, stockholders 0 in that round.
Debtors and Creditors. Let‟s now make the point about who gets protected in case of a
corporate default. Bondholders (creditors) are senior to the shareholders (owners), so in case
of a corporate collapse, bondholders are paid first with any assets that remain, and within this
class there is also a bond hierarchy since there are other types of bonds and stocks that we
haven‟t discussed, e.g., convertible bonds, preferred stock.
Recently Ford Motors (F) tried to convince some bondholders to exchange their bonds for stock.
Why would a bondholder even consider this from a failing company? Ford‟s interest was clear.
They were trying to avoid paying the interest and principal on the bonds, money they barely
had. Instead, they were offering ownership in the form of shares. Why would bondholders
consider this? Well, it certainly depends on how many shares were being offered and the
bondholders‟ expectation of Ford‟s chances of survival. Also, the bonds could become
worthless if bondholders insisted on Ford incurring this continued expense….bond interest and
redemption, bringing everyone down. A tense little dance around probabilities and
expectations, where the bondholders will negotiate for the most shares they can obtain if they
let Ford off the bond hook. The stockholders‟ view? Often, they would be against this action
since additional shares (of ownership) would dilute their ownership percentage.
ETFs. As taken from http://online.wsj.com/ad/focusonetfs/history.html, “exchange-traded funds
(ETFs) were launched in 1993 by State Street Global Advisors, though similar products traded
in both the U.S. and Canada in years prior to that. The SPDR fund (pronounced “spider”) – the
very first ETF – tracks the Standard & Poor‟s 500 stock index and is still the largest ETF on the
market. With assets of around $58 billion, it is the granddaddy of all ETFs, accounting for about
16% of all assets in the ETF market.”
ETFs have grown along with the increasing popularity of fee-based, rather than commission-
based, advisory compensation structures. Today, there are hundreds of ETFs that give
investors an array of choices that range from broad market coverage, e.g. SPY (S&P 500), DIA
(Dow Jones 30), to theme-based ETFs, such as XLE (energy), XLF (financials), USD (semi-
conductors), and GDX (gold mining). There are also country-based ETFs, allowing an investor
to get geographic diversity, such as FXI (China), RSX (Russia), EWZ (Brazil), and many others.
Newer ETFs offer choices in „responsible‟ investing, such as clean energy (PBW), solar energy
(TAN), water (PHO and PIO) and wind (PWND). Then there is PIV, an ETF that contains the 50
highest ranked stocks among the Value Line top 100 ranked stocks. [Note: The three-letter
codes such as SPY and TAN are stock symbols.]
Want to buy specific commodities directly? Try GLD (physical gold), SLV (silver), and JJC
(copper). These are ETFs and can be bought and sold just like any other stock symbol.
A caution. It is desirable to invest in an ETF that has sufficient liquidity; that is, sufficient shares
that trade daily. Same comment goes for any financial asset. This way, you‟ll have a better
measure of an asset‟s of true market value and get better prices when you buy and sell.
You can learn more by going to the websites of three large purveyors of ETFs:
State Street Global Advisors at www.spdrs.com
Barclays at www.ishares.com (though Barclays has been ‟shopping‟ this asset to raise
money they apparently need to meet financial regulatory metrics)
Powershares at www.invescopowershares.com
There are also bond ETFs of all kinds, so an investor could achieve substantial diversity using
Finally, there are even more exotic ETFs available. They offer, in one package, the option to
select both a theme and market direction at the same time. So, we now have SSO, which
represents the S&P 500 but moves twice as much (up) as SPY. That is, when the S&P 500
rises by 1%, SSO will rise by about 2% (it is rarely exactly 2x).
What if you think the market is over-priced and more likely to go down than up. Well, there is
SDS, which is an inverse ETF. It rises roughly 2x as much as the S&P500 goes down and
vice versa. Effectively, this offers virtual shorting of the market. Inverse ETFs can be used to
hedge a „long‟ (ownership) position or they could be used as a way to take advantage of a
dropping market, as occurred in 2008. Interestingly, inverse ETFs are allowed in an IRA, where
direct shorting of stocks is not allowed. [Shorting is discussed in another newsletter, but, simply,
it is a strategy to make gains when a stock drops in price.]
In fact, there are lots of inverse ETFs, practically one for every „regular‟/long ETF. Moreover,
one can make single, double, and (amazingly) even triple bets on market and theme direction.
For example, FAS and FAZ represent triple up and triple down ETFs for the financials,
respectively. Clearly, one must use caution with financial instruments that pack so much punch.
On the other hand, one could use a much smaller amount of money to get the same impact
from a 1:1 ETF.
Another caution: The mathematics of double and triple moves up and down is such that equal
percent changes up and down will not leave you even; in fact, such a pattern usually results in a
decaying price (loss) over time, referred to as „leakage‟. This requires more research on your
part. You could start with
In addition, some inverse ETFs attempt to achieve their performance objectives relative to their
benchmark on a daily basis and, therefore, are unlikely to correlate with their benchmark
performance over longer periods of time. Double and triple ETFs will tend to exaggerate these
differences, especially since they attempt to target daily returns. The effects of compounding,
using prices changes over periods longer than a day, will tend to make the returns one achieves
differ, possibly significantly, from what one would achieve on a daily basis. One thought is that
this type of ETF is better used for short-term trading only, not for longer buy-and-hold periods.
As an advisor, I have seen that it is the minority of investors that feels comfortable „betting
against the market.‟ That‟s fine. If this is not for you, pass it up – it‟s just another tool in the
toolset, if one chooses to use it. Finally, be aware that any ETF may not achieve its investment
objective and that an inverse ETF will most likely lose money when its benchmark rises.
However, for many investors and advisors. ETFs have become alternatives to mutual funds.
Like mutual funds, they offer diversity.
They are typically cheaper to own than mutual funds because there is no manager.
They may be bought and sold throughout the market day, not just at 4pm as with funds.
Also, some mutual funds assess a penalty if they are sold before a minimal holding
period, say 90, 180 or 270 days.
They trade with supply and demand, as do individual stocks and are not subject to
redemptions, as occurs with funds.
ETF owners have more control than mutual fund owners over tax impacts, since funds
distribute capital gains on their schedule, not on the investor‟s
One may sell call options against ETFs, but not against mutual funds. [We‟ll discuss
options – puts and calls -- in another newsletter.]
Possible disadvantages of ETFs? Mutual funds are actively managed while ETFs are passive;
that is, once defined, an ETF‟s composition stays fixed. For example, FXI contains the 25
largest firms in China and that collection will stay unchanged, for the most part. Mutual fund
managers buy and sell their holdings, as they seek market gains.
Interestingly, some of the largest mutual fund companies, such as Vanguard and Rydex, have
also introduced (competing?) ETFs.
One can construct a fairly well-diversified portfolio using just a handful of ETFs since they cover
stocks of all stripes (large, medium and small cap; most industry sectors, international stocks)
and bonds of all flavors.
Summary. This issue was meant to a) describe bonds and how they work, and b) stretch
your horizons of investible asset classes and to suggest ETFs as an asset class to
To think about: Historically, stocks have outperformed most other asset classes over
time. How does one recognize those times when it is better to be in bonds than stocks?
In commodities over stocks? How should allocations be adjusted in those cases?
To think about: Compare the performance of a mutual fund and a comparable ETF. Does
active fund management trump a passive ETF when all factors are considered? Should
one still seek out the best fund managers over buying an ETF? Should one re-evaluate
buying or holding a successfully mutual fund when the manager changes?