Exchange-Traded Funds: How They Operate: The Pros And The Cons

Covered call writers can use individual stocks or exchange-traded funds as the underlying securities. Each has its own set of advantages and disadvantages. In this article we will explore the mechanism behind ETFs and evaluate the pros and cons of incorporating them into our covered call writing portfolios.

When we buy one share of the Qs (Powershares Exchange-Traded Fund Trust – Powershares Qqq Trust, (NASDAQ:QQQ) for $55, we are purchasing a piece of all 100 shares in the fund. So how does that work? Are we applying $0.50 towards each stock? It’s actually a bit more complicated than that. 

The Mechanics of an ETF: 

These funds are continuously creating new shares or redeeming existing shares depending on market demand. The shares represent ownership interest in the underlying basket of securities. Only large institutional investors called Authorized Participants (APs) partake in this creation and redemption process. They will buy creation units or sell redemption units over sophisticated electronic platforms. Shares are created when the APs provide a basket of securities to the fund which then creates ETF shares that are handed over to the AP. These ETF shares are then sold on the secondary market (exchanges) to us by the APs. 

On the other hand, when an AP provides the fund with a number of ETF shares (redemption unit), they will receive from the fund the associated basket of securities. 

What’s in it for the APs? 

Are they doing this to be nice guys and allow BCIs to take advantage of these funds? I don’t think so either! They are doing it to take advantage of arbitrage opportunities. These are simultaneous purchases and sales of assets in order to profit from a difference in the prices. Here’s how the game is played: 

The underlying securities in an ETF are priced every 15 seconds during the trading day. This value is similar to the NAV (net asset value) of a mutual fund which is priced only after market close. When there is a small difference between the intraday NAV and the actual share price of the fund, the AP can buy one and sell the other to generate a profit. This arbitrage process actually serves a useful function for us in that it keeps the fund price and the NAV price very close. 

ETF Pros:

• Diversification
• Lower annual taxable distributions
• Lower costs
• Lower management fees
• No 12-b-1 fees (marketing and distribution costs)
• Trading flexibility:

1. can be purchased on margin
2. can be bought and sold @ intraday market prices
3. can be traded with stop and limit orders
4. can be sold short 

ETF Cons: 

• Subject to market risk like investor sentiment and global conditions
• Market pricing discrepancies (between NAV and actual share value) particularly in less liquid funds
• Tracking discrepancies- returns may be more or less than the benchmark for the following reasons:

1. A fund may sample the benchmark rather than duplicate it exactly
2. Dividend distributions from a fund may differ from the equities themselves
3. The expense ratio (administrative costs) reduces profits
4. Regulations require no one company represent more than 25% of the fund. This may not represent the actual fund allocation.   

ETFs and covered call writing: 

The conservative approach would be to get the most diversification so that out-of-favor securities can be mitigated by the others. Usually the greater the diversification, the lower the premiums because of  lessened volatility. But this seems to suit the needs of conservative investors.

Two popular ETFs with tremendous diversification are: 

• VTI- Total Stock Market 
• SPY- S&P 500 

For greater premiums but also greater volatility: 

• QQQ- Nasdaq 100 
• IWM- Small Cap 

Other popular ETFs: 

• DIA- Dow 30 
• MDY- Mid-Cap 400

 Over the years I have used the Qs in my mother’s account with excellent success. More recently I have been utilizing the top performing ETFs and updating my portfolio on a regular basis. This information is provided weekly to our premium members. Here is a chart taken from a recent Premium member ETF Report:

ETF Report: Page 1

In the BCI methodology, we identify the securities that are outperforming the market as you see in the chart above before considering them as candidates for our covered call writing portfolios. Our members are provided with over 20 such securities each week.

Conclusion: 

ETFs are vehicles that can benefit both institutional and retail investors. For writers of covered calls, the main asset is its instant diversification that permits a conservative approach to an already conservative strategy.

Next Speaking Engagement:

March 21, 2013 6:00 pm – 9:00 pm

South Florida Options Trading Meetup

Many thanks to our members who attended my presentation for The Money Show @ the Marriott Marquis Hotel in NYC. It really made me feel special when I saw all those “Ellman-authored” books sitting out there in the audience. I’m sorry so many of you had to stand as we didn’t anticipate the amazing turn-out…Thank you!!!

Market tone:

Positive economic reports dominated this week with the fears of an $85 billion “sequester” looming which could result in severe government spending cuts:

• Annual inflation rate remains below the Fed’s 2% target
• The Conference Board index of leading economic indicators  rose by 0.2% in January boding well for continued economic expansion
• Minutes from the January 29-30 FOMC meeting reflected a positive attitude regarding economic recovery citing improving housing, business investment and consumer spending as reasons
• Consumer prices remained flat in January but up 1.6% from January, 2012
• Producer prices increased by 0.2% in January
• New residential construction dropped by 8.5% in January, however up 24% from January, 2012 which represents the 2nd best pace since mid-2008
• Exisiting home inventories have declined by 25.3% from 2012
• The median price of existing homes is now 12.3% higher than last year

For the week, the S&P 500 declined by 0.3% for a year-to-date return of 6.27%.

Summary:

IBD: Uptrend under pressure

BCI: Cautiously bullish favoring in-the-money strikes until “sequester” issues are resolved

Wishing you the best in investing,

Alan and the BCI team ([email protected])

www.thebluecollarinvestor.com