Comparing investment prospects between domestic ETFs is hard enough, but between ETFunds holding stocks from different countries or regions - that's really tough. Our advice is "don't try this at home," get some experts to do it for you.
Yeah, but who can be trusted? Who knows all the political intrigues, currency games, secret inter-country agreements, recent economic developments and unfolding corporate commitments in all those places where they even prefer not to speak English?
Do ya believe in free markets? Do ya believe in competition? Do ya believe in getting rich because of what you know - and what "he" doesn't?
Then let the markets do the heavy lifting for you - by using behavioral analysis. Here's how it works:
Setting the valuation stage
The big-money funds are constantly shuffling the holdings in their portfolios, trying to get ahead of one another so they can grab more money to control and charge management fees on. But many of the funds are now so big they can't just duck into and out of the market with ETF trades that are big enough to make a difference in a $10 billion, $100 billion, or even a $ Trillion portfolio. Even tiptoeing around in "dark pools" and probing with computer-programmed trade robots, looking for opportunities, still can't get them the order "fills" that they need.
So one important resource they use is the volume "Block Trade" facilities of the major "investment banking" houses. These "market-makers" [MMs] are financial engineers that, if they can't find sufficient volume on "the other side of the trade" from what the client wants to do, at an acceptable price, they will put the facilitating firm's own capital at risk to provide the stub end of the block order that the market won't otherwise cough up.
Their engineering skills come to light in the way they hedge the risks that the firm's capital is exposed to in the process. If prices run against them before the position gets unwound and the firm loses money, serious money, the MM loses his job. A job that annually often pays seven figures.
So the MMs make darn sure that doesn't happen. But if they buy too much protection in the hedge, the trade order may not make the firm its usual egregious profit. Or, since the cost of the hedge is buried in the bid-offer spread on the trade, that overall cost of the transaction may get to be more than the client will stomach, and the deal gets killed.
And there is another force involved that helps keep the game honest. The hedge protections are usually sold, for advantageous prices, by the proprietary trading desks of competing "investment banking" houses. They price their services based on their judgments of what might happen to the ETF's market price while the risk is on their book. Since both buyers and sellers of the protection are equally intelligent and equally well-informed in most cases, their negotiations are usually pretty well focused on expected reality.
And both sides of this market-facilitating protection transaction are operating with judgments, not about the specifics of what is going on in the nation of Upper Whoknowswhere, but with a general sense of the capital risks and rewards involved in this transaction, compared with hundreds of other corporate stock commitments that they might do just today.
The common denominator of comparison comes down to the general cost and rewards of a financial risk to be undertaken, not the minutia of local geographic vagaries. Those are embedded in the overall.
The power of a market-made deal is in competition and measurable performance
Because the price to be paid for risk protection, and the way the hedge is structured, tells just how far the ETF's price is likely to travel, now we have the means of comparing an agricultural product ETF centered in some frontier country with an ETF tracking an index of semiconductor stocks in Taiwan, just for example.
Just as the MMs decide where to commit their capital at this point in time by tradeoffs between risk and reward, so can the investor take a similar approach with what price gains seem likely and what drawdown hazards may be confronted in the process.
And because the tradeoff discipline itself is self-regulating, it is both possible and desirable to keep score of how well these intermediary market professional judges have done in the past in making their forecasts.
So here is how the pros have done during the past five years, in the 3 months following all prior forecasts like the ones they are implying now with their self-protecting behavior.
The implied forecasts are in the two left-most data columns of the table below. Their credibility rests on how well prior forecasts with like balances between upside and downside have performed in actual market prices in the next 3 months after each forecast.
The most right-hand columns of the table indicate how many days of the past 5 years have seen a forecast like today's. The Sell Target potential is the percent change between each ETF's Price Now (9/16/2013 close) and the top of its current forecast range.
To contrast with this promise, the Range Index tells what proportion of the forecast range lies in the opposite direction, the percent of the range below the Price Now.
Our standard performance test is applied to each ETF's similar prior forecasts, to see what was the typical worst-case price drawdown below a cost of investment, made at the close of the market day following each forecast. On the benefits side, each forecast reaching its sell target at end of day is closed out at that point. Failing to do so in 3 months, it is forced into liquidation at that time. The ODDS / 100 column tells what percentage of the experiences ended in gains above cost, and the PAYOFFS column gives their net average gains. The Days Held column records the number of market days positions required to be held on average. Annual rates contemplate the 252-day year of the market, based on daily average net change compounded.
These top ones are not the best half dozen global ETFs for all time, they are merely six of the best from dozens of ETFs at this point in time in a comparison based on several criteria. The principal concern is over which ones have the greatest likelihood of adding value to a portfolio in the next few months at a competitive rate of gain while encountering the least likelihood of interim substantial decline in value. The iShares on Mexico (NYSEARCA:EWW) are clearly attractive, and the Vanguard Emerging Market Vipers (NYSEARCA:VWO) are competitive within the Global ETF set.
Investors should continually be alert to what the better, more competitive ETFs are offering as portfolio improvement potentials. Specific row details of the table highlight how much difference often appears between ETF investment candidates. The blue aggregate averages lines give some norms, with the global ETFs as a group at a significant disadvantage to our overall population of stocks and ETFs, particularly in upside target objectives, and in accomplished annual rates of price gains in the past.
This may just be a passing condition at this point in time of the market's progress, or some conditions, like limited upside, may just be a prevalent cost of the security of diversification found in a fund of holdings.
Additional Disclosure: The author has an investment interest in the website blockdesk.com which, while not yet open to the public, is in conversion from being a delivery medium of information to institutional investors to a new life of providing similar help to do-it-yourself investors. Both brief and extended-time subscriptions for single or multiple issue inquiries should be at quite reasonable and manageable costs for individuals. Announcement of its opening is hoped for in the 4th quarter of this year.