August 01, 2009

Market Insights - 1 August 2009

Weekly Snapshot
• U.S. GDP fell at a 1% annual rate in the second quarter - better than expected (Reuters)
• Euro Zone unemployment rate at 9.4% in June (
• Microsoft and Yahoo! agree to integrate their internet-search and advertising businesses (Economist)
• Exxon Mobil quarterly profit slumps 66% (Reuters)
• Royal Dutch Shell’s net profit dropped by 67%, to $3.8 billion (Economist)
• U.S. first-time jobless claims jumped 25,000 to a level of 584,000 (Bloomberg)
• Germany's unemployment rate in July was unchanged from the previous month at 8.3% (
• Household saving rate at 15.6% in the euro area and 13.8% in the EU27 countries (Eurostat)
• U.S. durable goods orders fell 2.5% in June, the largest drop since January (Reuters)
• Japanese retail sales weakened slightly on a year-on-year basis in June (
• Shanghai's SSE Composite Index down 5% on Wednesday (Yahoo! Finance)
• Five million young people unemployed in the EU27 countries during Q1-09 (Eurostat)
• U.S. consumer confidence index fell a sizable 2.7 points to 46.6 in July (Bloomberg)
• U.S. home price index of 20 cities shows the first monthly rise (0.5%) since 2006 (CNN Money)

Chart Video of the Week
Daily Show's John Oliver gives a hilarious assessment of the housing market. Click here to see the video...

Highly Recommended Read
Please consider an excellent perspective on the issues facing both China and the U.S.: The China Bubble's Coming -- But Not the One You Think

Shanghai's stock index fell 5% in on Wednesday this week, putting a small dent into an otherwise glamorous run of Chinese stocks which are up about 85% so far this year. On the issue of whether this is a sign of a Chinese stock market bubble about to burst, Vitaliy Katsenelson writes:

"Who cares! What happens to the broader Chinese economy is what we should really be watching. It will have a far-reaching impact on the rest of the world -- much more far-reaching than a decline in stocks.

And to answer that question, the author uses a fascinating example, comparing China with Lucent Technologies of the era.

China's fortunes over the past decade are reminiscent of Lucent Technologies in the 1990s. Lucent sold computer equipment to dot-coms. At first, its growth was natural, the result of selling goods to traditional, cash-generating companies. After opportunities with cash-generating customers dried out, it moved to start-ups -- and its growth became slightly artificial. These dot-coms were able to buy Lucent's equipment only by raising money through private equity and equity markets, since their business models didn't factor in the necessity of cash-flow generation. Funds to buy Lucent's equipment quickly dried up, and its growth should have decelerated or declined. Instead, Lucent offered its own financing to dot-coms by borrowing and lending money on the cheap to finance the purchase of its own equipment. This worked well enough, until it came time to pay back the loans.

The comparison, albeit far-fetched, makes sense and the author continues on explaining the perhaps ironic situation China is in with stunning clarity. To further illustrate where China came from and to see how significant the impact of exchange rates are to both China and the US, here is a reminder of the historic exchange rates and China's GDP by comparison.


In closing, the author predicts a big Chinese bubble that eventually has to burst. Double-digit growth rates could only last so long, something everyone should be painfully aware of from recent history. Personally, I am curious to see how China can manage its exposure to the US Dollar without causing global imbalances. A managed floating exchange rate may be an option to consider. There are now indications that some form of relaxation of currency controls and possible rate adjustments may happen sooner than previously expected.

More on ETFs
In our ongoing quest to shed some light on new financial products such as Exchange Traded Funds (ETFs) or Exchange Traded Notes (ETNs), I thought it was timely to review the real expense ratios of some of these products. As I mentioned numerous times before, one has to be careful and review the prospectuses of these new funds before considering an investment. Not only do some of these ETFs have a slightly deceiving approach in terms of truly matching the underlying asset(s), but the more obscure ones are also rather expensive. There are over 800 ETFs available trading in U.S. Markets today and many of them now have expense ratios of about 1% which brings them into the league of Mutual Funds. Obvious question: If an ETF is supposed to track an index or underlying asset(s) and no ongoing stock/asset selection needs to be employed, why do they have to be so expensive?

Originally, ETFs were designed to give smaller investors an easy way to diversify and buy the entire market index, with as little as one share. The first ever ETF SPDR (Ticker: SPY) which began in 1993 and the popular Vanguard Index Funds (e.g. Tickers VTI, VV, VXF) are still the most reasonable ETFs available. They have expense ratios from 0.07%-0.09% and still represent one of the better deals in terms of achieving wide market diversification at a minimal cost and without the need of a six-figure portfolio.

On the other side of the spectrum, we have a growing number of fancier and more obscure sounding ETFs including inverse and leveraged ETFs, all of which should be taking with more than just a grain of salt and which are not recommended for smaller and unsophisticated investors (see Market Insights 6 June 2009).

Below now is a list of some of the most expensive ETFs showing expense ratios reported by Yahoo! Finance, ETF Connect, Charles Schwab.

As you can see, the information is sometimes not as plain and simple as it should be. For instance, some brokers and some websites do not disclose all gross expenses and one has to weed through pages of prospectuses to get the correct information. Most people do not pay attention to these fine details, because these expenses are not shown on your brokerage statement. Unlike Dividends which are declared and either reinvested or cashed out, expenses of ETFs are generally built into net asset value (NAV). Hence much more difficult to capture.

When you examine these costs in more detail, many more questions should be raised...

To understand these numbers a little better, let's look at the first one Claymore/Zacks Dividend Rotation. The stated expense ratio cap is 0.60%; however, they sneak in other expenses which cannot be included in the expense ratio cap (see red highlighted text below). In reality you end up paying the fund 1.78% of your investment in fees every year. But wait, there's more. If you intend to hold this fund for a few years, you might get caught with another item in the fine print (see green highlighted text). After 2011, this ETF might quite possibly cost you 5.70% in expenses each year. How is that for a boost in your returns...

FROM the Prospectus of IRO
4. The Fund’s Investment Adviser has contractually agreed to waive fees and/or pay Fund expenses to the extent necessary to prevent the operating expenses of the Fund (excluding interest expenses, a portion of the Fund’s licensing fees, offering costs, brokerage commissions and other trading expenses, taxes and extraordinary expenses such as litigation and other expenses not incurred in the ordinary course of the Fund’s business) from exceeding 0.60% of average net assets per year, at least until December 31, 2011. The offering costs excluded from the 0.60% expense cap are: (a) legal fees pertaining to the Fund’s Shares offered for sale; (b) SEC and state registration fees; and (c) initial fees paid to be listed on an exchange. The Trust and the Investment Adviser have entered into an Expense Reimbursement Agreement (the “Expense Agreement”) in which the Investment Adviser has agreed to waive its management fees and/or pay certain operating expenses of the Fund in order to maintain the expense ratio of the Fund at or below 0.60% (excluding the expenses set forth above) (the “Expense Cap”). For a period of five years subsequent to the Fund’s commencement of operations, the Investment Adviser may recover from the Fund fees and expenses waived or reimbursed during the prior three years if the Fund’s expense ratio, including the recovered expenses, falls below the Expense Cap.

Further, there are currently over 100 additional ETFs where full expense details are not even available via Yahoo! Finance and one would have to go through every prospectus to figure out what these expenses are. Again, find out in detail before considering any ETF purchase in very much the same way you should be fully aware of all expenses charged by Mutual Funds before investing. On a final note, I wanted to highlight two relatively popular ETFs which should be handled with care as well.

Ultra S&P500 ProShares (SSO) Ultra QQQ ProShares (QLD) both of which are leveraged ETFs with stated expense ratios of 0.95%. On closer look though, there's more to come and please note that expenses in these funds are only capped until 30-September of this year. As of yet, there is no announcement as to what the new fees will look like but beware if you currently own these or similar ETFs.

One more peculiarity with these two leveraged funds (as well as some others not listed here). Both charge so called 12b-1 fees of 0.25% after 30-Sep-09. In case you wondered, 12b-1 fees are another creative invention of the financial services sector. Originating from the Mutual Funds industry, fees of up to 0.25% can be charged for marketing expenses and as long as they are within that limit, a Mutual Fund can still be called a "no load" fund. Isn't it nice to know that we, the lowly investors, pay for those glossy brochures and television commercial of the funds we're supposed to invest in?

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Good luck & good trading!

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