TimingCube - More on ETFs versus bull/bear mutual funds - bull/bear,bull/bear mutual funds,slippage,prime rate,margin rate,margin strategies

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Signal Update

Current Signal Performance as of

Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500
		QQQQ

Cumulative Returns since First TimingCube Live Signal () as of

Index	Long Only	Long Only with Margin	Long & Short	Long & Short with Margin	Buy & Hold
Nasdaq 100
Russell 2000
S&P 500
QQQQ

Note: QQQQ returns are included for continuity sake.

Market Update

Markets started the week on a strong note. Following the widely anticipated decision by the Fed to increase its funds rate by 25 basis points, stocks kept rising until Wednesday. Higher oil prices and negative news in the influential drug sector then took their toll and caused markets to give up a good chunk of the previous days' gains by week end. The move lower occurred on brisk volume, as market activity was likely exacerbated by the fact that Friday was an options expiration day. On the economic front, inflation appears under control as the November Consumer Price Index (CPI) checked in at 0.2%, matching consensus expectations.

The Nasdaq 100 lost 0.53% on the week. Both the Russell 2000 and S&P 500 did better, finishing with respective gains of 1.56% and 0.52%. All three indices remain within striking distance of their 52-week high. The week's action did not affect our Buy signal, which consequently remains active.

Trend Timing School

More on ETFs versus bull/bear mutual funds

The data presented last week in the comparison of investing in ETFs versus bull/bear mutual funds has come as a shock to many of you who, very naturally, expected comparable performance. Many now wonder why anyone would bother with the mutual funds at all. Remember that due to government regulations one cannot short or invest on margin in qualified retirement accounts and therefore, all strategies but Long Only are unachievable with ETFs. The bull/bear mutual funds provide a very valuable solution in these cases, albeit at somewhat lower performance.

Once the sticker shock recedes, one starts asking why the discrepancy between the returns of ETFs and bull/bear funds exists in the first place. A large contributor to the performance deficit is the lag incurred by the mutual funds for having to trade at the close on the trade date instead of at the open like ETFs (also read April 30, 2004 FAQ of the Week "What is the effect of slippage?").
In Chart 1 we show that if instead of trading at the open QQQQ was traded at the close, like the mutual funds, the resulting performance would drop substantially. Instead of being 54% less performing in the case of Long and Short with Margin, the mutual funds only trail by 27%. The remaining shortfall is mostly attributable to the negative compounding effect inherent in how the funds work (See the November 28, 2003 FAQ of the Week), and the mutual fund's costs. Note that we could not find prices to reproduce the Rydex mid-morning trading feature but we guess that the resulting performance would be somewhere in between.

Chart 1: Impact of open/close slippage on ETF versus bull/bear fund comparison
(from 06/18/2001 to 12/09/2004)

As we do with all our results, for clarity and transparency, we presented the "raw" data (no fees, costs, or taxes included). But in some ways this is not a realistic or apples to apples comparison. Yes, taxes we can discard because they are irrelevant to this analysis, and would be the same in either case. Transaction fees or commissions are an advantage of mutual funds (they have none) but with our infrequent trading these fees are negligible. The margin interest however, cannot be avoided when implementing the Long and Short and Long and Short with Margin strategies with ETFs and besides, they can be significant. When you short an ETF or trade on margin you are effectively borrowing from your broker, for which service he charges you an interest called the margin rate (the fact that he frequently lends you shares he takes from another client is besides the point...). Margin rates vary widely over time, between brokers, and as a function of the amount borrowed. The margin rates brokers charge are all loosely tied to the U.S. Prime Rate, which is determined by the Federal Reserve and today stands at 5.25%, but can vary substantially. The rates we found at various brokers ranged from 5.35% at BrownCo to 8.99% at E*Trade, but for our calculations we used 7.5% throughout.

For the sake of fairness we calculated the impact of margin costs on the results. Chart 2 below shows that in a more realistic comparison that includes the margin costs incurred by ETFs, the bull/bear mutual funds still lag by a significant 40% (17% for Long and Short). The obvious conclusion is that if you can (i.e. non-retirement money), it is still better to use ETFs, even after the heavy margin costs.

Chart 2: Impact of margin costs on ETF versus bull/bear fund comparison
(from 06/18/2001 to 12/09/2004)

So what is one to do with retirement funds? Are we condemned to live with the somewhat inferior returns of bull/bear mutual funds? For self-motivation we find it healthy to always remember that those "somewhat inferior returns" have blown away Buy and Hold returns (378% versus -6%!)
That being said, there is also hope on the horizon. We have been researching alternative investment vehicles and we found some that are quite promising. The use of options strategies in particular can be implemented in qualified retirement accounts and offers good risk/return/cost characteristics. We are planning to publish a primer on such options strategies in the near future.

FAQ of the Week

Question: Why did yesterday's closing price for QQQQ suddenly change?

Observant souls picked-up on a few intriguing QQQQ price movements since the close last night. For example, the closing price was $39.95 yesterday and now Yahoo! Finance says it was $39.57. The mystery can be explained by a rare cash dividend on the QQQQ.

On July 20, 2004, Microsoft Corporation (MSFT), a component of the Nasdaq-100, and therefore of QQQQ, announced a $3.00 cash dividend per share which, after all the math is done, translates into a $0.38 cash distribution per QQQQ share. The timing, as outlined in the table below, means that today, the ex-dividend date, the price of the shares was reduced by the amount of the distribution (38 cents), and that any shareholder on the record date, next Tuesday, will be set to receive the cash distribution into his/her account on December 31, 2004.

July 20, 2004, Microsoft announces cash dividend
December 17, 2004, ex-dividend date for QQQQ
December 21, 2004, the record date for QQQQ shareholders
December 31, 2004 distribution paid to QQQQ shareholders

While all of this seems terribly complicated, the cash received will offset the price reduction and, except for small details such as taxes, the whole event is mostly a wash.

Warm wishes and until next week.

The TimingCube Staff