Table Of ContentPOWER
INVESTING
wwiitthh
BASKET
SECURITIES
THE INV ESTOR’S
GUID E T O E XCHANGE-
TRADED FU NDS
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PETER W . MADLEM, CFA
LARR Y D. EDW ARDS, CFA
POWER
INVESTING
wwiitthh
BASKET
SECURITIES
THE INV ESTOR’S
GUID E T O E XCHANGE-
TRADED FU NDS
ST. LUCIE PRESS
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Preface
Power Investing with Basket Securities, The Investor’s Guide to Exchange-Traded
Funds, represents the second volume in the Power Investing series of books. Several
years ago, when the publisher originally suggested the idea, there was some hesitancy
regarding the series title. Power seemed, well, a bit robust as a title theme. However,
upon consulting the dictionary, the primary definition was found to be, “the ability
or capacity to act or perform effectively.” Who can quarrel with that? After all, that
is exactly what the series is intended to do, impart to readers the ability and capacity
to perform effectively with their investments. Each volume presents an investment
strategy or approach that empowers the investor, whether professional or individual,
with proven and innovative approaches to improve performance in the convoluted
and confounding world that makes up the financial marketplace.
This book is about basket securities and how investors can use them. Spiders,
Sectors, Holders, ETFs, iShares, Vipers, and Qubes, are all acronyms for members
of this relatively new class of financial products. Most investors know them as
exchange-traded funds, or ETFs. However, not all basket securities are exchange-
traded funds, in the strictest sense. The fundamental concept of a basket is any
grouping or combination of financial assets that underlie the value of a single
exchange-traded security. Many, but not all, are based on indices, or subsectors of
indices. In addition, most are structured as securities issued by unit investment
trusts or mutual funds, but not all. The term “basket security” covers a broader
spectrum of useful securities than just index fund products issued by registered
investment companies.
Most baskets are designed to track specific indices or subgroups. Others select
specified portfolios within an industry group such as telecommunications and phar-
maceuticals. Because they are basically passive portfolios, baskets incur lower
expenses than actively managed mutual funds. Moreover, they typically entail a
lesser tax burden, since the underlying stocks are generally traded when an index
needs to be rebalanced.
Like stocks, you can buy baskets on margin and trade them anytime the market
is open. Baskets also are easy to short because they are exempt from the uptick rule,
which forbids the selling of a stock short in a declining market. Baskets can be used
to manage portfolio risk through hedging. Professional traders can swap shares of
a basket security for the underlying stocks, or vice versa. This form of arbitrage
keeps basket security prices very close to their net asset value, which means they
can track an index better than a closed-end mutual fund.
This book describes the origins of basket securities and reviews their beneficial
features and structures. It covers the broad array of currently available basket securities,
and suggests the likelihood of others on the horizon. Most importantly, the book presents
some strategies for their successful and powerful applications in managing portfolios.
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Those who can benefit from reading and using this book include investors who
have made asset allocation decisions as to their overall financial assets, and are now
considering how to achieve an appropriate level of diversification in the equity
portion of their portfolios. The authors hope that this book will be useful to its
readers in accomplishing such diversification, and perhaps in providing some further
insights into the portfolio management process.
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About the Authors
Both authors are currently portfolio managers with the Trust Investment Services
Division of Santa Barbara Bank & Trust, located in Santa Barbara, CA. Their
professional backgrounds, while significantly different, share much in common.
Peter W. Madlem, CFA, has nearly 20 years of
diverse investment experience. In the mid-1980s he
cofounded two publishing and investment advisory firms
specializing in closed-end funds and REITs. His market
and financial comments have appeared in The Wall Street
Journal, Investor’s Business Daily, Kiplinger’s, and
Money Magazine.
A published author and composer, Madlem has written
six investment-related books and his musical compositions
have been performed at the Sydney Opera House, the
National Cathedral in Washington, D.C., and London’s
Wigmore Hall, and have been recorded on Sony/Classical
and Sonora records. Madlem earned a Master’s degree from the University of
California, Santa Barbara. He lives with his wife, Katherine, and two children in
Carpinteria, CA.
Larry D. Edwards, CFA, has more than 30 years of
broad experience in the investment management industry.
In addition to being an experienced portfolio manager, he
served as President of Leland O’Brien Rubinstein Associ-
ates Incorporated (LOR) and its subsidiary, SuperShare
Services Corporation from 1984 to 1988. In these capaci-
ties, Edwards had an integral role in the creation of “The
SuperTrust” and its various securities that are described in
Chapter 1 and Appendix B. One of these securities, the
Index Trust SuperUnit, was the first successful U.S.
exchange-traded basket security, preceding the introduc-
tion of the Spider by about 3 months.
Prior to joining LOR as president, Edwards was chief investment officer for
Western Asset Management Company. He began his professional career with Scud-
der Stevens and Clark Inc.
A graduate of Occidental College and the Stanford Graduate School of Business,
Edwards and his wife, Janice, reside in the Santa Ynez Valley.
At Santa Barbara Bank & Trust, Madlem and Edwards, together with their
associates, are developing creative applications for basket securities, some of which
are described in this book.
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Introduction
Tremendously versatile, basket securities have the potential to change the way money
is managed. They are similar to index funds but trade like stocks, so they enjoy the
advantages of both worlds. Baskets provide a way to obtain the diversification of,
say, the Standard & Poor’s 500 Stock Index in a single security that can be bought
and sold during market hours just like any other stock.
Unlike regular mutual fund shares, which calculate their net asset values at the
end of each trading day, baskets trade continually on a stock exchange, where their
prices can change from trade to trade.
This book provides the proper definition of the basket security, a brief exploration
of their true history, and simple yet powerful ways to exploit their advantages. To
that end the book is organized into three broad sections containing nine chapters,
and three appendices.
Section I contains Chapters 1 through 3. The first chapter reviews the origin of
basket securities, as we know them today. The need for baskets became clear during
the stock market “Crash” of October 1987. It took 5 years to develop one that worked
and that had a sound regulatory structure.
In Chapter 2, some of the primary structural characteristics and related benefits
of baskets are reviewed, using the “Spider,” or SPDR, as a model. These innovative
securities can provide instant diversification, price efficiency, tax efficiency, liquidity,
and cost efficiency. When used as part of equity portfolios, they can reduce the
likelihood of bombshells and, over time, assure freshness.
Chapter 3 surveys the major participants in the basket securities business and
those firms that are sponsors or managers. Many of the currently available baskets
have come to market only recently.
Section II, encompassing Chapters 4 through 7, represents the applied portion
of the book. Chapter 4 explores simple, yet effective, ways basket securities can be
used in asset management strategies, including trading the market, building a diver-
sified core, or creating a “thousand stock portfolio.”
Chapter 5 presents a more technical look at trading strategies using basket
securities, including using baskets together with individual securities, the application
of momentum screens, and how to utilize straightforward and useful charting tech-
niques. A sample basket portfolio strategy, the Basket Case Portfolio, is introduced.
Chapter 6 acknowledges the ongoing debate between active and passive man-
agement and suggests a portfolio management approach to blending them. Based
on a comparison between the capitalization-weighted and equal-weighted S&P
500 returns, two variants are introduced to ascertain whether active or passive
investment is more likely to succeed. Next, a method for determining the appro-
priate blend of the diversified core indices using an iterative historical value at
risk computation is presented.
