Category Archives: Specific Concepts

Following FINRA’s changes to the Series 7 Content Outline in late 2011, exchange-traded funds (ETFs) became a topic that is a potential test item students may see on their exam. You can read more about ETFs in our Study Manual, but let’s visit them briefly here.

Exchange-traded funds are investment companies, either open-end or unit investment trusts, that differ from mutual funds in the way they are issued, traded, and redeemed. Investors can buy ETFs that track essentially every sector of the equities markets, as well as ones for fixed-income securities, commodities, currencies, metals, and hedge funds. Most recently, ETFs have been created that are leveraged 2 or 3 times to an index, as well as ones that are leveraged to the inverse of an index. We will discuss leveraged and inverse ETFs and the concerns they raise in a separate blog. For now, we will focus on traditional ones and the ways they differ from mutual funds.

One disadvantage of a mutual fund is that there is no secondary market for its shares. Shares can be redeemed only by the mutual fund company. Since shares must be redeemed at the fund’s closing net asset value (forward pricing), the investor does not know the full redemption value of the shares until the market closes for that day.

The inconvenience of forward pricing may be apparent especially in circumstances where an investor is engaging in a same-day substitution, selling a mutual fund with the intention of using the proceeds for the purchase of another securities product. If the full redemption price of the mutual fund is not known, it is difficult to invest in another product simultaneously with the sale of the fund. This problem is most critical in a tax-deferred account where the customer may have limited funds to invest without making additional contributions.

ETFs do not have forward pricing. They trade in the secondary market and can be purchased or sold anytime throughout the trading day. Therefore, the liquidation value is known immediately and the investor can reinvest the proceeds without delay. It is easy to move in and out of most ETF positions. However, this ease of purchasing and selling ETF shares can cause inexperienced individuals to make inappropriate trading decisions. They may find themselves entering and exiting a position more frequently than necessary, generating excessive commissions that outweigh any gains they may have realized.

There are management fees and administrative costs associated with both mutual funds and ETFs. These fees and costs increase the expense ratios of both. Active management results in higher management fees and administrative costs. Actively managed mutual funds have the highest expense ratios. Passively managed index mutual funds have expense ratios that are lower than actively managed funds because management fees and administrative costs are lower.

Since mutual funds are purchased and redeemed directly from the issuer, they may not be sold short. Selling short and rapidly covering is attractive to the short-term trader, and also to a money manager who wants to take short positions in overvalued sectors to hedge long bets made on stocks. Since ETFs may be sold short, they have an advantage over mutual funds.

Mutual funds may not be purchased on margin. ETFs may, and, in the hands of experienced investors, can enhance returns. If the wrong investment decisions are made, however, margin can amplify losses and have a negative impact on an investor’s portfolio. Consequently, the use of margin may be suitable for some investors but not for others.

An actively managed fund will produce capital gains as its managers buy and sell stocks, which the fund must pass on to its shareholders once each year. This means that investors may incur capital gains taxes even if the net asset value of the mutual fund has actually declined in value or remained the same.

As with index funds, ETFs tend to minimize capital gains taxes since their turnover is usually low. ETFs can be redeemed the same way, minimizing the purchase and sale of securities within the fund. Traditional ETFs will remove securities and replace them only when the underlying index changes and the fund must rebalance its holdings.

While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a small number of questions about ETFs.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

Recently, U.S. equity markets updated their market-wide circuit breakers rule. For those unfamiliar with circuit breakers, they are used to protect investors from a huge decline in overall stock prices.

STC has written a summary of the updated rules.

The changes in the circuit breaker rules, which are designed to address extraordinary volatility across securities markets, include (1) replacing the DJIA with the S&P 500® Index as the reference index, (2) recalculating the values of the triggers on a daily basis rather than quarterly, (3) reducing the market decline trigger percentages, (4) shortening the length of the trading halts associated with each market decline level, and (5) modifying the times when a trading halt may be triggered.

 Trigger Value Time Action (all times Eastern Time)

 Level 1: 7% decline between 9:30 a.m. and 3:25 p.m.—15 minute trading halt

Level 2: 13% decline between 9:30 a.m. and 3:25 p.m.—15 minute trading halt

Level 3: 20% decline anytime trading halts for the remainder of the day

 At or after 3:25 p.m., trading will continue unless there is a Level 3 halt.

The Dow Jones Industrial Average (DJIA) was used as the benchmark for the old circuit breaker rule. It’s actually one of the oldest financial benchmarks in the world, created at the end of the Nineteenth Century. It was named after the persons who created it, Charles Dow and Edward Jones. Their intent was to create an overview of U.S. stock prices. There was actually a transportation index created before the industrial index, creatively called the Dow Jones Transportation Index.

The industrial index was composed primarily of industrial companies. Dow and Jones may have been financial pioneers, but they lacked pizazz when naming things. Anyway, the index originally had companies dealing with rubber, coal, electricity, and natural gas (i.e., industrials). The index is now comprised of industrial juggernauts such as Disney, Microsoft, and Bank of America, which aren’t really industrial companies so the name really doesn’t fit anymore. Nowadays, the Dow Jones Industrial Average is really 30 of the best companies in the U.S., regardless of the industry they’re in.

The most important aspect of the DJIA is how the value is calculated. It is price-weighted. To determine the value, the prices of all 30 companies are added and the result is then divided by the number of companies in the index.* The denominator, also known as the Dow Divisor, started off as the number of companies in the index, which created the average** that most people are familiar with. Over the years, the Dow Divisor needed to be updated for spinoffs, stock splits, and stock dividends. We’ll skip the adjustment calculation, but today the divisor is about 0.13, which means the index value is greater than the sum of the prices of the stocks. It doesn’t look much like a typical average.

The other issue with the Dow (and really any price-weighted index) is that it doesn’t reflect changes in total value or market capitalization of the index. Let’s simplify things a bit and say the DJIA only has two stocks. Company A is relatively small, has only100 shares outstanding, and a market value of $100. Company B has 1,000,000 shares outstanding and a market value of $10. Company A has a market cap of $10,000 (100 shares x $100) and Company B’s market cap is $10 million (1 million shares x $10). Economically speaking, Company B is contributing much more to the total value of the U.S. stock market. However, changes in Company A’s price will have a larger effect on the index because one of its shares is worth 10 times as much as Company B’s ($100 compared to $10). In short, price-weighted indexes (e.g., DJIA) make no adjustment for the total value of a company. They simply consider the value of a single share.

*Formula form:

(Σ (Stock Price))/(Number of Companies in the Index)


(Σ (Stock Price))/(Dow Divisor)

**It’s officially an arithmetic average in case the math police are reading this.

The flaw in a price-weighting index became a bigger issue as U.S. equity markets became more valuable. Industry analysts began using a new index valuation method—market-value indexing. Market value (capitalization-weighted) indexes use a weighted average to calculate the index’s value. To derive the value of a market-weighted index, add the number of shares outstanding multiplied by the market price of the shares for each company in the index and divide by the total number of shares for each company in the index.***  I’ll admit that’s a bit of a simplification. In reality, the denominator, the number of shares, will need to be adjusted for spinoffs, stock splits, and stock dividends, much like the Dow Divisor. By taking a weighted approach, price-weighted indexes tend to more accurately represent the total value of the shares in the index. Small companies no longer have a large effect on the value of the index, unlike the DJIA.

***Formula form:

(Σ (Price x Quantity))/(Σ Number of Shares)


(Σ (Price x Quantity))/Divisor

There are quite a few market-weighted indexes. In fact, the Dow is somewhat unique as a price-weighted index. The circuit breaker rules now use the S&P 500, which tracks some of the 500 largest market cap stocks in the U.S. The specific companies that make up the index are chosen by a committee. The methodology can be read about here. While the S&P is a broader index than the Dow, its goal is the same—to provide a summary of the U.S. stock market. The S&P 500 Index is also calculated a bit differently than described in the previous paragraph. Instead of using the total number of shares issued, the S&P uses only the number of shares freely available (public float), which is known as float-adjusted weighting. In finance, creativity is never wasted on naming things. The difference is sometimes significant, but won’t really change the basic understanding of market value indexing.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

Following FINRA’s changes to the Series 7 Content Outline in late 2011, exchange-traded notes (ETNs) became a topic that is a potential test item students may see on their exam. You can read more about ETNs in our Study Manual, but let’s visit them briefly here.

Essentially, an ETN is an unsecured debt obligation that may be worth much more at maturity than its purchase price depending on the performance of the assets or index to which it is linked. The dealer adjusts the intraday and closing indicative values based on the performance of the linked index. The market price often closely tracks that value, although there may be variations based on supply and demand. Unlike an exchange-traded fund (ETF) that is subject only to market risk, ETNs are subject to both market risk and credit risk. The price of an ETN will also reflect the credit quality of its issuer. As a result, an investor must review the liquidity of any given ETN as well.

Although ETNs must be registered under the Securities Act of 1933, they are not classified as investment companies. They are structured products that contain a debt obligation of the issuer that is linked to an index that represents a basket of stocks, bonds, commodities, interest rates, volatility, master limited partnerships, private equity, or metals. Derivative contracts are employed to provide the linked returns. An investor’s return is based on the performance of the underlying index, and ETNs are not principal-protected. If returns on the index are meager or nonexistent and fees outweigh appreciation, it is possible for the investor to experience a negative rate of return.

As with ETFs, ETNs can be leveraged or nonleveraged, inverse and noninverse. Those that are nonleveraged mirror the performance of the linked index. Those that are leveraged can return two or three times the return of the linked index. The values of inverse ETNs and inverse leveraged ETNs move in the opposite direction of the linked index. Similar to leveraged and inverse leveraged ETFs, leveraged ETNs are rebalanced daily or monthly and are best suited for short-term trading and not buy-and-hold strategies. They are not suitable for long-term investors because the daily or monthly rebalancing of leverage could result in the leveraged compounding of losses.

ETNs can experience large price swings when issuers increase or decrease the creation of notes. For example, if an issuer stops creating a popular ETN, demand may outstrip supply, causing prices to rise. When the issuer begins creating notes again, supply will increase, causing the ETN’s price to decline.  Investors who bought the ETN at its elevated price may experience a loss if they need to liquidate their holdings at the subsequent depressed prices.

Unlike ETFs, ETNs can be called at the discretion of the issuer. If an issuer finds that a particular issue or group of issues lacks investor interest, the issuer might call the ETN. Investors receive the ETN’s indicative value, based on the performance of the linked index less fees. This may result in a gain or a loss depending on the ETN’s purchase price.

While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a small number of questions about ETNs.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

As an instructor, there are some concepts that are more difficult to explain than others. Because time is limited, advanced concepts that aren’t heavily tested are compressed. In Series 3, contango and backwardation markets are a good example. Today, we’ll attempt to give contango a more robust explanation than we would in class.

Contango doesn’t even sound like English, and it’s never been entirely clear to me whether it’s a noun or a verb. Contango is actually a mispronunciation of the word continuation. Simply stated, a market is in contango when the forward or futures price is higher than the spot (cash) price. In a contango market, the further you continue along the forward curve, the higher the prices are.

A market in backwardation has a higher cash price, with futures going progressively lower. Since most of the time markets are in contango, the term backwardation, which is the opposite of contango, comes from the idea that the market is abnormal or backward. So far so good, and if you’re just looking for answers to questions on your exam, this is the extent of what will be asked. But we promised a robust explanation, so let’s continue.

As we’ve said, a market is in contango when futures prices are higher than spot prices. So, what causes it? The futures premium is usually caused by the costs of holding onto the commodity. This is known as the cost of carry. For example, if I own 20,000 bushels of wheat, I’ll need to put it somewhere. It’s not going to fit into my apartment, so I’ll have to pay storage costs plus insurance and financing (i.e., carrying charges). What if I bought a futures or forward contract instead? Well, I wouldn’t have to worry about storing anything until delivery, which is typically preferable.

Predictably, the convenience of owning futures over the spot (cash) commodities causes futures prices to rise above the spot price and, before you know it, you have a contango market. The further into the future you look, the higher futures prices will be. The comparison of near and far delivery futures contracts is known as the forward curve. In a contango market, the forward curve is positive (i.e., upward sloping).

If a market is in contango, what will happen to prices in a few months? As students of commodities know, the spot (cash) price and the futures (forward) price must be the same upon the arrival of the delivery month. If they’re not, traders can arbitrage the difference, which will drive the prices closer anyway. In a contango market, either futures prices must fall or cash prices must rise as the delivery month approaches. So, which is it?

Historically, the futures prices will fall to meet the spot price as the delivery month approaches. This has been a problem for investors that bought commodity ETFs, which are typically long futures, not the spot commodity. As delivery nears, futures prices fall and the ETFs lose money, even if the underlying cash price isn’t moving at all. Most ETFs have the option to choose whether they buy futures or the cash commodity, which makes it difficult for retail investors to know the risks of an ETF portfolio at any given time.

Profits can be made in a contango market by those holding the cash commodity. Assuming we had a spare oil tanker lying around, we could buy spot crude oil and sell futures. As the delilvery month approaches, we will profit on our futures position as the futures price falls, and we deliver the oil in the tanker. In some instances, there has been more oil in tankers just sitting around in a contango trade, than actually being sent somewhere. This type of contango trade will be profitable, as long as the futures premium keeps exceeding the cost of carry.

If contango is normal, then what causes the market to be abnormal? The short answer is a shortage of the cash commodity or a spike in demand. Under these conditions, the futures price will be lower than the spot price, which is called backwardation. In fact, the longer delilvery contracts will have lower prices than the near-month contracts. This means that the forward curve is negative (i.e., downward sloping).

Just as in a contango market, futures prices and cash prices must meet at the time of delivery. In backwardation, futures prices tend to rise to meet the cash price as the delivery month approaches, which is similar to how futures prices fall as the delivery month approaches in a contango market. This means that long futures positions will tend to profit and short positions will tend to lose. This can be especially problematic for producers of a commodity such as farmers, who sell futures to hedge. Profits can be made in backwardation by buying long-dated futures and then selling in the cash market at delivery. Some traders will also buy long-dated futures and sell near-dated futures, which is called a calendar spread.

Thanks for spending time with us. We hope you found it worthwhile.

-Securities Training Corporation