Monthly Archives: March 2014

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