ETFs - A Superior Trading and Investment Vehicle

The ETF, or Exchange Traded Fund, has grown from consisting of a handful of broad-based index products, to now consisting of hundreds of products representing almost every conceivable investment theme or idea. Volume has expanded on many of the issues, making them some of the most liquid trading instruments around.

It seems clear that the debate between choosing a traditional mutual fund or an ETF is clearly in the corner of the ETF. ETF fees are much lower than mutual funds, and even factoring in the small brokerage commission applied to an EFT, the savings in fees will make up for the commission many times over. And, some brokerage firms that deal in no load mutual funds will charge a commission to get out if not held a certain length of time. There is no restriction on the holding period of an ETF. And with and ETF you won’t get hit with capital gains distributions, so, with the exception of dividends, you get to control when you pay capital gains, short term or long term. You can get in and out during market hours instead of just the close, and there is the ability to easily trade on the short side with most of the active ETFs, with no uptick rule. And there are options available for outright purchases, or for hedging, or for other option strategies. Also, there are ETFs that have leverage, and some that will be inverse to their index, so a long-term short position could have long-term capital gain potential.

The comparison between ETFs and CEFs (closed-end funds) is a bit different. With CEFs, which are somewhat similar to ETFs, you have a security that can trade on its own supply demand; therefore the fund can go to a premium or a discount to its net asset value, sometimes substantially. With CEFs there is also the chance of dilution if the firm wants to issue more stock, usually with an offer for existing shareholders to purchase more shares at a predetermined price. While brokerage commissions will be the same as with an ETF, the management fees will usually be higher with CEFs. CEFs will often target a more specific type of investment, whereas ETFs are usually more broadly index based. However, that has been changing over the last couple of years.

There are more and more ETFs being issued almost daily with very specific objectives. You can find an ETF for almost any country, style, sub-sector, commodity, and even for currencies. There are so many ETFs coming out, it is getting hard to sort through the list. One way to pare down the list is to look at monthly average trading volume. Liquidity is certainly an issue, as some of the newer, narrowly focused ETFs have very low trading volumes, with correspondingly wider bid ask spreads, while the most popular choices are extremely liquid, with a penny or so spread between bid and ask. In time the best will survive, and many too-specific issues will disappear. In my opinion, some of the too narrowly focused issues defeat the purpose of investing or trading in ETFs.

In comparison to individual stocks, there are valid arguments on both sides of the issue. One theory favoring stocks is that you can just pick the best stocks in whatever group or index you are interested in, and not be weighted down by the dogs of the group. That’s true. Of course, that depends on you being an excellent stock picker. Roughly 85% of professional, full time mutual fund managers can’t beat a benchmark such as the S&P 500. Individual part time investors think they can do better than professionals. I’m not so sure.

It is difficult enough to pick the direction of a market. Much of the movement of a stock will be influenced by the overall market direction. Some say stock movement is about 70% dependent on overall market direction. I can’t verify that number as being correct, but it seems in the ballpark. Picking an individual stock on top of picking market direction adds a second variable. If 70% of a stocks movement is influenced by the overall market, and 85% of professional stock pickers under-perform benchmark stock indexes, it doesn’t seem worth the effort to try to sort through the list of thousands of stocks for the small chance of making a larger gain.

It is always gratifying to pick a stock that goes up 200% while the overall market is only up 8%. How many stock picks do this? It is easy to fool ourselves into thinking we know something other people don’t when we do pick a big winner. But what is the net result of all the stock picks over a period of years. How many stock picks are down 10% with the market up the same 8%? If you diversify your portfolio, it will probably average out. If you diversity enough, and your stock picking is good, you will probably mirror the indexes. If your have a couple of stinkers in your portfolio then you will probably under-perform the indexes. If you add human emotion and refuse to get out of the stinkers until you break even on those, you might end up severely under-performing the indexes. We all have the same information to work with. It is the information we don’t have that will blindside us. It is only our biases and our opinions on the information that we do have that will influence our trading decisions. And, of course, there is a lot of guessing, as long as we do it with the appearance of authority. Is stock picking with the limited amount of information that we have the best approach?

Since most professionals try to beat the indexes and fail, it seems less likely that individual investors can beat the indexes in the long run. So does one have to accept average returns in an index fund if stock picking proves not to provide the desired returns? Not necessarily. Another approach is to try to beat those returns with a combination of asset allocation and market timing. By not focusing on individual stocks, one is not as concerned with company specific issues such as earnings release dates and guidance disappointments, or with worrying about CEO option backdating, or bookkeeping irregularities, or many other assorted insider problems. Without having to baby-sit a portfolio of individual stocks one can better analyze and assess broader, more accessible issues such as which sectors are trending, which countries are in bull or bear markets, which styles are leading and which are lagging. Superior returns on the more active ETFs can also be enhanced by the use of option strategies which have liquidity and pricing advantages over many individual stocks.

If your stock picking performance over the long run has not kept pace with the main benchmark indexes, you might try picking a small number of active, liquid ETFs representing different sectors of the economy, different countries, different styles. Then concentrate your efforts on that small basket. Try to determine which are trending up and which are trending down. Trade accordingly. Rebalance on a regular basis. You might find you’ve created your own hedge fund without the high fees.

Doug Tucker has a blog with daily commentary on stock indexes, precious metals, and other markets. There are many articles on technical analysis and indicator design and interpretation. To visit go to: http://tuckerreport.com/

options backdating | stock option backdating

How Steve Jobs Personally Benefited from Options Backdating at Apple Computer

Apple Computer stock dropped recently after the San Francisco Recorder, a legal newspaper, said Federal prosecutors are examining Apple’s stock option documents to decide whether to file criminal charges. That was an escalation from the previous level of expectations. Some of the stock’s cheerleaders are saying it won’t hurt Apple or Steve Jobs, and there is not a chance he will be leaving Apple.

I think that’s wrong, or at least expresses a lot more certainty than any outsider could know. The other, quieter announcement was that Steve Jobs has “decided” that he needs to hire his own attorney to deal with the SEC and the Justice Department from now on. Up to now, he has been represented by the company’s outside law firm.

One of the big advantages of being in and around Silicon Valley for 25 years is the déjà vu effect. I have seen this before. CEOs usually don’t hire their own counsel until the company counsel tells them that the company’s interests and the CEO’s interests have diverged. In other words, if Apple’s counsel has seen enough to believe the company was hurt and the CEO was involved in it, they have the potential of representing the company in a lawsuit against the CEO, and therefore have to advise him that they can no longer represent him..

Now that the company has admitted Jobs knew about the backdating, I think the next announcement we will see is that Steve Jobs has been notified he is the target of a criminal investigation, and then the Board will have a very difficult time doing anything other than suspending him until the investigation is over.

I think these things because I have been through the numbers, including what I believe is the largest stock option grant ever, to Steve Jobs in January 2000.

Overall, since the current proxy disclosure rules started in 1994, Apple made 15 rounds of options grants through their September, 2002 fiscal year. If you look at the price of those grants compared to the annual range of the stock for the six months prior to the grant and the six months following the grant, all 15 should average somewhere around the 50th percentile of the annual range. Some grants made right before the stock declined would be in higher percentiles, while others made right before the stock shot up would be in lower percentiles. But averaging all 15 rounds together, it seems reasonable to expect the 50th percentile if no funny business was going on.

Apple’s grants average in the 15th or 16th percentile. That is powerful evidence that a company backdated, or at least granted options right before they had reason to believe the stock was going to jump. Of course, Apple has now admitted that they backdated options, and Jobs knew about it

There are three transactions the SEC and Justice Department probably are looking at for backdating. One was on July 11, 1997, when Apple repriced options and executives turned in old options with a $7.44 strike price for an equal number of new options with a $3.31 strike price. There were only two other days in the 1997 fiscal year when the stock closed at a lower price. On August 6, only 26 days after the repricing date, the stock jumped 33% and then added another 11% on August 7. The question is whether someone decided on August 8 that July 11 would have been a great day to make the repricing effective.

A second case was January 17, 2001, when four top officers (not including Jobs) got options totaling two million shares at $8.41 a share. A few months before, on the last business day of the 2000 fiscal year, September 29, AAPL was cut in half when they preannounced an earnings shortfall. It kept dropping to the $8.41 option price, and then staged a nearly 60% rally in four months.

The third and most serous case is the giant 40 million share (split-adjusted) grant at $21.80 a share to Jobs on January 12, 2000. This one is a bit tricky, as the company has said Jobs “didn’t benefit” because the stock eventually went below the option price. But here’s what really happened.

In the previous 26 trading days, AAPL fell 26%. Jobs then got his grant on the exact day the stock hit its low, and the stock rose 65% in the following 10 weeks. The issue, again, is whether someone decided in February or March that January 12 was a great day to price the boss’s options, it being the lowest price for many months. AAPL stock eventually went below the option price, and the options were cancelled. The company says due to “irregularities in the grants, the options were canceled and resulted in no financial gain to the CEO.”

Oh, really? This bunch of options would have expired in January 2010. Apple’s stock kept declining in the tech bear market, so the Board gave him 10-year options on another 15 million shares in October 2001. But the second batch went underwater, too, and on March 19, 2003, Jobs “voluntarily cancelled” all 55 million options. That’s why the company claims there was no financial benefit to him from the perfectly-timed 40 million share grant.

But the Board of Directors Compensation Committee report for that year disclosed that “in exchange for his cancelled options” Jobs was given 10 million split-adjusted shares worth around $75 million at the time. They were restricted from sale for three years, and when they became free to trade on March 19, 2006, they were worth $640 million. Not bad!

Here’s the rub, and I am indebted to compensation consultant Graef Crystal for doing the calculations. How did Apple’s Board decide on the number 10 million shares? Almost certainly, they used an options pricing model to calculate the current value of the options, which still had seven and eight years to expiration. Even though they were underwater on that day, the long time to expiration gave them value. Crystal used the Black-Scholes option pricing model to calculate the current value of the 55 million options: $77 million. That’s close enough to $75 million to believe this was their methodology.

But remember that the value of the options also depends on their strike price, and the very favorable strike price on the first 40 million grant raised their value quite a bit. If the strike prices of the two contracts had been set at the 50th percentile of the daily closing prices in their respective fiscal years, the calculated value on March 19, 2003 would have been $10 million less, around $67 million. So the Board might have given him, say, $65 million in shares instead of $75 million, or 8.7 million shares instead of 10 million. Those 8.7 million shares would have been worth $557 million when the sale restrictions expired on March 19, 2006, instead of $640 million. That’s an $83 million difference.

Yet in an October 4, 2006 filing with the SEC, Apple said: “In a few instances, Apple CEO Steve Jobs was aware that favorable grant dates had been selected, but he did not receive or otherwise benefit from these grants and was unaware of the accounting implications.” He didn’t receive the grants? He didn’t benefit from the grants? What about the $83 million? Get real.

It now appears that the paper trail around the October 2001 grant (7.5 million shares at the time; 15 million split-adjusted) was falsified. Recently, Apple has been saying that, yes, there was something wrong with the first and maybe both of these grants, but Jobs was not aware of the “irregularities.” But Jobs also was CEO of Pixar at the same time, which also appears to have backdated stock options. So he is the only CEO of two companies caught in this scandal, and it looks to me like someone on the East Coast has decided to teach the freewheeling entrepreneurs on the West Coast a little lesson by nailing a very big target. I still think there is a substantial risk that Jobs will be forced to leave Apple, and therefore it is too risky to step into the stock yet.

Michael Murphy, CFA, has been a technology stock analyst for over 35 years. He founded the first technology investing newsletter, the California Technology Stock Letter, in 1982. He now writes New World Investor, a weekly advisory letter, with more information available at [http://www.NewWorldInvestor.net].

Article Source: http://EzineArticles.com/?expert=Michael_Murphy

gregory reyes | options backdating

Estimates on How Much Companies Will Spend to Resolve the Options Backdating Issue

First some answers on a not so serious note:

1. Make an estimate, then multiply by 2, divide by 0.134263 and take the square root after adding Pi times the estimate times 12.345

2. Use a dart board and get some friends together to change the numbers to very high 8 figures. The one person that hits the same estimate range on the dart board 3 times is the closest to the estimate.

3. Take a wild swing and at the end of the report, cite the analyst firm IMTSU 2006 (I Made This Stuff Up).

There are 3 portions to the cost of resolving the options backdating issue:

1. Tangible costs - Regulatory fines and expenses - Internal investigation fees - Audit investigation fees - Documentation & restatement fees - Back tax dues and penalties and interest - Share holder lawsuits: Settlement fees, Defense fees

2. Intangible costs - Market capitalization loss - Employee turnover (not easy to guesstimate, but rest assured there will be some) - Internal & external communication expenses - (If delisted): stock appreciation opportunity costs

3. Variable expenses - Reduced revenue from customer becoming nervous about purchasing products

For the 3 companies we have worked with estimating $100 Million for a $3-5 Billion market capitalization in Tangible costs alone is on the average side.

http://blog.vangal.com

backdating crime | greg reyes