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In 20th-century investing, stocks and bonds were different and reasonably simple. Stocks were all about capital gains, risks, dividends (sometimes) and opinions, while bonds were about safety, income, ratings and a little bit of mathematics. Many of these notions have been altered since the appearance of ETFs and structured products in recent years, giving us income-oriented products based on stocks and risk-focused instruments built from bonds. To some extent and for some investors, too many choices mean confusion, not opportunity.
The good old simple days were easy to explain. Stocks are a share in ownership and a claim on uncertain profits—uncertain because everything else must be paid before profits are earned. On the positive side, profits may have virtually unlimited upside. That upside can inspire wild dreams, and those dreams may turn into stratospheric price gains even if the profits lie far in the future. Of course, sometimes the rush to the stratosphere becomes a bubble. Dividends encourage shareholders to stay the course when few believe that profits will surge and sustain share prices. Evaluating and choosing stocks is as much a beauty contest as an analytical challenge.
Bonds represent a senior claim on revenues among all those claims that come before profits. Bonds offer a promise of both income and eventual return of the principal investment with the solemnity of the promise being independently rated. Some differences among bonds depend on the mathematics of bond pricing: Bonds with unusually large coupons or short lives respond very differently to interest rate changes than seemingly similar bonds with low coupons or long lives. Bonds can also differ by the ability of the bond issuer to pay interest and principal as promised. Compounding all these bond/stock differences were the market structures where almost all stocks are traded almost every day, so their prices reflected competing visions of the future, while few bonds trade on any given day, and their prices are often someone else’s best estimate.
ETFs—especially what one might call “second generation” ETFs—have changed all this. First-generation ETFs, such as those tied to the S&P 500, track a market or a clearly defined market segment and, through market-cap weighting, take on the investment and statistical properties of the market or market segment. Their lure is the efficient means to participate in the market—an investor looking to invest in large-cap stocks got large-caps stocks. On the bond side, there were some bits of subtlety since an index of several thousand bonds might be tracked with a portfolio of a few hundred issues, but the link to the market’s behavior was still very strong.
Second-generation ETFs, however, are blurring the division between stocks and bonds. Take low-volatility equities as an example. The extreme gyrations experienced in the equity markets in recent years worry many investors. Turning to bonds to escape volatility would mean trading hopes of capital gains in exchange for low coupon income. An “engineered” alternative would be a low-volatility index and associated ETF offering stocks selected and weighted for reduced anxiety or churning. The methodology might choose the 100 stocks of the S&P 500 that are the least volatile as shown by their daily returns over the last year, and then weight the index by the reciprocal of their volatility. Instead of tracking the large-cap U.S. segment of the stock market and all its statistical pluses, minuses and quirks, this index extracts a key previously hidden aspect—low-volatility equity behavior. The hopes for profits are retained and combined with the stability that was previously regarded as the province of bonds.
One can take this process much further. Bonds offer income from periodic interest payments. ETFs built from dividend-paying stocks and weighted by dividends or dividend yield include a “promise” of income. One can create a bond-behaving ETF with targeted income and stability, built solely from stocks. The mirror image is also possible—building stocks from bonds. Recall that the origin of the Black-Scholes option pricing model was a hedge equation that replicated a stock as an option on its price and a dividend stream based on a fixed-income instrument.
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2012
