Archive for the ‘Exchange Traded Funds’ Category
Why Trade Exchange Traded Funds
June 18th, 2009
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Exchange Traded Funds
During the 1990s there was an incredible flow of assets into the mutual fund market, as investors became acclimated to the period’s hottest investment vehicle that brought the benefits of professional money management to the ‘Main Street’ investor.
Well, more than 10 years have passed, and now there’s a hot new investment that’s caught everyone’s fancy, as active asset management has become a more acceptable course. I’m speaking about exchange-traded funds, or ETFs.
An ETF share represents an ownership stake in a basket of stocks. These baskets can represent any number of entities, including a specific index (S&P 500 Index, Nasdaq 100), segment of the market (small caps, large growth stocks), sector (semiconductors, retail), or foreign country (Japan, China). Others represent holdings in bonds, gold, silver, or other commodities. The value of the ETF is tied directly to the value of the underlying securities.
While ETFs sound a lot like a mutual fund, there are a number of important differences. ETFs are bought and sold throughout the trading day just like stocks. Their price changes instantaneously, whereas mutual funds are priced at the end of the day. Also, because most ETFs mirror an index, they are passively managed and therefore have lower expense fees (no loads, either, like many mutual funds). They do incur a brokerage commission, however.
ETFs can be shorted, traded with a margin account, and many trade options. You can trade ETFs using market, limit, and stop-loss orders. Finally, there is no minimum for ETF purchases. (A similar class of shares called HOLDRs – which are often mistaken for ETFs – is different in that they trade only in round lots.) In short, ETFs offer the diversification advantages of mutual funds and the flexibility of stocks.
Investor interest in ETFs has grown for a number of reasons, primarily due to their diversification, low expenses, and offerings that track a number of sectors. These attractive options have been made available at a time when the independent investor, or what the business refers to as the ‘retail investor,’ has found some comfort in navigating the market on their own to find above-average returns. This mindset is due to the availability of research and trading tools via the Internet and years of watching the professional managers of typical mutual funds fall short of expectations.
But could too much of this goodness be a bad thing for investors? Let’s reflect on the growth in the industry. As of December 2006, there were 357 ETFs available for trading. That’s triple the number of three years ago. In fact, 153 new ETFs were launched for trading last year. Compare that to 2003, when only six new ETFs launched.
One would think that more options for investors would be a good thing. But this growth comes with some caveats that every investor should know. The first is liquidity. We currently track the daily activity of more than 200 ETFs that regularly trade. An easy gauge of liquidity is a stock or ETF’s average daily volume (ADV). The average ADV of the ETFs we track is 2.9 million shares.
While this appears to be very robust activity, it is rather deceiving.
Let’s drill down to the individual ETF level. Only 38 (19 percent) listed ETFs sport an ADV of more than one million shares, while 44 percent trade fewer than 100,000 shares per day. (Again, this is of the ETFs we track.) To put this into perspective, the average S&P 500 stock has an ADV of 5.5 million. A little further down the liquidity chain, the average ADV of a Russell 2000 Index stock is 542,000 shares. Only 45 ETFs have an ADV of 542,000 or better.
Since lower liquidity typically translates into less favorable pricing, there is a very real risk that the ETF that you see as the perfect addition to your portfolio may be priced poorly. Buying a poorly priced share of anything (ETF, stock, option) means that you may end up at the mercy of an individual establishing the price rather than a robust market.
In addition to the liquidity issue, the ETF market’s increasing diluted landscape is also creating another potential risk – the loss of diversification. Like a mutual fund, ETFs offer diversification of one’s investment dollar. But many of the new breeds of ETFs that are hitting the market are taking an ultra-focused approach. It’s been called ‘ETF pollution.’
Take, for example, the HealthShares Cancer ETF (HHK), which focuses on companies that are involved in cancer treatments. While this fund currently invests in 22 stocks, it is hardly diversified. There’s little doubt that HHK will experience a lot of volatility based on company-specific risk. This potentially washes out the diversification benefit typically offered by ETFs.
The potential diversification dilution (can we call it ETF pollution dilution?) brought on by the continued release of these more exotic ETFs offers potential risks that investors may not be considering. As such, it’s just as important to consider the hidden risks of a particular ETF as it is to properly analyze the sector the ETF represents.
I like to wrap up these columns with a ‘So what?’ finish, so here goes. The evolution of ETFs has provided investors with a terrific opportunity to build a portfolio geared to truly outperform the market in any market environment. The cost associated with this benefit is that you need to separate the wheat from the chaff in the ETF world along with doing your regular analysis of the underlying sector. Only by doing both will your portfolio achieve the alpha performance you seek.
I follow this process in my Sector Profit Alert trading service, which recommends only those ETFs that won’t have liquidity issues. There are plenty of alternatives to choose from, from both the long and short side, without having to resort to these ’boutique’ ETFs that are all the rage now. I stick to the basics to take advantage of the benefits that ETFs were originally intended to (and still do) offer.
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