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ETFs Unplugged
By: Carl Delfeld
Is your financial advisor missing a critical piece to the ETF?
Exchange-traded funds (ETFs) are great investment tools but most have a flaw
that investors and advisors usually miss. Let’s take a look under the hood and
introduce some new and innovative ETF products.
Essentially, ETFs are nothing more than an index fund that trades like a stock.
Because of their simplicity, flexibility, low cost and tax efficiency they are
growing fast. Last year the Barclays iShares family of ETFs brought in more new
money than the Fidelity mutual fund machine.
Diversification
Unfortunately, many investors and advisors are building portfolios of ETFs
without looking inside the box and seeing where the money is going. One of the
chief goals of a portfolio is diversification and many ETFs are not very
diversified. This is because the companies in the ETF are weighted by size –
specifically by the market value of its outstanding stock. This can result in an
unwise concentration of risk and uneven performance.
The index fund community’s preoccupation with market cap weighting may have a
strong theoretical basis but to me it is contrary to common sense. To be blunt,
I pay very little attention to it while building global portfolios for clients.
Most investors would agree that just because a company is bigger doesn’t mean
that it is a better investment. Let’s look at the most well known index – the
S&P 500 index. Many investors think that investing in the S&P 500 means that
their money is being divided equally between 500 companies. This is far from the
truth. Because the companies are weighted by size, 22% of your investment is
going to the ten largest companies in the index and 60% of your investment is
going to the largest 50 companies in the index.
Unequal Weighting, Unequal Returns
This is why I have been advising clients to invest in the Rydex S&P 500
equal-weight ETF (RSP) which weights each company in the index equally. In 2003
the equal weight S&P 500 ETF beat the S&P index by 11%, in 2004 it beat the
index by 5% and year-to-date it is up slightly while the S&P index is down.
In my book, “The New Global Advisor”, I ask readers a provocative question. If
you wanted exposure to the dynamic biotechnology industry, would you prefer to
primarily invest in a few large well know biotech companies or would you prefer
to spread your investment over thirty biotech companies? If you’re the former,
you might invest in the iShares Nasdaq Biotechnology ETF (IBB) whereby 25% of
your investment would go to three companies. For those that prefer broader
exposure including some small cap companies, I have discovered a new family of
ETFs called Powershares.
The new and innovative Powershares family of ETFs essentially creates its own
indexes based on rules-based quantitative analysis that they refer to as
“intelligent indexes.” This seems to me to be more useful than blindly following
market cap weighted indexes. There are two Powershares that I particularly like
at this point.
Two I Like
The first is the biotech Powershare (PBE) that contains 30 biotech companies. If
its holdings were weighted by market cap, two companies would account for more
than 60% of its holdings. Instead your exposure is spread among 30 different
companies with no company accounting for more than 5% of the total. 30% of your
exposure is to large cap companies, 26% is to mid-cap companies and 43% is to
small cap companies.
The biotech Powershare is an aggressive position so don’t get carried away. I
think it is a smart play on the tremendous opportunities for capital
appreciation in the biotech industry which is showing some momentum after
trading sideways since early 2004. The annual fee is only 0.60%.
The other Powershare that I like is the International Dividend Achievers
Powershare (PID) that contains 42 ADRs traded on U.S. exchanges. I am usually
not a big fan of ADRs since they usually trade at a premium to the underlying
security but they do offer some comfort to investors since they meet U.S.
reporting requirements and can be easily purchased on U.S. exchanges. The ADRs
in this Powershare have to pass a stiff test: five fiscal years in a row of
increased dividends. Again the top holdings are no more than 5% of the total
index and so you get great diversification.
A Better Way to Get Global Diversification
One problem with the most widely used international index, the MSCI Europe, Asia
& Far East Index (EAFE) is its concentration in Japan and the United Kingdom
which account for almost 50% of the index’s total value. Meanwhile exposure to
promising countries such as Ireland and Hong Kong are less than 2%. Last year,
this Powershares index beat the MSCI EAFE index by 7% and companies in the ETF
averaged a 29% return on equity. The index is re-balanced quarterly and has an
annual fee of 0.50%. Right now 67% of the companies in the index are large cap,
20% are mid-cap and 13% are small cap companies.
Getting the right blend of ETFs takes some time and effort. Remember that all
ETFs are not equal so choose carefully.
About the Author:
Carl Delfeld is head of the global advisory firm Chartwell Partners and editor
of the the "Asia-Pacific Growth" newsletter. He served on the executive board of
the Asian Development Bank and is the author of "The New Global Investor." For
more information go to http://www.chartwellasia.com or call 877-221-1496
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