Index funds have long been promoted as a way for investors to get broad diversification at a low cost. They?re efficient, effective, and easy to implement. Exchange-Traded funds (or ETFs) have become extremely popular in the past few years, even though they existed in 1993. There are currently over 160 different varieties now available with total assets of $250 billion. While ETFs share many characteristics with indexed mutual funds, there are some significant differences which allow for strategies to enhance your returns while minimizing your risk.
Differences Between Index Funds & ETFs:
ETFs trade like individual stocks.
Unlike mutual funds, which are priced and available for purchase only at the end of each trading day, ETFs trade continuously throughout the day like individual stocks. You can also do other 'stock-like? things, including: buy them on margin, short them, use limit and stop orders. For example, if you?re bearish on the market, you can bet against the SPDR Trust, the ETF that tracks the S&P 500, by shorting it.
ETFs are diversified.
Like mutual funds, ETFs hold multiple stocks and track almost any index, sector and country. In fact, it's easier to invest in certain market niches using ETFs than traditional index funds, because in some cases there aren't any index funds following the less prominent indexes and market segments.
ETFs are more tax efficient than regular index funds.
Index funds are known for being very tax efficient, since by their very nature they rarely sell stocks from their portfolio, triggering capital gains. In addition to sharing this benefit, ETFs also avoid the possibility of having to sell stocks from their portfolio to meet redemption requests. When ETF owners want to sell, they do so on there own in the open market with other buyers and sellers, so there's no need for any stocks in the underlying portfolio to be sold to raise cash, even in the event of a big sell-off.
ETFs can be cost effective.
There are no A, B, or C shares with ETFs, you simply pay the broker commission wherever you trade (which can be under $10 at some on-line brokerages). This would make ETFs less attractive for those that dollar-cost-average on a monthly basis.
ETFs have funny names.
Don't be thrown off by terms like Spiders (SPDR), Vipers (Vanguard), iShares (State Street), etc. These refer to the either the index the ETF represents or the firm that represents them.
Your Investment Philosophy Determines Your Use of ETFs:
If you are an Index Fund junkie, then simply finding the ETF alternative and comparing the above noted differences and the fact that the internal expenses of ETFs are even lower than Index Funds, would be your course of action in determining if they are right for you.
My investment philosophy begins with the premise that active management provides better long-term results with lower volatility than index investing. That is a discussion for another article; however, there is clear evidence that while Index Funds outperform the majority of active managers in up markets, they are quite handily beat in flat and down markets.
An example of this would be a fee paying client of mine who preferred investing on his own with Index Funds as opposed to utilizing my investment services. During our 2001 review, following the negative returns of 2000, I asked him one simply question: ?How did you like your index returns this year?? Of course, I knew that the S&P 500 was down -12% for the year and down -9% the year before. He responded 'terrible,? and I went on to say that my parameters in determining which fund managers I select, are based upon how they do in the down and flat years (?87, ?90, ?94, ?00, ?01, and ?02). I like to know that there is a ?pilot flying the plane,? who can pull up and move to cash, if need be. In the case of Index Funds, most investors are not paying attention and the autopilot takes them right into the ground. To drive home my philosophy, I said, ?In 1997, a great year in the market, the S&P 500 was up +33%, while the Large Cap manager I was utilizing with clients, Dodge & Cox Stock Fund, was only up +28%. That's a 5% difference plus fees. But? in 2001, while the S&P 500 was down -12%, Dodge & Cox was up +9%, a 21% swing.?
My experience tells me that people get less angry with ?not making as much? versus losing money. So, given this information, how can you enhance your returns using ETFs?
Sector & Country Bets with Strict Sell Orders!
With their low cost and increasing diversity of offerings, ETFs are a great way to invest in a sound industry without the risk of choosing the wrong companies. Instead of buying 20 to 30 stocks (and paying a commission for each), you can buy one ETF. One of the most popular ETFs is the QQQQ, which tracks the Nasdaq 100, which includes companies like eBay, Intel, Starbucks and Apple. Two sectors that I have been in the past few years are Energy and Utilities.
The Energy Select Sector SPDR (XLE) owns 29 energy related stocks, including Exxon/Mobil, Devon Energy, and Occidental Petroleum. It has an expense ratio of only 0.27 and returns for my clients have been 26.32% in 2003, 33.46% in 2004, and 40.18% in 2005.
The Utility Select Sector SPDR (XLU) owns 33 electric and gas utilities, including Duke Energy, Southern, and Dominion Resources. It has a 3.6% dividend yield, a 0.27 percent expense ration, and has returns of 25.80% in 2003, 23.86% in 2004, and 16.31% in 2005.
Are returns in these sectors always this high? No. Should you rush out and put money into them now? Probably not. Is there a way to reduce your risk while seeking to capture higher returns in various sectors (Health Care, Financials, Info Tech, Biotech, Telecomm and Materials, to name a few)? Yes!
Even though I believe in active management, I am not a 'short-term? trader. Besides determining what sector to be in and when to purchase, the next tough decision is when to sell. I adhere to a strict selling strategy of 10%. When I make a purchase for a client, I always put in a sell order 10% below our cost basis. Then, when the price goes up, I increase the sell order to maintain that 10% differential. If the market drops significantly in the future, we?ve captured our gain and don't ride that sector down. If our cost basis drops right after our purchase and we sell right away, we limit our downside loss and live to fight another day.
Another asset class that shows a great deal of promise with ETFs is Region or Single Country investing. While the U.S. economy chugs along, other, less mature markets are growing more quickly. I will typically hold a Core international fund for clients, my favorite being First Eagle Overseas, which has never had a negative return and was up 5.68%, 5.35% and 12.53% respectively in 2000-2002 when the U.S. markets were down. Unfortunately, success has caused that fund to close, so I am recommending Dodge & Cox International Stock Fund to new clients. I then surround this core holding with country specific ETFs. For example, iShares MSCI South Korea (EWY) affords U.S. investors the opportunity to own tech giant Samsung, which is only available on the Korean exchange: steelmaker Posco, Kookmin Bank and Hyundai Motor also figure prominently. Returns in 2003 were 33.74%, in 2004 they were 18.22% and in 2005 EWY was up 55%. Two other country specific ETFs I initial purchased a few years ago, due to their low PEs in relation to other countries, were iShares Brazil Index (EWZ) and iShares Belgium Index (EWK).
While ETFs are not for everyone, they do provide some distinct advantages over mutual funds. Not only do they provide an opportunity to decrease your fees and enhance your investment returns, but if strict limit orders are put in place and updated periodically, you can also limit your downside risk. If you?ve never looked into ETFs before you should make it one of your New Year's Resolutions!