How Investors Can Control Political Risk with ETFs
Companies / Exchange Traded Funds Mar 25, 2010 - 10:41 AM GMTBy: Ron_Rowland
Even if you aren’t very interested in politics, you have to admit that political factors can have a huge impact on your investments. These days government policy affects everything — for better or worse. And that includes exchange traded funds (ETFs).
The hard part is what to do about it. Sometimes the decisions made in Washington don’t have the same market impact we might expect.
So today we’ll talk about how politics can influence your ETF results.
Did Health Care Legislation Help Or Hurt the Markets?
Obviously the most current example is health care. This sector is a huge part of the economy, and government spending was already one of its primary drivers.
More than a few analysts thought the recently-approved plan would be bad news for health care stocks. Apparently not! Just look what happened to three sector ETFs on Monday, March 22, the first day of trading after the key House vote:
- First Trust Health Care AlphaDex (FXH) … up 1.7 percent
- PowerShares Dynamic Health Care Services (PTJ) … up 2 percent
- SPDR S&P Pharmaceuticals (XPH) … up 1.6 percent
This was on a day when the S&P 500 changed by only half a percent! Judging from the market’s reaction, it sure looks like the new legislation was good news for the health care sector.
Keep in mind that whether the legislation is actually a good idea is a totally separate question. And whether it will help or hurt you personally is not the issue. My point is the stock market seems to have determined that the changes will be a net positive for the industry.
Could the market change its mind later? Sure. Prices are set by the collective decisions of all buyers and sellers. When circumstances change or new information comes out, buyers and sellers make different decisions. Prices adjust.
This is why my top rule is: Follow the trend as it is, not how I wish it could be. In other words, don’t fight the tape.
Political Bolts from Out of the Blue
The problem with politically-driven market change is that it is unpredictable. We can guess, we can talk to experts, we can weigh the odds, but we can’t know in advance what a bunch of bureaucrats or elected officials will decide to do (or not do). This can cause surprises — and sharp price reversals.
I’ll tell you about one such reversal I saw up close and personal …
On January 7, 2000, I told my subscribers to buy Fidelity Select Biotechnology (FBIOX). The biotech sector was trending up, and my analysis showed very strong momentum. (ETF selections were very limited back then, which is why I was using a mutual fund.)
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On March 10, investors who took my advice were holding a 46 percent open gain. Then it happened: President Bill Clinton and the U.K.’s Prime Minister Tony Blair announced all the government’s human genome research would be released into the public domain.
This instantly derailed the plans of some big biotech companies to patent new genetic substances. Boom — FBIOX fell more than 18 percent over the next two days!
My readers bagged a profit of more than 34 percent when we sold FBIOX during the midst of the plunge, but it could have been a lot more. This was frustrating, of course. And to this day I don’t know what I could have done differently.
I didn’t have any idea what President Clinton was planning. Nor did very many other investors, judging from the way prices fell so sharply. We were simply hit by a bolt from the blue.
Sometimes, Lightning Helps
Of course, there are times when political action can help the stock market, or at least certain sectors. These situations tend to be less obvious, maybe because politicians are more careful to hide their tracks.
Moreover let’s not forget that central banks are often political, too, despite their claims to the contrary. For example, back in March 2009 the U.S. Federal Reserve began a program to buy boatloads of failing mortgage-backed securities. This was indeed a gift to the banks that owned most of the near-worthless paper.
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| Sometimes a storm is just what you need. |
Surprise! The banking sector reversed what had been a vicious slide into oblivion and flew higher and higher in the next few months! Consequently, SPDR KBW Banking ETF (KBE) more than doubled between March 6 and May 8, 2009.
Of course, no one beyond a few insiders knew what the Fed was planning, so not many people enjoyed such returns. Anyone who was short in the financial services sector had their heads handed to them.
How to Handle Political Risk
Is there a way to protect yourself from these rude surprises? Unfortunately, there isn’t a perfect solution. Investing always has risks — and political risk is one of them. Yet without risk there would be no reward.
You can, however, reduce the potential damage. The best way is to be prudently diversified. By spreading your assets among several ETFs that tend not to move together, you can limit the fallout when something goes wrong.
Of course, diversification also reduces your potential profits. That’s why so many people don’t do it. They see that sector X is going up and figure they should jump in with both feet. This is almost always a bad idea.
My hope is that you don’t make the same mistake. Because if you don’t put all your eggs in one basket, it won’t matter what the politicians do.
Best wishes,
Ron
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