Goldman Sachs Fraud and ETFs

By: Ron_Rowland

Last week the U.S. Securities & Exchange Commission filed a civil lawsuit against Goldman Sachs (GS) alleging fraud. And the news hit Wall Street like a volcano!

Of course the SEC sues companies all the time. Goldman Sachs isn’t just any company, though. Goldman is big — very big — a financial Godzilla with unmatched power and vast political influence.

The immediate reaction was that share prices plummeted 13 percent on April 16, wiping away about $10 billion of Goldman Sachs’ market value. And as you might expect, this loss had an impact on some financial services sector exchange traded funds.

Goldman Sachs is a financial Godzilla.

But because ETFs are diversified, your potential exposure to problems in any one stock is reduced.

However,

Some ETFs Are More Diversified Than Others

When an ETF has a big concentration in one stock, you’ll probably be happy about it as long as that stock is going up. Unfortunately, stocks that go up quickly can fall even faster.

As of April 15, 2010, seven ETFs had 5 percent or more of their assets in Goldman Sachs stock. Here they are with their approximate weightings:

• iShares Dow Jones U.S. Broker-Dealers (IAI) — 11 percent
• SPDR KBW Capital Markets (KCE) — 8 percent
• WisdomTree LargeCap Value Fund (EZY) — 7 percent
• WisdomTree LargeCap Growth Fund (ROI) — 7 percent
• iShares Dow Jones U.S. Financial Services (IYG) — 5 percent
• Claymore/Clear Global Exchanges, Brokers & Asset Managers (EXB) — 5 percent
• SPDR Select Sector Financials (XLF) — 5 percent

Additionally, leveraged ETFs have more exposure than what their underlying index suggests. For instance, an ETF like Direxion Daily Financial Bull 3x Shares (FAS) would essentially have 15 percent exposure to a stock with a 5 percent weighting in the underlying index.

So, if you want to be in the financial services sector but keep your individual-company exposure to a minimum, you probably shouldn’t buy any of the funds listed above — and especially IAI.

I also want you to notice something important about the above list …

Some of the funds simply sound like they are a lot broader than others. And the broader they are, the less they typically have in Goldman Sachs.

The two funds from WisdomTree don’t even focus on the financial sector. Even more confusing is the fact that the WisdomTree classification methodology declares Goldman Sachs to be both a “value” stock and a “growth” stock at the same time. Meaning that you cannot always go by the fund’s name.

Another one is SPDR Select Sector Industrials (XLI). It sounds innocent enough. There is no shortage of industrial stocks, but General Electric (GE) accounts for about 13 percent of the XLI holdings.

On the other hand, take IAI. It zeroes in on a sector (financials), a sub-sector within it (broker-dealers), and a certain geographic region (the U.S.). If that’s what you want to specialize in, then of course you’re going to have a big position in Goldman Sachs. No surprises — it’s right there in the name.

How to Reduce Your Company Risk

Some ETFs allocate their assets equally rather than by market capitalization. Others use a modified market-weighted scheme that imposes a cap on any one company.

Rydex S&P Equal Weight Financial Services (RYF), for example, actually has the same stocks as XLF — but they’re spread equally and periodically rebalanced. So instead of Goldman Sachs being more than 5 percent of RYF, its weighting is closer to 1 percent.

Some Financial ETFs include companies from other countries, helping to reduce the exposure to any one stock.

Simply avoiding Goldman Sachs isn’t a complete solution, though. What if the SEC is just getting started? More firms could be charged. Even if they ultimately prevail, these companies could be looking at years of litigation and bad press.

Sector ETFs are a partial solution to this dilemma. They give you a way to bet on the success of a particular sector without putting all your chips on one company.

Within the financial services sector you’ll find there’s more than just big banks and brokers. There are also regional banks, insurance companies, foreign financials, and other niches. You can stay in the sector, broadly speaking, but go in a different direction with a variety of other ETFs. Here are three to consider:

• SPDR KBW Mortgage Finance ETF (KME)
• SPDR KBW Insurance ETF (KIE)
• iShares Dow Jones Regional Banks (IAT)

Keep in mind, of course, that these other sub-sectors have risks of their own. The mortgage finance group was slammed by the housing downturn, insurance stocks can be hit by natural disasters, and many regional banks are not “too big to fail.”

The bottom line: Successful investing still has a lot to do with balance and timing. So be careful — and do your homework before you buy any ETF.

Best wishes,

Ron

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