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Into the Pool - ETF Skeptic

Stock-Markets / Exchange Traded Funds May 26, 2007 - 12:00 AM GMT

By: Roger_Conrad

Stock-Markets

Here's a confession from a 20 years-plus industry veteran: I use investment conferences for more than making my points and chatting with current and prospective readers. I also like to scope out what the rest of the industry—including the competition—is doing, chiefly the products they're selling and the public's reception to them.

One of the most popular items at last week's Las Vegas Money Show was exchange traded funds (ETFs). It's not hard to see that these have captured investors' imagination, and dollars, during the past year. The “Wall Street Journal” now publishes what seems to be an ever-expanding page of ETFs that are offered by a growing array of financial houses anxious to cash in on the trend.


I'll admit I'm a skeptic. One of the truest adages in investing is that Wall Street—as well as Fleet Street, Bay Street and every other investment capital—will always produce to demand. Whether investors want ETFs, yield or tech stocks, the marketers will work overtime to come up with unique products they'll buy. And they'll keep churning them out until the popularity wanes.

The reason is simple: money. The more investment products a Wall Street firm sells, the bigger the bonuses at the end of the day for the executives who drive strategy. It's in everyone's interest to get on board a popular investment trend and ride it as long as they can.

ETFs have been marketed very simply. They're essentially an opportunity to make a bet on a specific investment or sector without going through the trouble of building a diversified portfolio on your own.

So the pitch goes; all you pay is one commission, and you can ride the trend to big profits. The only decision to make is what sector, or sectors, you want to play.

Unfortunately, it's not quite as simple as it looks. In fact, the more I've looked at these things, the more I've become convinced that most of the people buying them don't really understand their actual structure and workings.

For clarification, I've gone to the best resource I know of on mutual funds and related investments: my colleague Ivan Martchev, editor of Louis Rukeyser's Mutual Funds and Vital Resource Investor and a long-time contributor on the subject to the nation's oldest newsletter Personal Finance .

Below is a synopsis of his remarks as I interviewed him this week. I hope you find them instructive.

Q. WHAT'S THE MOST-IMPORTANT THING TO LOOK FOR WHEN CHOOSING AN ETF?

A. The most-important thing is to pick the investment or sector you want to play. That would seem to be a relatively easy task, because ETFs tend to pick names that identify them with a certain investment, such as “Utilities” or “Gold.”

Unfortunately, it's not that easy at all. Most ETFs do remain true to their mission. In other words, if the name says “Utilities,” that's what they own.

But not all of them do. In fact, there's an ETF supposedly specializing in water stocks that actually holds very few of them.

The brokerage used the name to get the business, but investors are actually getting something quite different.

The only way you can really avoid this problem is to get inside any ETF you're interested in first. In other words, make sure the fixed portfolio you're getting is really what you want. You shouldn't take the name for granted any more than you would an active fund. And you should never buy unless you can get information about what's in it.

Would-be buyers also need to be acutely aware that some brands of ETFs aren't based on conventional indexes at all but rather some formula designed by the brokerage. If you don't check first, you've only got yourself to blame.

Q. SOME SECTORS HAVE LITERALLY DOZENS OF ETF CHOICES. OTHER THAN WHAT'S IN THE PORTFOLIO, HOW DOES AN INVESTOR DECIDE WHICH TO BUY?

A. First, take a look at trading volume. ETFs only sell at the true value of what's inside them to the extent they can be arbitraged in the market place. And that's only possible if there's enough trading volume.

Basically, the true value of an ETF is the value of the basket of stocks or other investments it holds. That basket is generally based on an index and is fixed. There's no changing once it's set.

ETFs' market prices, however, can vary from the value of their assets during the trading day. When that happens, computer programs will buy or sell the same basket of stocks against the ETFs. The brokerage pockets the spread—which, by the way, is quite a lucrative business—and the ETF's price moves back into equanimity.

Effective arbitrage, however, can only happen when there's enough volume in an ETF for the computers to effectively and economically execute these trades, which are often for 50,000 shares or more.

Only the most-liquid ETFs can boast that much trading. Less-liquid ETFs should eventually be arbitraged back into balance, but it may take an uncomfortably long time to do that. And that pretty much makes them useless as trading vehicles.

Not surprising, the first movers in a particular area tend to be the ETFs that get the most volume. Those that are launched after them can attract initial interest, but they're almost always inferior vehicles.

In my opinion, there's no rational reason for having more than one ETF for a particular sector because each new entry is progressively less useful for trading. But then, that's not what's driving this.

It's the investment houses trying to make as much money as they can from the public's infatuation with ETFs. In other words, ETFs are one investment area where more choices don't mean better ones; in fact, it's just the opposite.

Q. ETF PROMOTERS ARE ALWAYS TALKING ABOUT THE FACT THAT THEIR INDUSTRY IS MORE EFFICIENT THAN, SAY, OPEN- OR CLOSED-END MUTUAL FUNDS. IS THAT A TRUE STATEMENT?

A. Yes and no. High-volume ETFs are definitely a better option for traders. Let's take the example of SPDRs, or spiders, one of the first and easily most popular ETFs and a bet on the S&P 500 index.

This is a big ETF and is heavily arbitraged. A trader can buy or short it—and now even trade options against it—with the assurance that performance is going to mirror the S&P 500.

In addition, unlike with a closed- or open-end fund, there's meaningful intraday pricing. Funds only set their net asset values at the end of the trading day, based on the value of the assets inside. ETF prices always reflect their true value—at least to the extent they're effectively arbitraged—whether it's 9:31 am in New York or 5 pm.

On the other hand, ETFs are an absolutely horrible way for long-term investors to play a market or index. For one thing, intraday pricing is basically meaningless to someone who's going to hold on for more than a day. But the main thing is fees.

Contrary to popular belief, ETFs do assess management fees based on their assets. In general, the percentages aren't as high as some actively managed funds charge. But then again, they shouldn't be because there's no active management. The fact that some ETFs are assessing fees of 1 percent for doing nothing is as mind-boggling to me as it is galling.

As for open-end index mutual funds, let's take the two biggest S&P 500 index funds, Fidelity and Vanguard. Fidelity charges investors 10 basis points a year, or 0.1 percent of assets, and has a minimum initial investment of $10,000. Vanguard's expenses are slightly higher at 18 basis points, but its initial minimum is also lower at just $3,000.

S&P 500 index ETFs assess two and three times as much in fees than these funds. Moreover, you have to pay a commission to reinvest dividends. The index funds will do this for free.

Of course, low-volume ETFs charge you management fees and fees for reinvestment—and they don't arbitrage well either.

Q. WHAT ABOUT COMMODITY ETFS? AREN'T THEY A GOOD WAY TO OWN HARD ASSETS CHEAPLY THAT INDIVIDUALS WOULD HAVE NO CHANCE TO OWN OTHERWISE?

A. They do give you ownership of assets without storage fees and without the expense or risk of futures. But not all of them are created equal.

I like the ISHARES SILVER ETF—issued by BARCLAYS—because I think silver is going a lot higher in coming years. Its expenses are low; it's liquid and transparent. The same is true of the major gold ETFs, though the iShares representative has the disadvantage of not being the first mover in the sector. That distinction belongs to the STREETTRACKS GOLD ETF. These apparently actually own the physical commodity, so you get all the play on the metals without the expense of storing them safely.

On the other hand, the oil ETF is probably the worst way to play rising energy prices I can think of. That's because it's based on futures contracts, not physical oil.

Oil futures trade on a contango, meaning further out contracts are always more expensive. As they near expiration, they come back to the physical price. Generally, that means that the ETF is constantly losing value, generally to the tune of about $1 a month.

Obviously, oil as a commodity is constantly in use and would be extremely expensive to store as opposed to gold, which is never used up after it's mined. You have to use futures. Consequently, it would be impossible to construct an oil ETF as effectively as a gold or silver ETF. But that hasn't stopped a lot of people from buying in and ultimately being very disappointed if they're paying attention.

Q. WHO SHOULD BUY ETFS?

A. Basically, it's a trader's gig, not a long-term investor's. If you can find a high-volume, low-expense ETF that's transparent with its holdings—based on a real index and not some arcane formula, as some ETFs are—you can play a trend effectively. Again, the gold ETF is a good example of an ETF that makes sense.

I also will look at ETFs if there's no equivalent index fund. That happens to be the case with the gold miner ETF that mirrors the XAU big mining stock index.

Q. WHAT ABOUT LEVERAGED ETFS?

A. In effect, ETFs based on major indexes are already leveraged, as they're generally priced at some fraction of the index they track. A relatively small move in the index can have a huge impact on the ETF.

Leveraged ETFs are actually financial engineering around the 50 percent margin requirement for stock trades. That actually has some very real implications for future market volatility. But the unwary investor—or anyone who thinks he or she can play these for the long term—is taking a very big risk.

For example, there are two leveraged ETFs that trade off the QQQ, or NASDAQ 100. This is a technology stock-focused index that's volatile enough in its own right.

The QLD is a long bet on the QQQ, with effective margin of 25 percent. If you margin the QLD itself, you can trade the QQQ on effective margin of 25 percent.

Every move in the QQQ has a fourfold impact on the QLD. Rallies in the QQQ will make you very happy, but even minor dips can be disastrous. The QID is essentially the opposite: a short bet on the QQQ, using 25 percent margin. Your investment appreciates four ticks for every tick down in the QQQ and is reduced four ticks for every tick up if you trade it straight (without margin). The key to remember is that the QID is an inverse ETF, so a long position in the QID is a double short position in the QQQ.

This is good stuff for anyone who really wants to trade the volatile technology market and is willing to take the risk of big losses. It couldn't be worse, however, for those who expect to buy and hold the volatile QQQ. In fact, given the sector's recent underperformance, I expect many people have discovered that already.

Q. DON'T ETFS PROVIDE DIVERSIFICATION?

A. One of the misconceptions people have about ETFs is that they're buying a balanced portfolio. In reality, they're no more balanced than the index they represent. And with no active management, they will only become less balanced over time.

Look at any index out there. Over time, some stocks outperform and others lag. The index doesn't adjust to balance things out.

Rather, the outperformers become more heavily weighted and the underperformers less so. Sometimes, what you end up with is one or two very highflying stocks really driving the index value and, therefore, the ETF as well. You can become absurdly unbalanced without even knowing it, unless you're paying attention.

In contrast, a good, actively managed fund will always avoid this pitfall. No competent manager will allow a single stock or small handful of stocks to get so heavily weighted that a single setback can undo the entire portfolio. That's one reason all good funds vastly outperform indexes when the market hits one of its inevitable downturns.

Take a look at an index that's probably close to the heart of many Utility & Income readers: the Dow Utility Average. From its peak in late 2000 to its bottom in late 2002, the Dow Utilities fell nearly 60 percent. One reason was that ENRON had become so heavily weighted because of its tremendous run-up in the late 1990s.

A prudent utility mutual fund manager would never have allowed Enron to reach such a high proportion of his or her portfolio.

Rather, he or she would have been taking profits along the way to keep the stock in balance, no matter how attractive it appeared fundamentally. The index by its very nature is a passive vehicle and can never adjust, and neither will an ETF.

That's a scary story. But it's the nature of markets. That's why investors need to know what's in the index the ETF is based on before putting in dollar one. It's also why ETFs are best used for trading—not as a substitute for building a diversified portfolio.

Q. WHAT ABOUT A PORTFOLIO OF ETFS? WOULDN'T THAT BE DIVERSIFIED ENOUGH?

A. There is some merit to that, provided the investor chose carefully and was willing to weed out the ETFs that became too unbalanced. But you're still going to wind up with the classic problem of owning indexes: You get the good and bad as well as the ugly. And as I've explained above, the blemishes have a tendency to get bigger over time.

Also, I would caution that ETFs really haven't been around long enough in quantity for there to be an effective study to prove that premise. You're really making some assumptions that may seem logical without hard, empirical evidence to back them up. That's always very dangerous when it comes to investing.

By Roger Conrad
KCI Communications

Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.

KCI has assembled a team of top investment analysts to create the finest financial news service possible. With well-developed research skills and years of expertise in their particular fields, our analysts provide quality information that few others can match.


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