John Nyaradi for Sector Selector writes: Various academic studies have indicated that asset allocation is more important than security selection, especially in times of greater volatility in the markets. However, according to Roger Ibbotson, writing about the importance of asset allocation in the March/April 2010 publication of the Financial Analyst Journal, about three-quarters of market gains or losses come from general (broad) market moves, rather than asset allocation or security selection. As a consequence, individual investors are turning more and more to index-based and/or sector-specific exchange traded funds (ETFs), rather than managed mutual funds or individual securities.
According to ETF Database, there are currently more than 1,400 exchange traded funds available, ranging from broad general market funds to highly specialized funds representing a single industry, country, commodity, or investment goal. You can pick ETFs which seek high dividends and/or interest payments, those focused solely on share appreciation, or those which seek both objectives. ETFs are available for bonds, commodities, real estate, or currencies. They are structured to move in concert with the index they track, exceed the index’s moves, or move in the opposite direction. The industry follows the advice popularized in the movie Field of Dreams: “If you build it, they will come.” And they have – to the tune of more than one million shares per day on average.
What Is an Exchange Traded Fund?
Simply put, an ETF is an exchange-traded mutual fund. Rather than buying or selling a mutual fund through its sponsor/manager once per day at the close of business, ETF shares are bought and sold just like shares of stocks – at anytime during the trading day. You can also use the same trading strategies you would use with a share of stock, such as selling short, using stop-loss orders, and buying on margin.
ETFs are passively managed funds, meaning their portfolios reflect the price movements of a weighted average of a group of selected commodities, stocks, or bonds. Samples of various indexes include the S&P 500 (stocks of the largest companies on the NYSE), the Wilshire 5000 (virtually all publicly traded companies in the U.S.), or a specialty index such as the Morgan Stanley Biotech Index which consists of the top 36 American companies engaged in biotechnology. Index funds are managed or “weighted” to reflect the changing price relationships of the underlying stocks in the index, not to pick winners and losers among individual companies. As a consequence, management fees for the typical ETF are considerably less than the fees paid for a typical mutual fund (0.53% versus 1.42%).
Investing Tips
When investing in ETFs, it’s essential to research the market and ask yourself several strategic questions.
1. Determine Your Risk Tolerance
The most critical element in successful investing is knowing your risk tolerance. All people want maximum gains, but few have the stomach to accept the possible losses that accompany a swing-for-the-fences philosophy. Similarly, most people’s tolerance is directly proportional to the amount of funds they have at risk. A younger person, for example, just starting to build an asset base may seek high-reward, high-risk investments; a 60 year-old is more likely to want to preserve his or her hard-earned capital and seek a moderate, though surer return. You need to ask yourself, “Can I live with a 10% drop in the value of my portfolio? a 20% drop? 50%?” Your answers can help you identify the investments that best fit your psyche.
2. Develop an Investment Philosophy
Your investment philosophy should match your risk tolerance as well as your investment horizon. The safest way to become wealthy boils down to three rules:
- Let the Magic of Compounding Work For You. Invest $5,000 today at 5% and it’s going to grow to almost $17,000 in 25 years. Investing should not be a once in a lifetime event, but a habit developed slowly over time.
- Protect Your Assets. Suppose your investment drops 50% in the first year, then gains 80% over the next two years. Unfortunately, your portfolio is still going to be underwater with a 10% loss over the three years. Successful stock investors let their profits run and cut their losses short. Sell assets only when they fail to meet your earnings expectations; the market price fails to respond to increased earnings; or the price of the asset declines a pre-determined amount from the purchase price. Good-to-cancel stop-loss orders at pre-determined levels below the purchase price are an effective way to implement this strategy.
- Maximize Investment Returns Within Your Risk Tolerance. While it is impossible to accurately project the future (contrary to what some stock market gurus tell you), you can reduce your investment risk by understanding key performance measures regarding volatility and correlation of specific ETFs, such as beta and R-squared values.
3. Develop an ETF Investment Strategy
Investors in ETFs employ a variety of different strategies to achieve their investment goals. While no strategy is exclusive or permanently appropriate, determine which program best fits your needs today and put it in practice until experience indicates a change is needed. The five most popular strategies are as follows:
- Buy and Hold. Used most often by those investors with limited time or inclination to study their investments, this strategy is regularly buying a general market ETF indexed to a broad market index such as the S&P 500 or the Wilshire 5000.
- Portfolio Completion. The objective of this strategy is to ensure broad market diversification across sectors, asset classes, or foreign markets.
- Core/Satellite. This strategy consists of a core holding of a broad-based index complemented with actively managed smaller assets (individual stocks or sector ETFs). The core holding minimizes the risk of lagging the market, while the satellite holdings provide upside potential.
- Fixed Income. This strategy maximizes your investment in fixed income vehicles for higher income, diversification, and low cost.
- Sector Rotation. “It’s not a stock market, but a market of stocks.” At one time, this old adage may have been true. After all, buying the stock market as a whole was extremely difficult, if not impossible, before the appearance of ETFs. But today you can buy the stock market or a single sector of securities which has enabled the sector rotation strategy. At any given point, some individual stocks and industries are popular and their stocks rise just as others go out of favor and their values drop. Employing this strategy requires active oversight of your portfolio and the economy in general as you rotate from one sector to the next, ideally catching each as it comes into favor and selling when it becomes unpopular.
4. Don’t Invest in Leveraged ETFs
Leverage – using other people’s money – is often very attractive, doubling, even tripling the gains of an investment when it works for you. Unfortunately, the same upside potential also exists on the downside, generating the possibility of catastrophic losses. Leveraged ETFs use debt and complicated financial derivatives to achieve a leveraged daily return. As a consequence, leveraged ETFs are exposed to a constant leverage trap so that when the market moves down, the ETF is forced to sell shares and reduce its debt level in order to make the targeted leverage return. This locks in losses and reduces the ETF’s asset base, making it harder to recover gains in the next market upturn.
Investment professionals generally agree that, while leveraged ETFs can be useful in certain situations, they are intended to be held for less than a day and should be limited to large institutional investors. The long-term investor has no need to be in these products at all.
5. Understand the Weighting Mechanics of ETF Construction
While ETFs are investments intended to track a particular index, the percentage of each stock within the portfolio varies according to the weighting method elected by the creator of the ETF. Examples of weighting methodologies include the following:
- Market Capitalization. Stocks are proportioned in the portfolio based upon their total market value (all of the outstanding stock of a company times its share price). As a consequence, companies deemed most valued by the stock market represent a greater proportion of the fund than companies less valued. ETFs weighted by market capitalization tend to have less trading and consequently are considered tax-efficient. They generally have lower expenses as well. One criticism of a market cap strategy is that selection potentially favors past performance rather than future potential.
- Equal. The simplest strategy is that every stock position percentage-wise is equal. If you have 100 stocks, each occupies 1% of the portfolio. ETFs using these schemes have more trading, requiring frequent re-balancing and tax consequences as well as higher expenses. Smaller companies represent a greater percentage of total assets than in most other weighting schemes.
- Fundamental. ETFs using fundamental weighting rely upon factors such as net profits, sales, book values, dividends, or other tangible measures to determine the proper proportion of the stocks in the ETF, premising that such factors better represent the economic value of the company. The underlying investment assumption is that all companies ultimately reflect their real economic value in the long-term; if the assumption is correct, the ETF reaps benefits as the stocks change to reflect that value. This weighting shares similar disadvantages of the equal weighting scheme – low tax efficiency and high operating costs relative to a market cap-weighted index.
- Other Schemes. The proportion of the individual securities in an ETF can be based upon share price, dividends, market factors such as momentum or volatility, or other special strategies to make them unique or serve a particular investment objective. It is always important to read the description of the ETF to see how the portfolio is built.
6. Keep Studying
Your investment returns from within your comfortable risk zone are directly proportional to the effort you expend learning about ETFs, the stock market, and the economy in general. The environment is constantly evolving, creating new opportunities and causing once-safe investments to fail. There is a vast amount of information on the Internet about investing and investment vehicles that can be easily accessed for no cost. Read the business section of your local newspaper regularly, subscribe to national periodicals such as The Wall Street Journal, and visit websites like Morningstar and Zacks. The more you know, the faster your portfolio can grow.
Final Word
ETFs offer investors one of the most efficient, cost-effective, and convenient ways to participate in the growth of businesses in the U.S. and around the world. In fact, evidence indicates that the majority of returns in any given investment portfolio results more from long-term asset allocation than trying to pick and time the purchase of individual securities. ETFs are the perfect investment vehicle for a first-time or beginning investor – transparent and low-cost, with broad diversification and excellent liquidity – and should be a part of every investor’s portfolio.
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