ETFs Unplugged
By Carl Delfeld
Is your financial advisor missing a critical piece to
the ETF?
Exchange-traded funds (ETFs) are great investment tools but
most have a flaw that investors and advisors usually miss.
Let’s take a look under the hood and introduce some
new and innovative ETF products.
Essentially, ETFs are nothing more than an index fund that
trades like a stock. Because of their simplicity,
flexibility, low cost and tax efficiency they are growing
fast. Last year the Barclays iShares family of ETFs brought
in more new money than the Fidelity mutual fund machine.
Diversification
Unfortunately, many investors and advisors are building
portfolios of ETFs without looking inside the box and
seeing where the money is going. One of the chief goals of
a portfolio is diversification and many ETFs are not very
diversified. This is because the companies in the ETF are
weighted by size – specifically by the market value
of its outstanding stock. This can result in an unwise
concentration of risk and uneven performance.
The index fund community’s preoccupation with market
cap weighting may have a strong theoretical basis but to me
it is contrary to common sense. To be blunt, I pay very
little attention to it while building global portfolios for
clients.
Most investors would agree that just because a company is
bigger doesn’t mean that it is a better investment.
Let’s look at the most well known index – the
S&P 500 index. Many investors think that investing in
the S&P 500 means that their money is being divided
equally between 500 companies. This is far from the truth.
Because the companies are weighted by size, 22% of your
investment is going to the ten largest companies in the
index and 60% of your investment is going to the largest 50
companies in the index.
Unequal Weighting, Unequal Returns
This is why I have been advising clients to invest in the
Rydex S&P 500 equal-weight ETF (RSP) which weights each
company in the index equally. In 2003 the equal weight
S&P 500 ETF beat the S&P index by 11%, in 2004 it
beat the index by 5% and year-to-date it is up slightly
while the S&P index is down.
In my book, “The New Global Advisor”, I ask
readers a provocative question. If you wanted exposure to
the dynamic biotechnology industry, would you prefer to
primarily invest in a few large well know biotech companies
or would you prefer to spread your investment over thirty
biotech companies? If you’re the former, you might
invest in the iShares Nasdaq Biotechnology ETF (IBB)
whereby 25% of your investment would go to three companies.
For those that prefer broader exposure including some small
cap companies, I have discovered a new family of ETFs
called Powershares.
The new and innovative Powershares family of ETFs
essentially creates its own indexes based on rules-based
quantitative analysis that they refer to as
“intelligent indexes.” This seems to me to be
more useful than blindly following market cap weighted
indexes. There are two Powershares that I particularly like
at this point.
Two I Like
The first is the biotech Powershare (PBE) that contains 30
biotech companies. If its holdings were weighted by market
cap, two companies would account for more than 60% of its
holdings. Instead your exposure is spread among 30
different companies with no company accounting for more
than 5% of the total. 30% of your exposure is to large cap
companies, 26% is to mid-cap companies and 43% is to small
cap companies.
The biotech Powershare is an aggressive position so
don’t get carried away. I think it is a smart play on
the tremendous opportunities for capital appreciation in
the biotech industry which is showing some momentum after
trading sideways since early 2004. The annual fee is only
0.60%.
The other Powershare that I like is the International
Dividend Achievers Powershare (PID) that contains 42 ADRs
traded on U.S. exchanges. I am usually not a big fan of
ADRs since they usually trade at a premium to the
underlying security but they do offer some comfort to
investors since they meet U.S. reporting requirements and
can be easily purchased on U.S. exchanges. The ADRs in this
Powershare have to pass a stiff test: five fiscal years in
a row of increased dividends. Again the top holdings are no
more than 5% of the total index and so you get great
diversification.
A Better Way to Get Global Diversification
One problem with the most widely used international index,
the MSCI Europe, Asia & Far East Index (EAFE) is its
concentration in Japan and the United Kingdom which account
for almost 50% of the index’s total value. Meanwhile
exposure to promising countries such as Ireland and Hong
Kong are less than 2%. Last year, this Powershares index
beat the MSCI EAFE index by 7% and companies in the ETF
averaged a 29% return on equity. The index is re-balanced
quarterly and has an annual fee of 0.50%. Right now 67% of
the companies in the index are large cap, 20% are mid-cap
and 13% are small cap companies.
Getting the right blend of ETFs takes some time and effort.
Remember that all ETFs are not equal so choose carefully.
About the Author: Carl Delfeld is head of the global
advisory firm Chartwell Partners and editor of the the
"Asia-Pacific Growth" newsletter. He served on the
executive board of the Asian Development Bank and is the
author of "The New Global Investor." For more information
go to
http://www.chartwellasia.com or
call 877-221-1496
Source:
www.isnare.com