“Exchange Traded Funds” – Look Before You Leap

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
April 18, 2006

IN THIS ISSUE:

1. The Basics of Exchange Traded Funds (ETFs)

2. ETF Advantages & Disadvantages

3. Just Another Form Of Index Investing?

4. Conclusions: As Usual, Be Informed

Introduction

In last week’s E-Letter, I discussed the excitement surrounding the upcoming launch of a new Exchange-Traded Fund (ETF) tracking the spot price of silver, as well as an existing gold ETF that has now been trading for over one year. I received many responses from readers – some thanking me for the information and, as always, others offering additional points of view.

I also received a number of responses that asked various questions about ETFs in general. Such as: What are ETFs; how do they work; and whether ETFs may be superior to individual stocks or index mutual funds. As is the case in the financial services industry, the marketing of new forms of investment often outpaces the explanation. Some investors rush into the latest “hot” investments without knowing exactly how they work, or under what conditions they are best used.

Believe it or not, the first exchange-traded ETF was launched in 1993 on the American Stock Exchange (AMEX), and was based on the S&P 500 Index. From this humble beginning, the total number of ETFs worldwide has now grown to approximately 400, and the list just keeps growing. It is reported that ETF trading now accounts for over 60% of the trading volume on the AMEX. Yet even today there are still many investors who are not very familiar with how ETFs work.

Because of your response to last week’s E-Letter on the new silver ETF, I thought it would be beneficial to discuss the rise of ETFs in the marketplace in this week’s E-Letter. In this issue, I’ll talk about how ETFs work, their advantages and disadvantages, and in what investment scenarios they are likely to work the best.

We have a lot to cover, so let’s jump right in.

ETFs – The Basics

An Exchange-Traded Fund (ETF for short) can probably best be defined as a low-cost index fund that trades on an exchange like a stock. In essence, ETFs are hybrid entities, in that they contain a number of stocks like a mutual fund, but they can be traded at any time the market is open, just like an individual stock. Using these investments, an investor has the potential to capture the performance of a selected stock index, bond index or commodity index using a single trade. Sounds good so far. The ability to trade any time the market is open makes ETFs an extremely flexible way to gain exposure to the growing number of market indexes now represented by ETFs.

As noted above, the very first ETF was rolled out in 1993 in the form of the S&P Depositary Receipts ETF, more commonly known as the “SPIDER,” designed to track the performance of the S&P 500 Index. SPIDERS were very popular, so several new ETFs were soon launched to track the performance of other major stock indexes. Some of the more commonly known ETFs are as follows:

“BLDRS”:	Baskets of Listed Depositary Receipts – sponsored by NASDAQ, these are a series of ETFs based on the The Bank of New York ADR Index
“DIAMONDS”:	Diamond Trust Series I – tracks the performance of the Dow Jones Industrial Average
“FITRS”:	Fixed Income Exchange Traded Securities – tracks the performance of a number of Treasury securities
“HOLDRS”:	Holding Company Depository Receipts – marketed by Merrill Lynch, these ETFs track a number of narrow industry groups or sectors
“iSHARES”:	Index Shares marketed by Barclays Global Investors tracking a number of different domestic and international broad market indexes, market sectors and even commodities, including the upcoming Silver ETF I discussed in last week’s E-Letter
“QUBES” (or “CUBES”)	Nasdaq 100 Index Tracking Stock – tracks the performance of the Nasdaq 100 Index
“StreetTracks”:	A Series of ETFs sponsored by State Street Global Advisors – perhaps the most popular of these is the StreetTracks Gold ETF
“VIPERS”:	Vanguard Index Participation Equity Receipts – a series of 23 ETFs based on broad market indexes, market sectors and even international markets

Given the popularity of these early ETFs, it is virtually assured that more will follow in the months and years ahead.

Understanding The Basics Of ETFs

While all of the various instruments discussed above are sponsored by different financial services companies, they are all basically baskets of stocks, bonds or commodities based on an underlying market index or spot price of a selected financial market or commodity index. Investors purchasing an ETF are, in essence, buying a proportional share of the individual securities making up the index or sector targeted by the ETF.

One of the early concerns with the ETF market was whether there would be sufficient trading volume of ETF shares for them to track closely to their target index. While volume did take a while to get up to speed, the ETF market is now very liquid, with millions of shares trading on a daily basis. Much of this volume is from institutional investors who see ETFs as a very cost-effective way to gain exposure to various market indexes.

Pricing of ETF shares is based on a fraction of the underlying index or indexes. Take the “Diamonds” ETF, for example, which is pegged to the Dow Jones Industrial Average. With the Dow over 11,000, it wouldn’t make much sense to base the Diamond share price on the full price of the index, since the ETF would then be priced at over $11,000 per share. Instead, the Diamond ETF share price is pegged at 1/100 of the overall Dow Jones Industrial Index price, which puts the share price at a more reasonable price of approximately $110.00. ETFs tracking other indexes have different proportionate shares, such as the SPIDER, priced at 1/10th of the S&P 500 Index and the QUBES that are priced at 1/40th of the Nasdaq 100 Index.

The legal structure of an ETF is that of an “open-ended Registered Investment Company” under the Investment Act of 1940, with a special exemption from the SEC allowing them to be traded like stocks on an exchange. Shares are created in large blocks by the sponsoring financial and brokerage firms, so that investor demand can be met on a continuous basis, usually without pushing the ETF share price beyond that of the underlying index or sector.

ETF Advantages

The first and most obvious advantage of ETFs is the ability to gain exposure to an entire index, sector or commodity in one single transaction, and at any time during the trading day. Index mutual funds can offer the same exposure, but can generally only be bought or sold once per day. The increased liquidity of the ETF allows for much more flexibility for the investor, especially in extremely short-term hedging transactions that might be bought and sold during the same day.

ETFs also enjoy the following additional benefits:

Most ETFs have low annual management expenses, since there is no discretion as to which securities are purchased. The holdings of the ETF will mimic the underlying index it seeks to track. In that regard, ETFs are similar to index mutual funds, but with the added advantage of additional liquidity throughout the trading day.

In addition, many actively managed mutual funds now carry early redemption fees designed to discourage frequent trading, while ETFs have no such fees. Thus, where an ETF is used in place of a traditional mutual fund, the absence of this early redemption fee can be significant.

Certain types of ETFs may provide diversification to a portfolio by investing in a number of different stocks rather than a single company within a market sector or asset class. As the number of ETFs has expanded to include a wide variety of asset classes and sectors, it is now possible to build a diversified asset allocation portfolio using nothing but ETFs.

ETFs may be more tax efficient than index mutual funds because they generally produce lower capital gains distributions. This can be an important consideration for someone contemplating a long-term hold of ETFs in a taxable account, but is not as important if the account is an IRA or other tax-qualified plan, or if the ETF is being used for short-term hedging purposes.

ETF shares can also be “shorted” in the open market, and without regard to the “uptick rule.” Under this rule, an individual stock can be shorted only if its price experiences an uptick prior to the short sale. ETFs have no such restriction, so they can be shorted at any time during the trading day. This compares favorably to index mutual funds, which cannot be shorted directly.

There are several mutual fund companies that have come out with “inverse” funds that provide similar results to a short sale of an index, but to transfer from a long position to a short position in these index funds requires the redemption of one fund and the purchase of another, which can only be accomplished once per day in most cases. The ETF allows for much quicker execution of these short trades.

NOTE: While ETFs make the ability to short an index or sector much easier, it is important to remember that shorting any security is a risky market strategy, and is best performed only by qualified professionals or sophisticated investors.

An investor can also place “limit” and “stop” orders for ETFs, while this is not generally available for mutual funds. In addition, ETFs can be purchased on margin and optioned within a brokerage account, whereas index mutual funds generally cannot be leveraged or optioned. However, as noted above, purchasing options on any security and trading on margin are sophisticated market strategies that can be risky.

ETFs generally have less “cash drag” on performance than mutual funds, since they typically maintain no cash reserve to meet redemptions. Instead, investors wishing to redeem their ETF shares sell them on the open market through their brokerage firm.

This list of advantages has been recognized by many analysts, but especially institutional investors that employ sophisticated strategies such as hedging and net short positions. The instant liquidity available in ETFs allows these institutional investors to “turn on a dime” during the day when their strategies call for such quick action.

These professional investors also use ETFs to “park” excess cash in certain situations. Since ETFs offer a high degree of liquidity, some professional money managers will use ETFs instead of moving to cash so they can maintain exposure to the overall markets while waiting for their strategy to generate another buy signal. As time goes by, I expect more and more individual investors will learn to use these potential advantages.

Some Disadvantages of ETFs

As always, new financial products like ETFs also have disadvantages that may offset some or all of the advantages listed above. One such disadvantage is that ETFs must be bought or sold on a stock exchange, which means paying a brokerage commission. While there are various discount brokerage firms available, frequent trading of ETFs could result in commissions that outweigh some or all of the popular advantages that ETFs offer.

This disadvantage is probably most pronounced for investors who want to use “dollar-cost averaging,” an investment strategy where small periodic (usually monthly) contributions are made to an investment. With commissions charged for each purchase transaction, ETFs may not be the best alternative for such investors.

Some of the other disadvantages associated with ETFs are as follows:

Since ETFs are bought and sold on the stock exchanges, they are subject to a bid-ask spread – this is nothing new. While the bid-ask spread is usually very small, it amounts to an additional hidden fee when buying or selling ETFs. This differential is likely to be insignificant if the ETF is to be held in a long-term portfolio, but could make short-term trading more expensive.

It is theoretically possible for an ETF to be sold at a price higher or lower than the net asset value of its underlying index. While a mutual fund’s share price is always a reflection of the current market value of its underlying stocks, the ETF’s share price is set by the market, which could add a premium or a discount to the share price. As a practical matter, however, any value differential would not likely last very long as market forces would soon move the share price back toward parity.

Since ETFs track the performance of specific market indexes and sectors, they do not benefit from the stock selection of a professional money manager. While the ETF and index mutual fund industry is quick to point out that the S&P 500 Index beats something like 80% of actively managed funds, that still leaves 20% of funds out there doing a better job. Plus, it is sometimes better to control risks than to beat the market, which an active manager does have the potential to do, but an index fund or ETF cannot.

While flexibility is the hallmark of ETFs, it can also lead to unwise trading strategies. For example, the ability to trade at any time the markets are open would allow an investor to “day-trade” these investments. The late 1990s showed us that, on the whole, day-trading is a bad idea. Doing so with an index-based ETF rather than an individual stock doesn’t make it any better of an idea.

In most mutual funds, investors can direct that dividends be automatically reinvested in additional shares of the fund. In an ETF, dividends are paid in cash to the brokerage account, where they will stay until the investor decides to use them to purchase more shares of the ETF (and thereby incurring additional brokerage fees).

While ETFs make it much easier to invest in foreign markets (including emerging markets), it is not always a wise decision to do so. ETFs carry the same risks in regard to foreign political developments, currency exchange-rate issues and global economic trends (good or bad), just as any other investment in foreign securities.

Most ETFs are established to track the performance of specific indexes, and like the indexes they mirror, ETFs are weighted by the market capitalization of the companies comprising each index. As the companies comprising an index get larger, they are given more proportional weight in the index. You may recall that in the late 1990s, the meteoric rise in the Nasdaq 100 Index was largely due to only a handful of companies, and when these companies faltered, the whole index paid the price.

Since index-based ETFs must buy stocks in the same proportion as in the underlying indexes they mirror, the result is that they can pour more money into securities that are rallying (and potentially overvalued), and there’s generally nothing that they can do about it. As the index increases, the greater the potential for money to flow into funds based on that index which, in turn, leads to more buying of the largest holdings of the index.

Can this lead to a problem in the future? No one knows what the future holds, but we do know that this issue has contributed to a problem in the past. Beginning in March of 2000, the Nasdaq 100 Index lost over 80% of its value over a period of only 30 months. Maybe it is for this reason that some companies are sponsoring ETFs that equally weight the stocks of an index rather than holding them in the same proportion as the index.

I have read about some closed-end mutual funds claiming to be ETFs in their marketing materials. While I have not seen any of this first-hand, it does stand to reason that closed-end funds might consider themselves the first ETFs, since they are made up of a variety of securities and trade on an exchange like a stock. However, there are important differences between a closed end fund and an ETF.

Closed end funds are typically actively managed, meaning that they have a fund manager or management committee that determines the mix of securities held by the fund. This, in turn, often leads to higher expenses than an ETF. In addition, closed-end funds can trade at significant premiums or discounts to the total value of their holdings, and closed-end funds are required to disclose their holdings only on a quarterly basis, rather than having the daily transparency of an ETF.

Lastly, in my opinion, perhaps the biggest disadvantage to ETFs is that they do nothing to reduce the risks of being invested in the stock market. While a variety of asset classes and market sectors can be included in an asset allocation for diversification purposes within some ETFs, this may not be sufficient to avoid large losses when the overall markets are trending downward.

The Perils Of Index Investing

In my December 6, 2005 E-Letter, I outlined the problems associated with “index investing,” which is defined as making long-term bets on the overall markets by investing in securities that track the values of one or more market indexes. With the arrival of ETFs, the financial media and Wall Street firms are claiming a new era of index investing has arrived, but is index investing using ETFs any better than doing so with index mutual funds?

In my opinion, the answer is “No.”

While I don’t have the space to reproduce all of the information in my December 6th E-Letter, I think a brief review is certainly appropriate in regard to index investing using ETFs. As I noted in my previous article, the primary notion behind index investing is the idea that investors cannot do better than the market indexes over long periods of time, so why try?

To prove their point, some proponents of index investing trot out charts and graphs showing various time periods over which the market indexes outperformed traditional mutual funds. In addition, adherents of index investing point out how fees for index funds and ETFs are usually a fraction of actively managed alternatives, in an effort to equate high fees with poor performance. These and other arguments are presented to support the idea that trying to beat the market indexes is futile. As usual, I beg to differ.

I do not believe that a buy-and-hold investment strategy using index mutual funds or ETFs is always the best alternative for an investor. While the financial media is fond of showing graphs over periods of time as long as 75 years as proof of the value of index investing, few, if any investors have the luxury of that amount of time. Most investors have much shorter time horizons, and a quick review of market indexes over shorter time horizons can cast a very different light on index investing.

There is also the issue of risk management. Over the 10-year period ending on March 31, 2006, the S&P 500 Index posted an average annualized return of 8.95%. This sounds pretty good, until you see that during this same 10-year period, there was also a –44.73% drawdown in value in the S&P 500 Index that is yet to be fully recouped. Can such a large drawdown occur again? Probably. What we do know is that market indexes are passively managed, and cannot get out of the way of a market downturn.

Thus, index investing – even with ETFs – is in some cases like buying a car without a steering wheel. It will generally go straight, but you won’t be able to steer around curves and obstructions (ie –recessions or major market corrections) in the road.

I encourage you to go back and read my December 6th E-Letter again to get a full picture of the limitations of index investing. Even if you have a long-term time horizon and think that index investing might be best for you, I encourage you to consider putting at least part of your portfolio in “actively managed” investment programs that have the flexibility to hedge positions or move to cash as market conditions warrant. In this way, you are not only diversifying among asset classes through index investing, but also among investment strategies by including both active and passive management.

Conclusions

Exchange Traded Funds have already made a big impact in the investment marketplace, even though they are a relatively recent phenomenon. The ability to gain access to a wide variety of stock market indexes, sectors and even commodities, with the liquidity of an individual stock, makes ETFs a highly sought-after investment.

One of the benefits of the ETF structure is that they are not limited to stock or bond securities, but have also been adapted to track the prices of physical commodities. I have previously written about ETFs that are designed to track the price of silver and gold, but there is also a new ETF that tracks the price of crude oil, and even one launched last December that tracks the price of companies involved in fresh water purification.

However, some of the very features that make ETFs so attractive also have the potential to lead to large losses in the hands of the unwary investor. The primary advantage of ETF investing is that they offer a highly liquid exposure to a large number of market indexes, but this can also be a disadvantage as I pointed out briefly above, and in more detail in my December 6, 2005 E-Letter.

Even so, I think the development of ETFs has been a positive thing, but primarily in relation to professional Investment Advisors who manage portfolios of index mutual funds. The flexibility inherent in an ETF allows these Advisors to have the same exposure to selected market indexes and sectors, but with added liquidity should the market turn downward over the course of a trading day. They also allow Advisors to trade on an unlimited basis, and without the fear of early redemption fees.

We have spoken to a number of Advisors who actively manage portfolios of mutual funds, and who are now investigating ETFs as a possible alternative to index funds. Some have even started to run parallel test accounts to see how their strategy fares using ETFs as compared to their mutual fund track record. If they are successful, I hope to be able to recommend some of their strategies to my clients in the future through our AdvisorLink® Program.

The one area where I do see a great deal of promise for individual investors is in the area of commodities exposure, specifically in those ETFs that track the price of gold, silver and oil. These commodity-based ETFs offer investors the ability to have exposure to markets that were once only available via stocks or mutual funds in mining or production, or the purchase of physical metals, coins or bullion, or by trading futures and options. ETFs also hold the potential to solve the storage and safekeeping problems usually associated with holding physical gold, silver or oil.

The bottom line is that we live in exciting times where we can look forward to even more specialized investment opportunities in the future. Unfortunately, the proliferation of investment options often creates a greater amount of confusion as to which investment alternatives are the best. Sometimes the most popular investment alternatives are not those that are best for an investor’s needs, but are the ones with the best advertising and promotion, or the most convincing sales representative. So, beware and be informed.

While it is a temptation to rush out and be the first to own some of these new “sexy” ETF investments as soon as they become available, I think the words of Alexander Pope may offer the best counsel:

“Be not the first by whom the new are tried, nor yet the last to lay the old aside.”

As always, we are happy to help you make these decisions, with no pressure or obligation.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

Why are ETFs more tax-efficient?
http://money.cnn.com/2005/06/14/funds/etf_ask_expert/index.htm

Not Your Father's ETFs
http://www.smartmoney.com/etffocus/index.cfm?story=20060329

Roll Out The Barrel (About the new crude oil ETF)
http://www.smartmoney.com/etffocus/index.cfm?story=20060405

Why America's Generals Are Out For Revenge
(An interesting viewpoint from across the pond.)
http://www.timesonline.co.uk/article/0,,6-2138690,00.html