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Saturday, 11 August 2007

ETFs - A Superior Trading and Investment Vehicle

By Doug Tucker

The ETF, or Exchange Traded Fund, has grown from consisting of a handful of broad-based index products, to now consisting of hundreds of products representing almost every conceivable investment theme or idea. Volume has expanded on many of the issues, making them some of the most liquid trading instruments around.

It seems clear that the debate between choosing a traditional mutual fund or an ETF is clearly in the corner of the ETF. ETF fees are much lower than mutual funds, and even factoring in the small brokerage commission applied to an EFT, the savings in fees will make up for the commission many times over. And, some brokerage firms that deal in no load mutual funds will charge a commission to get out if not held a certain length of time. There is no restriction on the holding period of an ETF. And with and ETF you won't get hit with capital gains distributions, so, with the exception of dividends, you get to control when you pay capital gains, short term or long term. You can get in and out during market hours instead of just the close, and there is the ability to easily trade on the short side with most of the active ETFs, with no uptick rule. And there are options available for outright purchases, or for hedging, or for other option strategies. Also, there are ETFs that have leverage, and some that will be inverse to their index, so a long-term short position could have long-term capital gain potential.

The comparison between ETFs and CEFs (closed-end funds) is a bit different. With CEFs, which are somewhat similar to ETFs, you have a security that can trade on its own supply demand; therefore the fund can go to a premium or a discount to its net asset value, sometimes substantially. With CEFs there is also the chance of dilution if the firm wants to issue more stock, usually with an offer for existing shareholders to purchase more shares at a predetermined price. While brokerage commissions will be the same as with an ETF, the management fees will usually be higher with CEFs. CEFs will often target a more specific type of investment, whereas ETFs are usually more broadly index based. However, that has been changing over the last couple of years.

There are more and more ETFs being issued almost daily with very specific objectives. You can find an ETF for almost any country, style, sub-sector, commodity, and even for currencies. There are so many ETFs coming out, it is getting hard to sort through the list. One way to pare down the list is to look at monthly average trading volume. Liquidity is certainly an issue, as some of the newer, narrowly focused ETFs have very low trading volumes, with correspondingly wider bid ask spreads, while the most popular choices are extremely liquid, with a penny or so spread between bid and ask. In time the best will survive, and many too-specific issues will disappear.

In my opinion, some of the too narrowly focused issues defeat the purpose of investing or trading in ETFs.In comparison to individual stocks, there are valid arguments on both sides of the issue. One theory favoring stocks is that you can just pick the best stocks in whatever group or index you are interested in, and not be weighted down by the dogs of the group. That's true. Of course, that depends on you being an excellent stock picker. Roughly 85% of professional, full time mutual fund managers can't beat a benchmark such as the S&P 500. Individual part time investors think they can do better than professionals.

I'm not so sure.It is difficult enough to pick the direction of a market. Much of the movement of a stock will be influenced by the overall market direction. Some say stock movement is about 70% dependent on overall market direction. I can't verify that number as being correct, but it seems in the ballpark. Picking an individual stock on top of picking market direction adds a second variable.

If 70% of a stocks movement is influenced by the overall market, and 85% of professional stock pickers under-perform benchmark stock indexes, it doesn't seem worth the effort to try to sort through the list of thousands of stocks for the small chance of making a larger gain.It is always gratifying to pick a stock that goes up 200% while the overall market is only up 8%. How many stock picks do this? It is easy to fool ourselves into thinking we know something other people don't when we do pick a big winner. But what is the net result of all the stock picks over a period of years.

How many stock picks are down 10% with the market up the same 8%? If you diversify your portfolio, it will probably average out. If you diversity enough, and your stock picking is good, you will probably mirror the indexes. If your have a couple of stinkers in your portfolio then you will probably under-perform the indexes. If you add human emotion and refuse to get out of the stinkers until you break even on those, you might end up severely under-performing the indexes. We all have the same information to work with. It is the information we don't have that will blindside us.

It is only our biases and our opinions on the information that we do have that will influence our trading decisions. And, of course, there is a lot of guessing, as long as we do it with the appearance of authority. Is stock picking with the limited amount of information that we have the best approach?Since most professionals try to beat the indexes and fail, it seems less likely that individual investors can beat the indexes in the long run. So does one have to accept average returns in an index fund if stock picking proves not to provide the desired returns? Not necessarily.

Another approach is to try to beat those returns with a combination of asset allocation and market timing. By not focusing on individual stocks, one is not as concerned with company specific issues such as earnings release dates and guidance disappointments, or with worrying about CEO option backdating, or bookkeeping irregularities, or many other assorted insider problems. Without having to baby-sit a portfolio of individual stocks one can better analyze and assess broader, more accessible issues such as which sectors are trending, which countries are in bull or bear markets, which styles are leading and which are lagging. Superior returns on the more active ETFs can also be enhanced by the use of option strategies which have liquidity and pricing advantages over many individual stocks.

If your stock picking performance over the long run has not kept pace with the main benchmark indexes, you might try picking a small number of active, liquid ETFs representing different sectors of the economy, different countries, different styles. Then concentrate your efforts on that small basket. Try to determine which are trending up and which are trending down. Trade accordingly. Rebalance on a regular basis. You might find you've created your own hedge fund without the high fees.

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