360 Degrees: Are ETFs for You?

They really are no different than assembling portfolios based on stock screening. Of course, back-testing is much different than real life, and I feel no need to be the first one into any of these funds, but I wouldn't ignore them. Some stock screens do work.

In April, I wrote about the First Trust IPOX-100 Index Fund (FPX Quote). Its strategy, or gimmick if you prefer, is to buy IPOs on their seventh day of trading and hold them until the 1,000th. The methodology of picking IPOs isn't the thing; it's the part of the market it captures. The index that underlies the fund has been around for several years and has served as a very good proxy for small-cap growth stocks -- it outperforms them. Even since its debut, this ETF has beaten iShares Small-Cap Growth(IWO Quote).

This will repeat over and over with the narrower ETFs -- they capture what they are meant to capture, though they could also capture some other effect.

I disagree with Jim on the utility of sector ETFs. On his TV show, Jim has helped his audience through a segment called "Am I Diversified?" The market, as measured by the S&P 500, has 10 sectors. I think Jim would be on board with a stock portfolio that had some exposure to all 10. Not everyone wants to take single-stock risk, but taking prudent sector risk, as opposed to making big sector bets, can be a different matter.

For example, the financial sector makes up 21% of the S&P 500. An investor wishing to underweight the financial sector could put 15% of his assets in one of the broad-sector ETFs with assets and then perhaps 2% in one of the insurance ETFs. This could be done for every sector. There are countless studies and white papers that show sector selection is more important than stock selection. ETFs provide a means for investors to tap this.

Another thing Jim is missing is that the ETF industry is new and evolving. In the course of product innovation, some very useful funds will be created and some others will just take up space (think the Morningstar ETFs). Hit and miss is inevitable.

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Beating a Good Idea to Death, by Howard Simons

If you create an ETF for stocks with no coverage, you are by definition covering those stocks. Integrity then demands those stocks be dropped from the ETF. This would leave no issues in the ETF, and that result is as fine with me as it is with Jim Cramer.

As an aside, the Chicago Mercantile Exchange launched a future on a bankruptcy index a few years back. I always wondered if a trader went bankrupt from trading this, would he then be charged with manipulating the asset underlying the futures contract?

ETFs should be confined to two classes of underlying assets: those that are so broad and liquid, such as the S&P 500, that they act as a diversifying index fund or as an asset-allocation vehicle, or those assets that cannot be accessed cheaply or efficiently otherwise though a vehicle such as a closed-end fund.

Narrow-based assets and sector funds are the perpetual darlings of exchange and investment bank product-development groups, despite their near-uniform track record of disappointment. They sound good, and potential customers gush about them until they are launched. Then they die.

Why is this so? Generally speaking, narrow-based or sector assets are niche products designed to add spice to a portfolio. They should be bought and held in recognition of this diversification value, not traded as if they were liquid or part of a portfolio's core. If you are allocating assets and making major portfolio changes based on uncovered issues, then you should be sent to your room without dinner. If you are actively trading illiquid niche products designed to give you diversification by virtue of uniqueness, you are going to run up a lot of trading costs and lose whatever benefits diversification would provide.

Wall Street certainly knows how to take a good idea and beat it to death, doesn't it?

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A Users Guide for Traders and Investors, by David Merkel

There are two basic ways average investors can use ETFs: to invest or speculate. It sounds obvious enough, but different ETFs tend to get used for each purpose.

For Speculators
Ticker	Name	% of Dollar Volume Traded
SPY	SPDR Trust Series 1	34.5%
QQQQ	Nasdaq 100 Index	15.0
IWM	iShares Russell 2000	12.2
OIH	Oil Svc HLDRS Trust	6.3
XLE	Energy SPDR	5.5
DIA	DIAMONDS Trust	3.1
SMH	Semiconductor HLDRS	2.1
EEM	iShares Emerging Markets	1.9
GLD	streetTRACKS Gold Trust	1.7
MDY	MidCap SPDRs	1.5
EWJ	iShares Japan	1.2
XLF	Financial SPDR	1.1
EFA	iShares MSCI EAF	1.1
RTH	Retail HOLDRS Trust	1.0
EWZ	iShares Brazil	0.6
IVV	iShares S&P 500	0.6
IYR	iShares DJ Real Estate	0.6
XLB	Materials SPDR	0.5%
IJR	iShares S&P Small-Cap	0.5
IWO	iShares Russ 2000 Growth	0.4
Source: Bloomberg, David Merkel

The top 20 ETFs in terms of dollar-volume-traded comprise 91% of all ETF dollar trading volume. There are more than 300 ETFs at present (and more on the way), so this is quite concentrated. Most new ETFs will probably prove to be marginal concepts as trading vehicles go. The field is too crowded, and most of the easy fundamental concepts have been developed.

So what gets traded? Primarily the major indices, sectors of the major indices and some commodities. These are areas where speculators commonly get macro views, and the ETFs allow them an easy way to express those views rapidly. Once you get past the major indices, energy gets a lot of attention.

For Investors
Ticker	Name	% of total ETF Market Cap
SPY	SPDR Trust Series 1	15.7%
EFA	iShares MSCI EAF	8.1
QQQQ	Nasdaq 100 Index	4.9
IVV	iShares S&P 500	4.8
EWJ	iShares Japan	3.7
EEM	iShares Emerging Market	3.2
IWM	iShares Russell 2000	2.7
MDY	MidCap SPDRs	2.5
DIA	DIAMONDS Trust	2.3
GLD	streetTRACKS Gold Trust	2.3
IWD	iShares Russ 1000 Value	1.9
DVY	iShares DJ Dividend	1.7
VTI	Vanguard Total Stock Market	1.6
IWF	iShares Russ 1000 Growth	1.5
SHY	iShares Lehman 1-3	1.4
IJR	iShares S&P Small-Cap	1.4
XLE	Energy SPDR	1.4
TIP	iShares Lehman TIPS	1.1
IJH	iShares S&P Mid-Cap	1.1
AGG	iShares Lehman Agg	1.0
Source: Bloomberg, David Merkel

By market capitalization, the top 20 ETFs comprise 64% of the aggregate ETF market capitalization. There's decent overlap between the two lists. Twelve names are shared by the two lists, though the positioning differs.

The market capitalization-weighted list has more foreign stocks, domestic bonds and a greater amount of small-cap exposure. If one were using ETFs for asset-allocation purposes, we would expect this. Many investors feel confident in their abilities with domestic larger-capitalization stocks, but don't want to try selecting foreign or small-cap stocks, much less bonds. It allows them to implement their full asset allocation in their brokerage account, which can definitely simplify things.

For Speculators			For Investors
Ticker	Name	Ratio of market cap to dollar volume	Ticker	Name	Ratio of market cap to dollar volume
OIH	Oil Svc HLDRS Trust	0.15	DVY	iShares DJ Dividend	17.27
SMH	Semiconductor HLDRS	0.17	VO	Vanguard Mid-Cap	17.06
IWM	iShares Russell 2000	0.22	LQD	iShares GS$ InvesTop	14.99
XLE	Energy SPDR	0.25	TIP	iShares Lehman TIPS	14.88
QQQQ	Nasdaq 100 Index	0.33	VTI	Vanguard Total Stock Market	14.74
SPY	SPDR Trust Series 1	0.45	RWR	streetTRACKS DJ Wil REIT	13.75
XLF	Financial SPDR	0.51	IVE	iShares S&P500 Value	13.52
IYR	iShares DJ Real Estate	0.55	AGG	iShares Lehman Agg	13.09
DIA	DIAMONDS Trust	0.75	IJJ	iShares S&P Mid-Cap/Value	12.26
XLB	Materials SPDR	0.75	IWB	iShares-Russell 1000	12.25
EWZ	iShares BRAZIL	1.01	IVW	iShares S&P500 Growth	11.92
TLT	iShares Lehman 20+	1.01	VNQ	Vanguard REIT ET	11.16
IBB	iShares Nasdaq Biotech	1.08	IWV	iShares RS 3000	10.99
BBH	Biotech HOLDR	1.18	IWR	iShares RUS M/C	10.62
GLD	streetTRACKS Gold Trust	1.36	IJT	iShares SP SCGRO	9.56
MDY	MidCap SPDRs	1.70	EZU	iShares EMU INDX	9.16
EEM	iShares Emerging Market	1.71	EPP	iShares MSCI PAC	8.95
IWO	iShares Russ 2000 Growth	1.72	IJK	iShares S&P MC/GR	8.90
XLU	Utilities SPDR	1.75	IYH	iShares DJ Health	8.85
XLI	Industrials SPDR	1.91	IWD	iShares Russell 1000 Val	8.71
Source: Bloomberg, David Merkel

On the left part of this chart, I have the ETFs with over $1 billion in market capitalization that have the lowest ratios of market cap to trading volume; on the right are the ones with the highest ratios. The left side has the ETFs where traders make their short-term bets; on the right side are the ones where longer-term bets are made.

But how long term is the right side of this table? Not very long at all. The ratio of 17.27 for the iShares DJ Select Dividend Index (DVY Quote) fund indicates that the entire fund turns over every 17 to 18 business days. The way that I interpret this is that ETFs are primarily used for trading, and the ETFs on the right side have a moderate amount of longer-term investors. Those on the left are for traders only.

Is this a bad thing? It depends on how one uses the ETFs. If all one does is implement macro ideas in the short run, then ETFs will be useful to the trader. For accounts needing broader asset allocation than just domestic stocks, ETFs can be a useful, though limited, tool.

All that said, I think many people will lose money through ETFs because they are too easy to trade and relatively few people are skilled at short-term trading. They are easy to use, which can overattract novices.

Those who don't use ETFs still derive one benefit from their existence: They create a lot more trading noise in the stocks that are in the ETFs. This helps both traders and investors resist trends and profit from being able to buy solid companies that are being punished simply because they are in a commonly traded ETF that is currently hated. For me, with my rebalancing strategies, this adds incremental value.

Whether you use ETFs or not, being aware of their effects on the market can help your overall performance.