ETFs Need to Be Weighed Carefully
In last week's article we discussed a circumstance where individual stocks might be better than ETFs for certain market segments, specifically the financial sector.
As a follow up, there is an article in the November issue of
Smart Money
magazine called "The New ETF Pitfalls" that I believe misses the mark in terms of understanding how to use this tool, that being ETFs, in constructing and managing a diversified portfolio.
A basic building block of understanding in using ETFs is realizing that an ETF is simply access to some segment of the market. If the topic is access to Brazil, an investor wanting that exposure needs to decide between a fund of some sort or an individual stock.
A fund will not be perfect maybe because of something in the composition like the
iShares MSCI Brazil Index Fund
(EWZ) - Get Report
having a disproportionate weighting to
Petrobras
(PBR) - Get Report
and
Vale
(VALE) - Get Report
; 35% between common and preferred issues of both companies.
Of course, buying an individual stock comes with the risk of choosing a stock that dramatically underperforms the Brazilian market.
The
Smart Money
article shares an anecdote of one investor's hard luck story with an "oil sector fund" but not mentioning which one saying that the fund "relied on contracts called futures; it didn't own any oil or even any oil companies."
While not crystal clear this quote may be implying that the investor did not realize it was a futures-based product but whether he realized this or not, it is clear that he did not understand contango or backwardation, words never used in the article, which is the circumstance that occurs when an expiring contract has to be replaced with a more expensive contract taking a little bite out of the fund (this is contango) or backwardation, where rolling to the next month results in buying a lower priced contract.
It is very possible that the "oil sector fund" in question is the
United States Oil Fund
(USO) - Get Report
which promises to track the front month contract of crude oil.
Contango has plagued the fund since inception creating a lot of disappointment for investors who did not understand the dynamics of the crude oil market but the fund itself has acted as advertised. It is just that the almost perpetual contango has caused the fund to lag the spot market which was a point that appeared to be lost in the
Smart Money
article.
This of course circles back to fully understanding the plusses and minuses that a given ETF offers and weighing them out for yourself.
USO requires an understanding of not only the crude oil market but also the dynamics of the futures curve. This added element makes the fund, for me, a very complicated way to access this market and so equity exposure is preferable. The fund is merely access, you can either live with the flaws or not. If not then the fund should be avoided.
A less dramatic example is the
iShares FTSE/Xinhua China 25 Index Fund
(FXI) - Get Report
, which owns large-cap stocks but is very heavily weighted to financial and real estate companies adding up to 47% of the fund. As I opined last week, if China is going to ever have a serious problem, it will tie into overcapacity, overbuilding, misusing off balance sheet debt and mistakes with monetary policy which would be a big problem for the Chinese banks and real estate companies.
Anyone agreeing with this would want to avoid the FTSE/Xinhua China 25 Index Fund or any broad-based China fund that is heavy in financials. GlobalX has several China sector funds available for anyone interested in access without picking individual stocks and of course there are dozens of individual Chinese companies available as well.
The ETF industry has obviously evolved at a rapid pace in the last few years and this will continue but one constant will continue to be that the funds are merely access, all with flaws that need to be weighed against alternatives means of access for each investor to determine their own best way into any given market segment.
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At the time of publication, Nusbaum had a client with a position in Vale.
Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;
to send him an email.
