This column was originally published on RealMoney on Sept. 28 at 4:00 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.Exchange-traded funds are different from typical index funds and much different from actively managed open-end funds. ETFs are index funds that trade throughout the day like a stock, while OEFs price once a day after the stock market closes. One more important difference: ETFs are very new, which means that many do-it-yourselfers do not know much about them and many investment professionals and market-related Web sites still are learning how to analyze them properly. While I may or may not know the best way to analyze ETFs, I sure do know a bad way to analyze them: to look at ETFs as if they were OEFs. An investor who wants to buy an actively managed OEF may find that there's not much to analyze, because that investor is really buying the manager's past performance on faith that that past performance can be maintained. Some bets, like Bill Miller, are better than others. Obviously, there's more to fund selection than this, but ultimately, it comes down to a belief in the manager.
Analyze This DifferentlyFaith in a manager plays no role in picking an exchange-traded fund. In most cases, ETF selection boils down to forward-looking analysis of a given sector, country, style, capitalization size and so on. ETF selection also involves selecting the best product to capture a given effect. For example, on the basis of a forward-looking analysis of supply and demand, economic conditions or technical analysis, an investor could decide to overweight or underweight the tech sector and buy the appropriate amount of a tech ETF to capture what that investor believes will produce the desired effect. After deciding that being overweight tech makes sense right now, an investor might then analyze the various tech ETFs available and decide that the Technology Sector SPDR ( XLK) is the best choice to trade. This could be applied to both long-term investors and short-term traders.
A Case Study: iShares CanadaToo many firms use what is, in my opinion, the wrong approach to analyzing ETFs. A case in point is a recent research report from Morningstar about iShares Canada ( EWC), called "Think Thrice Before Buying iShares MSCI Canada Index." The report generally is negative, but it offers no forward-looking analysis. It opens with the fact that it is not a good idea to buy a fund coming off of years of outperformance. But this truth is better applied to smaller, open-end funds that have had a huge inflow of cash that has the potential to alter whatever method generated those attention-getting results. iShares Canada and other single-country ETFs are index funds. How far down your list of important things to study before buying the ETF equivalent of a country is consideration of past performance? If you had read the Morningstar report, you might believe it should be the most important factor to consider, because it leads the report. The Morningstar report also warns about the 20% of the fund that is in energy stocks; actually, 28% of the fund is in energy stocks. I take the other side of that entirely: I want Canada to be a proxy for the energy sector. The U.S. imports a significant amount of its oil from its neighbor to the north. If you don't want the energy exposure, I would say there's no point in owning Canada. It makes sense to expect that whatever happens in Canada, good or bad, will be attributable to the oil market. The report also takes issue with the fact that the four top holdings each have a 5% weight in iShares Canada. If you look at the top holdings of some of the other single-country ETFs, you will see this is quite common. The reason for this is that some of these foreign markets have a lot fewer moving parts, so managers resort to weightings of 5% or more. While the point of single stock risk is valid, Morningstar's report makes it seem like this is unique to iShares Canada, which it is not. In fact, iShares Canada has relatively little concentration compared with other single-country ETFs such as iShares Sweden ( EWD), which has 22% in Ericsson ( ERICY), or iShares Belgium ( EWK), which has 24% in Fortis.
Better: Thesis-Driven AnalysisBuying a country through the corresponding ETF is about trying to capture a particular effect within a portfolio. A more useful approach to deciding whether iShares Canada is a good fit for a particular portfolio might involve study of the oil market, something Morningstar's report does not include. There are many valid reasons to account for the run we have had over the last year or two in the price of crude and energy stocks. A big part of the move, I believe, has been increased demand from China and India. In the late 1990s, China exported about 2 million barrels per day. Now it imports about 4 million barrels per day. I just heard one estimate that by 2025, China will consume as much oil per day as the entire planet consumes per day now.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider iShares Canada, iShares Sweden and iShares Belgium to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
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