360 Degrees: Are ETFs for You?

Editor's Note: In this edition of "360 Degrees," RealMoney commentators take a look at the proliferation of exchange-traded funds. Are they just another way for Wall Street to suck fees out of investors? How can investors best use them?

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ETF Overload, by Jim Cramer

This column was originally published on RealMoney on July 12 at 8:47 a.m. EDT.

Enough with the ETFs already.

Today's announcement that Claymore Group is launching an exchange-traded fund (ETF) to track stocks with little or no coverage is just the latest in the out-of-control creation of ETFs that's been going on lately. Claymore's also trying to launch an ETF made up of companies where there has been insider buying.

I am not against indexing per se. But these instruments are now taking on all aspects of stupidity. The idea of picking undercovered companies and buying them makes no sense at all. The idea of buying good undercovered companies makes sense. The idea of buying companies where there is insider buying makes no sense. The idea of buying good companies where there is insider buying, well, that I can get with.

The proliferation of ETFs has gotten so out of control that I would not be surprised to see an ETF of all ETFs. Or a best-of-ETFs ETF. Or a worst-of-ETFs ETF for those who want to bet that the ugly ducklings are going to become swans. How about an ETF that buys high-performing ETFs and shorts poor-performing ETFs?

How about an ETF that just owns stocks that start with the letter P?

All of these ETFs just serve to confuse people and fake them out of diversifying. The reason I like mutual funds is because they take a diversified approach and allow you to be cushioned against a market decline. Diversification, as I say over and over in Jim Cramer's Real Money: Sane Investing in an Insane World, is the only free lunch.

I have never liked sector funds. I always felt they were for young analysts at mutual funds to cut their teeth on before they get promoted to general mutual funds.

I didn't like them because you put all of your eggs in one basket. The ETF has become the ultimate all-eggs-in-one-basket philosophy coupled with a false sense of security that comes with grouping all sorts of stocks together with a common theme that is predictive of absolutely nothing. In 1998, I did a survey that showed if you bought the stocks with the heaviest insider selling you did the best. That's because they were the best-performing stocks. To set up an ETF on that would be beyond stupid, but I can see one coming, so you could short it or go long.

The creation and proliferation of new product has always been a Wall Street forte, long after we needed new product, because new product begets new fees.

Don't believe this industry is some knight in shining armor. The only ETF worth owning is one that is an index fund to a big index for diversification, and if you want that, I would go with Vanguard's mutual funds: low fees, good execution. Enough said.

Flaws, Yes, But Many Benefits, by Roger Nusbaum

Jim has some fun with the narrow themes that some new ETFs cover, like insider buying and undersponsored stocks.

I also wonder about the merits of the insider-buying ETF, but the back-tested numbers for these things are outstanding.

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). 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).

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.

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?

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
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
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) 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.

Jim Cramer is a director and co-founder of TheStreet.com. He contributes daily market commentary for TheStreet.com's sites and serves as an adviser to the company's CEO.

David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog.

Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System.

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