I’m a realist. Not everyone can spend 80 hours a week looking under the hood and kicking the tires of loads of individual stocks like I do. I’ve always said that picking good stocks is a labor of love, but if you don’t have the time to do, maybe your best investment options lay elsewhere.
One investment option that is growing like the outfield vines in Wrigley Field is the exchange traded fund, or ETF. What are ETFs? Simply, a basket of stocks that can be sector, theme, or even country oriented. Now, I have been critical of ETFs - why own a basket of stocks when you can pick out the good, individual stocks, and scuttle the bad ones? But if you don’t have a lot of time and you just want an average return, then an ETF could be the best move for you. There’s not a lot of homework, you only pay a small management fee, and there’s no lack of specialized ETFs to invest in.
You want to invest in Japan? The EWJ (Stock Quote: EWJ) tracks Japan’s Nikkei Index. You want to invest in U.S. stocks? The SPDR (Stock Quote: SPDR) tracks the Down Jones Industrials. You like oil and energy? The OIH (Stock Quote: OIH) tracks the oil sector index.
On and on and on they go. ETFs have as many flavors as Baskin-Robbins has different scoops of ice cream. That means ETFs can be used to develop diversified portfolios that give you a chance to be spared the worst of any one sector's downturn. But I don't like to have all of your eggs in one ETF basket. Instead, you should have five different sectors to protect yourself.
As an industry, though, ETFs are in good health. Assets under management are around $500 billion, and analysts expect the ETF market to grow by 20% in 2009, bear market or no bear market. The number of ETFs will slide, however. There were 290 ETFs in 2007, and 230 ETFs in 2008. This could be the year where ETFs slide under the 200 mark, as survival of the fittest – one of Wall Street’s finest traits – works its magic.
So how can ETFs help you? Let’s give it the Cramer treatment.
Simplicity – ETFs, by design, follow an investment index or sector. But they trade stocks on most exchanges. Consequently, you get the simplicity of a mutual fund but the trading abilities of a stock.
Flexibility – Sector shoppers make out okay with ETFs. As I said above, you don’t have to spend days researching stocks in a given sector. With ETFs, you benefit from the research managers do on a given sector.
Affordability – Compared to mutual funds, ETFs are cheap. On average, mutual fund fees clock in at 1.4%. ETF fees are much lower – about 0.32%.
Easier pricing – As ETFs are traded like stocks, they can be bought or sold all during the trading day, so you can trade them whenever you want. With mutual funds, you have to wait until the end of the trading day. The Nasdaq 100 Trust ETF, for example, is the most liquid stock among all the global financial markets, generating more than 112 million shares per day, based on one recent monthly average.
Tax efficiency – Mutual funds can be a tax nightmare. ETFs? Not so much. Mutual funds can be forced to sell underlying stocks to pay for shareholders who want out of the fund. Often, that results in an onerous capital gains tax that’s passed along to the rest of the fund shareholders. But with ETFs, which trade all day on the open market, fund managers aren’t forced to liquidate shares as often as mutual funds.
No redemption fee – If you want to get out of an ETF, you just sell it on the open market – there are no redemption fees, like you see with mutual funds (especially for new fund shareholders). You know Cramer’s rule: the less money you spend on taxes and fees, the more you get to keep working for you in your investment portfolio.
Still, you have to be careful with ETFs, just like you would if you would be trading stocks. Trading too frequently can generate nasty brokerage fees. Try going through a discount brokerage site like Zecco.com (which has free trading options, with no minimum account balance). Also, make sure to do your due diligence. Specifically, make sure the ETF isn’t “hiding” any stocks that shouldn’t be in the fund. In other words, make sure the ETFs holdings match the label. If you see Portuguese debentures in an oil ETF, that’s a big red flag.
Also know that when you invest in an ETF, chances are you’re going to wind up with some real dogs - it’s inevitable when a fund has 30 or so stocks in it. My theory has always been to take the time to weed out the winners from the losers, but, once again, I devote 80 hours a week to this stuff and you don’t.
I also don’t like the fact that, with ETFs, you take the risk of being left holding the bad when an entire sector goes down the tubes, like retail or auto stocks in recent months. Sure, you can sell out fast, but if you’re not paying attention, the damage could already be done.
In particular, I totally disdain ANY and all of the Bear and Bull ultra-ETFs. Not only are these vehicles wrecking the stock market, as their volume is so heavy they have undue influence on their underlying stocks. They just don't get the job done. Recently on "Mad Money" I expressed outrage that an ETF designed to profit from a decline in Chinese financial markets LOST investors a fortune, even though Chinese financials went into the tank. ETFs like these never should have been green-lit by the SEC. It's too late for those investors, but you can see why I advocate avoiding such ETFs with the proverbial ten-foot pole.
So if you’ve got the time, focus on individual stocks. But if you don’t, ETFs aren’t a bad consolation prize.
—Brian O’Connell contributed to this article