Exchange-traded funds extremely complex
October 16, 2012 4:38PM
Updated: November 18, 2012 6:44AM
Dear Mr. Berko: I have a mutual fund that is supposed to own only utility stocks, and another one should have only drug stocks. However, about 30 percent of their portfolios are in other industries. I didn’t bargain for this, and these additions affect my funds’ performance. I want to invest in pure sectors — such as real estate, oil, natural gas, banks, insurance, etc. — without owning other industries. So what can you tell me about exchange-traded funds? Or are there any open-end funds with only oil stocks, insurance stocks or bank stocks you’d recommend? I’d like to invest $180,000 in exchange-traded funds. Could you recommend a portfolio?
— WP, Detroit
Dear WP: Somewhere in the time ripples of a quantum universe, where gravity, negative gravity and antimatter collide with gluons, quarks and mesons, fusing with anomalous subatomic detritus, there may be an open-end fund adhering to the investment style iterated in its prospectus. However, my financial telescope can’t find even one. It’s like searching for a Higgs boson.
Enter exchange-traded funds that have been investing only in an index promoted by their prospectuses. They’ve been around since Noah bowled a perfect game. They were straightforward and uncomplicated — like buying 100 shares of stock that you owned “till death do us part.” But in the past 20 years, ETFs have become extremely complex investments, thanks to Wall Street’s ubiquitous quants who hibernate in dark cubicles with white powder traces on their noses. And though ETF returns are often superior and less volatile than their common stock cousins, the complicated investing calculus works best in the hands of knowledgeable and experienced professionals. Yes, things have changed since Log Cabin syrup poured from red cottage-shaped cans and Aunt Jemima wore a bandanna. How often have you put a quarter in a glittering gumball machine and gotten a jawbreaker so disappointing that you had to spit it out? Today only a gross ignoramus (12 times dumber than a normal ignoramus) drops his quarter in the index machine, only to watch a poorly structured ETF pop out. And then this ignoramus wonders why his ETF seriously lags the benchmark or the market. Here are several points most folks seldom consider:
1) Is the index your ETF mimics market-weighted? Market-weighted indexes are prone to distortions based on the value of the individual stocks in the index. For instance, Apple has a market value of $625 billion, which is larger than the combined total of all stocks traded in Ireland, Portugal, Spain, Greece and Somalia. Apple’s value is also greater than all the stocks of the iShares MSCI China Index! Apple is huge, but so are Exxon Mobil, IBM, Wal-Mart and General Electric. So in every index, it’s wise to know which large-cap issues are included. If that index holds 87 issues and Apple constitutes 75 percent of the value of that index, you may be looking for growth in all the wrong ETFs.
2) Check the liquidity of your ETF. If it’s trading at a premium or discount to the index, you need to know why.
3) Are all the stocks in the index trading at the time you place your order? Asian markets don’t overlap the U.S. market, while various commodity markets have different opening and closing times. Do you know when the oil market or corn market stops trading in the U.S.? When buying a global or commodity index, it’s important to know how many issues in that index are trading when you place an order. The more the better.
4) Be informed when placing orders at the opening or at the end of the trading day. At the opening, there’s a good chance many of the index stocks won’t be trading, and at the close of the market, most makers are busy balancing their positions.
Those are only some rules professionals use when managing ETF portfolios. It’s best to get experienced professional advice before investing $180,000, because as you can see, it’s complicated out there. And I can’t knowledgeably recommend a portfolio of ETFs without getting to know “all about you.”
Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775, or email him at firstname.lastname@example.org.