ETFs – Advantages and Application

The ETF, or Exchange Traded Fund, has grown from consisting of a handful of broad-based index products, to now consisting of hundreds of products representing almost every conceivable investment theme or idea. Volume has expanded on many of these issues, making them some of the most liquid trading instruments around.

It seems clear that the debate between choosing a traditional mutual fund or an ETF is clearly in the corner of the ETF. ETF fees are much lower than mutual funds, and even factoring in the small brokerage commission applied to an EFT, the savings in fees will make up for the commission many times over. Of course, the mutual funds that charge a huge front or back end load are a real rip-off and should be avoided. And, some brokerage firms that deal in no load mutual funds will charge a commission to sell if not held a certain length of time. There is no restriction on the holding period of an ETF. And with and ETF you won’t get hit with capital gains distributions, so, with the exception of dividends, you get to control when you pay capital gains, short term or long term. You can get in and out during market hours instead of just on the close, and there is the ability to easily trade on the short side with most of the active ETFs, with no uptick rule. And there are options available for outright purchases, or for hedging, or for other option strategies. Also, there are ETFs that have leverage, and that will be inverse to their index, so a long-term short position could become a long-term capital gain.

The comparison between ETFs and CEFs (closed-end funds) is a bit different. With CEFs, which are somewhat similar to ETFs, you have a security that can trade on its own supply demand; therefore the fund can go to a premium or a discount to its net asset value, sometimes substantially. With CEFs there is also the chance of dilution if the firm wants to issue more stock, usually with an offer for existing shareholders to purchase more shares at a predetermined price. While brokerage commissions will be the same as with an ETF, the management fees will usually be higher with CEFs. CEFs will often target a more specific type of investment, whereas ETFs are usually more broadly index based. However, that has been changing over the last couple of years.

There are more and more ETFs being issued almost daily with very specific objectives. You can find an ETF for almost any country, style, sub-sector, commodity, and even for currencies. There are so many ETFs coming out, it is getting hard to sort through the list. A few years ago, with very few ETFs to choose from, it was a simple matter to decide which instrument to trade, as only the basic indexes and sectors were represented. Now it is getting almost as difficult to pick the proper ETF as it is to pick an individual stock. One way to pare down the list is to look at monthly average trading volume. Liquidity is certainly an issue, as some of the newer, narrowly focused ETFs have very low trading volumes, with correspondingly wider bid ask spreads, while the most popular choices are extremely liquid, with a penny or so spread between bid and ask. In time the best will survive, and many too-specific issues will disappear. In my opinion, some of the too narrowly focused issues defeat the purpose of investing or trading in ETFs.

In comparison to individual stocks, there are valid arguments on both sides of the issue. One theory favoring stocks is that you can just pick the best stocks in whatever group or index you are interested in, and not be weighted down by the dogs of the group. That’s true. Of course, that depends on you being an excellent stock picker. Roughly 85% of professional, full time mutual fund managers can’t beat a benchmark such as the S&P 500. Individual part time investors think they can do better than professionals. I’m not so sure.

It is difficult enough to pick the direction of a market. Much of the movement of a stock will be influenced by the overall market direction. Some say stock movement is about 70% dependent on overall market direction. I can’t verify that number as being correct, but it seems in the ballpark Picking an individual stock on top of picking market direction adds a second variable. If 70% of a stocks movement is influenced by the overall market, and 85% of professional stock pickers under-perform benchmark stock indexes, it doesn’t seem worth the effort to try to sort through the list of thousands of stocks for the small chance of making a larger gain.

It is always gratifying to pick a stock that goes up 200% while the overall market is only up 8%. How many stock picks do this? How many stock picks are down 10% with the market up the same 8%? If you diversify your portfolio, it will probably average out. If you diversity enough, and your stock picking is good, you will probably mirror the indexes. If your have a couple of stinkers in your portfolio then you will probably under-perform the indexes. If you add human emotion and refuse to get out of the stinkers until you break even on those, you might end up severely under-performing the indexes.

Of course, the purpose of choosing stocks over ETFs is to not have the stinkers, but what looks like the best pick may turn out to be the stinker, and the stock that didn’t look so good might turn out to be the winner. There are always surprises on individual stocks. Suppose you are bullish on drug stocks. You do all your research and pick the best stock based on all the fundamentals you can find. You search Value Line, and Zacks, and Schwab’s ratings. You read everything you can. You even call Cramer to get his opinion. Everything says the stock is the best in the group and the group is headed higher. Of course, everybody else has this same information and is also bullish. Then, out of the blue, a lawsuit on a particular drug this company makes is filed and the stock tanks. The effect on the ETF may be minimal. Possibly another stock could benefit. It evens out. Of course, this news might affect the whole group negatively. But that could be dealt with just analyzing the group’s ETF and trading off those signals. It is one less decision to have to make. It is one less chance for making an error.

Another really annoying thing about individual stocks is earnings reports. It seems nearly every time a company beats earnings forecasts by a couple of cents, the stock gets clobbered. They blame some little thing the CEO said in the guidance. This happens over and over. But this seems to even out when trading an ETF. I’m not even concerned now with earnings release dates, unless it’s on a key stock that might move the overall market.

Sometimes it’s not the product that goes bad; it’s the CEO, or financial officers. There’s a long list of companies that went out of business while reporting great prospects, and the main officers were getting their money out while shareholders were left holding the bag. If this happens to a stock in an ETF, or even a mutual fund, holding the ETF instead of the individual stock minimizes the damage. I know we all think we can avoid these disaster stocks. We all have the same information. When it is evident that something has gone wrong, it is too late to act on it. We all think we know something unique, but in reality we all have the same information. We come to have a different interpretation of that information, but all the information that is available is known by all. It’s the information that is not available that can blindside us.

With a broad based ETF the types of events that are stock specific should even out, or at least be muted. With individual stocks you have a higher chance of ending up with a portfolio of under-performing stocks unless you are extremely disciplined. The human element often compounds an already complex situation. Add to that all the brokerage commissions of all the individual stocks, as compared to the far fewer ETFs that can fund the portfolio. And all the extra time spent screening and analyzing.

Certainly over-diversification can stunt overall portfolio performance. An argument can be made for picking a few specific stocks rather than an index so one is not over-diversified. Some may not believe the statistic that 85% of professional fund manager under-perform a benchmark, as stated above. But it is important to keep in mind the problem of being fooled by the exceptional moves in certain stocks, and then comparing that to the more muted performance of an index. There are always a few stocks, such as Apple lately, that make huge percentage moves, dwarfing the indexes they are in. Spectacular overall portfolio gains are usually achieved by concentration, rather than diversification. Bill Gates wouldn’t be nearly so rich if he only had 3% of his assets in Microsoft instead of the nearly 100% that he had in it during years it was growing rapidly. That was a spectacular success story. On the other side of the coin is Enron. For most people it doesn’t make sense to have all their eggs in one basket. And, of course, the more eggs in the basket, the more muted the returns will be, even with excellent stock picking skills and discipline. The more sensible the portfolio, which means the more diversified, the more the returns will mimic those of a benchmark stock index.

If the above is correct, then it really comes down to market timing to reach superior returns. Of course, there are those who say market timing is impossible. I disagree. It is certainly difficult. It wouldn’t make sense for it to be easy. The market can’t reward everyone. Anything worthwhile is difficult. The many that fail will always say it’s impossible. The establishment says that if you are a market timer you have a chance of being out of the market during the few times per year that the big moves are made. I’m not sure that’s true. The big moves usually don’t come out of the blue. Usually there are small trends that accelerate into larger trends. Most trend following techniques, while late on entry and exit, generally keep you on the right side of the trend during this acceleration phase. Sometimes a spike up happens during a downtrend that might be missed. More often, if you stay out of downtrends the big sell-offs are avoided and that would help overall performance.

With market timing skills one could make use of leverage by trading options with a smaller dollar amount and keeping the balance in interest bearing accounts. That way a smaller percentage move in the index could still result in superior returns without subjecting the entire account to risk. Of course, not everyone wants to be a trader. But for those who do, options on ETFs offer some advantages. First, since the volatility is lower on a broad-based index, the premiums on the options are lower. Therefore, one can participate in the movement of the underlying security without having to overcome such a high premium before the position becomes profitable. Also, most ETFs are priced in one-dollar increments, so there is more precision is choosing a strike price. This also makes it easier and more flexible to roll up to follow a position if you are trying to squeeze the most percentage gain, rather than just hold an option that becomes in the money and starts trading with the underlying. A relatively small movement in the underlying can have a very large percentage gain on a carefully chosen option that is a bit out of the money.

Even though there are now several hundred ETFs out there, I still find the greatest advantage to trading ETFs, and the options on ETFs, is the relative simplicity of choices. For me, it is best to concentrate my focus on a handful of issues, as opposed to sorting through an ever-changing list of hundreds or thousands of stocks. I can’t become familiar with each individual stock as it comes in and out of a stock screener every day. If I just stick with a static basket of stocks, they usually, at some point, go out of favor. Then new stocks come into favor that are not in my basket, and they are missed. It is more sensible to narrow my focus on a handful of ETFs. I can do better analysis by concentrating on a few items than by spreading myself too thin. Regarding the vast choices available, I tend to just ignore most of the new products. The large, liquid ETFs have enough movement to provide plenty of opportunity. With fewer choices in selection, and fewer decisions in analysis, there is a better chance, at least for my style of trading, of being on the right side of the market.

I attempt to sort out the best ETF short-term trading vehicles that have active option contracts in the next article.