jump to navigation

Strategies for exchange traded funds July 17, 2010

Posted by mytruthaboutoil in Uncategorized.
trackback

Let’s forget oil for a moment. I’ve seen a very good article about exchange traded funds from the excellent Barron magazine that I wanted to share with you? It starts right now…

BECAUSE THEY CAN BE BOUGHT or sold at any time during the day, offer access either to broad or thin slices of a market at relatively low cost and facilitate hedging strategies, exchange-traded funds have become a favorite of financial advisors. ETFs’ overall popularity is obvious. As of June 30, there were about 1,000 of them, with $793 billion in assets, up from 780 handling roughly $600 billion 12 months ago. Barron’s recently checked in with five financial advisors who’ve ranked highly in our surveys over the years and give ETFs a significant role in their portfolios. Here’s what they had to report from the front lines.

Charles Zhang

Zhang Financial, in Portage, Mich., has about $1 billion in assets under management, and ETFs make up a hefty 50% of its holdings. Like other ETF advocates, Zhang, 43, can reel off the well-known benefits of the funds—including their tax advantages. However, he suggests that investors haven’t taken full advantage of one important feature: the ability to create limit orders on them to profit from the stock market’s recent volatility.

A limit order, which instructs a broker to buy or sell a specific amount of stock at, below or above a preset price, allows clients to cash in on brief trading opportunities in ETFs that Zhang believes are less risky than applying the same strategy to individual stocks. A stock’s price can fall for reasons that might be difficult to grasp quickly, or could signal fundamental problems (think BP). But Zhang says a quick intraday drop in the price of a broad basket of stocks—creating momentary value—is much more likely to correct itself.

ETF_advisor_p

“In a very volatile market like we see today, limit orders to buy and sell make a lot of sense. They let clients take advantage of the ups and downs in the market,” says Zhang.

For instance, during the flash crash on May 6, the intraday drop for the Dow Jones Industrial Average was about 10%, but the Vanguard Total Stock Market ETF (ticker: VTI) dropped more than 30% from roughly $60 a share. One of Zhang’s clients had a limit order to buy $400,000 of the ETF if it dropped to $40, which it did before quickly returning to about $60. Within three days the investor booked a tidy $200,000 profit.

Another broad-based fund Zhang uses for limit orders is the iShares Russell 2000 Value Index (IWN). To get exposure to the emerging markets he often turns to the iShares MSCI Emerging Markets Index (EEM) and the Vanguard Emerging Market Stock ETF (VWO). He says limit orders are also appropriate for more narrowly focused commodity ETFs. For retirement accounts, he favors the iShares S&P GSCI Commodity-Indexed Trust (GSG), the United States Oil Fund ETF (USO) and, given the run-up in gold of late, the SPDR Gold Shares (GLD). He likes these funds because they’re big and liquid, and the commodities-related ETFs offer a hedge against inflation, which Zhang foresees rising in the next 24-36 months.

Teresa Jacobsen

A senior vice president-investments at UBS Financial Services, Jacobsen appreciates ETFs’ flexibility and low cost, but she worries that investors don’t always understand the pitfalls. “Some tend to think of ETFs as static portfolios that track an index, but that’s not always what happens,” says the Stamford, Conn.-based advisor. “There can be surprises, and when there are, they can be quite unfavorable.”

A big problem is “tracking error”—when an ETF doesn’t match the returns of the securities it’s intended to track. This can occur with thinly traded or commodity-based ETFs that attempt to mimic the underlying asset by purchasing derivatives. Commodity ETFs often buy futures contracts, locking in positions that may not track recent shifts in spot prices.

BA_etf_jacobson

Investors must also pay heed to the individual securities an ETF owns and how they are weighted within it, Jacobsen says. ETFs that track a narrow equity sector might be heavily weighted in just two or three stocks, and a buyer may not realize that he already owns those shares. “ETFs are not a mindless thing to put in a portfolio; they need to be closely monitored,” she says.

Generally, Jacobsen sticks with the biggest, least expensive, most liquid ETFs for investors looking to match the market—since these have very little tracking error. She particularly likes the Rydex S&P Equal Weight Index (RSP), which gives equal weight to all the components of the S&P 500; also based on the S&P 500 but market-cap weighted, SPDRs (SPY) have consistently underperformed the RSP.

Jacobsen has $400 million in assets under management and a mix of retail and institutional clients. For the most sophisticated and risk-tolerant investors she will occasionally dip into leveraged ETFs, which are designed to amplify the moves of the underlying index. Some of her customers used them to play the recent stock rally. “They’re good at catching a trend at a particular time, but leveraged ETFs are designed for the short term. They can be useful, but they’re very volatile,” she says. Daily monitoring is required.

Laila Pence and Dryden Pence

For some investors, dividend income from an ETF is a nuisance—an unwelcome, taxable event. But for Laila Pence, president of Pence Wealth Management in Newport Beach, Calif., ETF payouts are exactly the point. “About 70% of our clients are retirees, so we love to capture cash flow. Our strategy is dividend- and income-driven.” And among ETFs there are many options, such as the iShares S&P U.S. Preferred Stock Index (PFF), which in early July offered a dividend yield of nearly 8%.

BA_etf_DrydenjDryden Pence, the firm’s 50-year-old chief investment officer, explains the husband-wife team searches for “choke points in the economy,” where industries have pricing power and thus the potential for increased cash flow and higher dividends. That would include railroads and water companies. They then locate ETFs that contain leading names in these businesses. “It can be inefficient to buy eight or nine [individual] stocks to get exposure to an industry, but buying an ETF makes sense,” he says.

The firm, with 350 clients and $600 million in assets, uses leveraged ETFs to stretch investment dollars. If an investor wants a portion of his portfolio focused on stocks with a good chance of price appreciation, the team might invest in a leveraged ETF that tracks technology shares. This might include the ProShares Ultra Technology (ROM), which offers twice the daily performance of the Dow Jones U.S. Technology Index, or the ProShares Ultra QQQ (QLD), which offers twice the daily performance of the Nasdaq 100. Pence Wealth Management can thus commit fewer dollars to get exposure and free up money to buy dividend-yielding investments. Dryden Pence cautions that any leveraged investment must be monitored closely and should be paired with stop-loss orders to reduce risk.

Although ETFs provide many benefits, Laila Pence, 52, recommends avoiding those that don’t have significant trading volume and are prone to tracking error. Another caveat: ETFs must be continually reviewed for any changes in their components, which can upset carefully balanced portfolios. “These are not fire and forget investments,” she says.

Dalal Salomon and Dan Ludwin

The past 10 years have been a “challenging, nauseating ride” that’s left major stock indexes pretty much where they started, says Ludwin, president of Salomon & Ludwin, in Richmond, Va. The experience left Ludwin and CEO Salomon frustrated because they couldn’t find any money managers taking advantage of the volatility.

BA_etf_salomon

Their solution: create their own trading software for ETFs. For two years they have used their patent-pending program, “ETF Trigger Point Strategy,” to trade eight different ETFs. So far, 200 of the firm’s 400 clients have committed $125 million to the strategy (the firm has $450 million under management). Because each account differs in asset allocation and start date, no overall return figures are available.

Volatility is here to stay, Ludwin says, but most investment firms remain fully invested. “Buy low, sell high is still a good strategy, but applying that to a fully invested approach really does not help us.”

One day this spring the Dow dropped 300 points in the morning but finished up by the close. Many money managers were happy to manage a gain. But Ludwin, 41, says by using Trigger Point, some Salomon & Ludwin clients bought ETFs in the morning and enjoyed much greater profits.

The software also aims to provide a long-term allocation strategy. Once a trigger price is hit and a sale occurs, part of the profit goes into cash, where it can be used to repurchase the ETF if its price falls. The rest shifts to fixed-income. “You should get more conservative as you get older, so this is a way to transition,” says the 54-year-old Salomon.

Fred Fern

Fern, chairman and CEO of Churchill Management Group, is a long-time market-timing investor who’s survived 11 major bull-bear cycles since opening his doors in Los Angeles back in 1963. He’s learned that aging bull markets tend to become volatile, which is a great environment for ETFs. “ETFs are a wonderful way to reduce the volatility of a portfolio,” he says.

TOC ETF photo

In anticipation of a new bull market, Fern, 72, picks the sectors he thinks will lead the charge and then focuses on his favorite stocks in those groups. But as the bull market matures, volatility increases,which is what’s happening today, Fern says. To smooth out this volatility, he sells stocks and buys ETFs to maintain a broad exposure to his chosen sectors. When he believes a bull market is finally petering out, he starts selling his ETFs and moves most of his holdings—$2 billion in all, from 3,000 clients—into cash and money-market funds.

He’s recently held positions in emerging-market ETFs, such as the iShares FTSE/Xinhua China 25 Index (FXI), whose underlying index consists of 25 of the largest and most liquid Chinese companies. He has also invested in technology ETFs, specifically the PowerShares QQQ Trust(QQQQ), which tracks the Nasdaq 100 index.

In a sign Fern believes the bull market is nearing its end, he’s started to lighten up on his ETF holdings. He’s exited the FXI, though he’s still holding the QQQQ.

He, too, cautions investors to pay attention to the size of the fund. “ETFs are one of the hot new games, and there are a ton of them. But some are real small, and investors need to be aware of their volatility and how they work.” Or perhaps put that volatility to work for them.

Advertisements

Comments»

No comments yet — be the first.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: