The Investment U E-Letter: Issue #453
Monday, July 18, 2005

Exchange Traded Funds: A Better Way for Sector Investing
By Dr. Steve Sjuggerud, Chairman, Investment U

In his current business bestseller The Bull Hunter, my good friend Dan Denning refers to exchange traded funds (ETFs) as “Precision-Guided Investments.“

Dan raves about the benefits of exchange traded funds in his book… “Imagine a single security that allows you to buy an entire sector or industry or even country - in just one stock. ETFs are a cross between individual stocks and index mutual funds, and they offer the best of both worlds…”

“I agree with Dan, but I’ve been frustrated with some of the opportunities available in exchange traded funds until now…

Three weeks ago, a handful of “PowerShares” sector exchange traded funds were introduced. These things are fairly revolutionary in the ETF market, and I’m excited about them.

If Dan liked exchange traded funds before, then he’ll really like PowerShares. Let me explain…

Are PowerShares Better Than Exchange Traded Funds? I Think So…

Traditional exchange traded funds are, as Dan described, single investments that allow you to hold an entire sector (like the energy sector, for example) in just one stock.

Investors looking for information about exchange traded funds should know that ETFs are like a mutual fund, in that they hold a basket of stocks with a similar theme (energy stocks, for example). And they’re generally most like index funds, in the sense that they just hold a fixed portfolio of companies in that theme.

Lastly, and importantly, exchange traded funds generally hold the stocks in proportion to the size each stock makes up in its sector.

To me, this is where the problem comes in…

Exxon and Chevron, for example, make up nearly half of the iShares Energy Sector exchange traded fund. So are you really holding a basket of stocks representative of the energy sector? NO… It just so happens that Exxon and Chevron are so huge, based on their market value, they’re the industry giants.

So if you buy the iShares Energy Sector ETF, you’re not getting diversification in energy stocks… you’re really just buying Exxon and Chevron.

If I want a basket of 30 or so energy stocks, I want all 30 of them to contribute to the performance of my portfolio. However, in the case of the iShares Energy Sector ETF, if Exxon and Chevron lose half their value, I’m bound to lose a lot of money no matter how the other 28 stocks perform.

Why Some Exchange Traded Funds Are a Real Scam

To me, the whole point of investing in exchange traded funds is to get broad exposure to a sector (like 30 stocks) in just one buy… all with low fees, easy trading (just like a stock) and tax benefits. But consider the flip side. While the low fees, easy trading, and tax benefits are definitely there, the broad diversification promised by exchange traded funds is a bit of a scam in some cases…

For example, take the semiconductor exchange traded fund with the symbol SMH… Intel and Texas Instruments make up nearly half of this ETF. Like the Energy ETF above, by buying SMH you’re not buying a basket of semiconductor stocks. You’re really just buying Intel and Texas Instruments, as their performance is going to make up most of the performance of this ETF. As far as diversification goes with these kinds of exchange traded funds, it’s a sham.

The worst offender might be the ETF with the symbol BBH. BBH is a biotech ETF where two-thirds of the ETF is made up of just two stocks - Genentech and Amgen. That’s terrible… When you buy BBH, you’re not getting a diversified portfolio of biotechs. You’re really just buying these two stocks.

The “promise” of exchange traded funds is this: diversified exposure to an entire sector in just one stock. I don’t know how these exchange traded funds above went so wrong. But a relatively new ETF manager, PowerShares, seems to have gotten it right…

Broad Exposure, Dropping the Losers, and Other Advantages

It seems to me that PowerShares actually started out by asking, “What would the customer want?” As the customer, I want broad exposure to a sector (maybe 30 stocks). Don’t mess with it too much, please. But if you must mess with it, please kick out the “dogs” every once in a while, and don’t just passively sit by and watch them go to zero.

And please don’t load up on overpriced stocks simply because the market value of these stocks has gone up. I don’t want the fund to buy more and more of what’s already become super expensive. PowerShares fulfill both of these objectives…

Each PowerShares sector ETF actually contains 30 stocks. And most importantly to me, no stock can make up more than 5% of the portfolio. So the biotech PowerShares, for example, couldn’t possibly have two stocks make up two-thirds of the assets. Simple stuff. But great stuff.

Thankfully, the dogs can also be kicked out… stocks that appear attractive (based on quantitative measures) can be let in… and the super-expensive stocks will still never make it to more than 5% of the portfolio. That’s because instead of holding a fixed portfolio, the PowerShares portfolio changes quarterly based on dynamic underlying indexes, called “Intellidexes.”

The Bottom Line on PowerShares

Let me get to my bottom line here… PowerShares allow me to invest in sectors the way I want… where all 30 stocks in the fund actually affect the performance, which is exactly the diversification I expect from investing in exchange traded funds.

If I want to buy biotech, I don’t want to own Amgen and Genentech. I want to own the 28 other stocks that have bigger upside potential than the two giants. I don’t want to own BBH… I want the biotech PowerShares.

Also, the fact that the PowerShares portfolio changes quarterly is actually attractive to me… it’s a way to kick the dogs out of a portfolio early on, instead of waiting for some stuffed-shirt committee to finally (and arbitrarily) decide to kick a dog out.

So, to my friend Dan: if you like exchange traded funds, I think you’ll love PowerShares. And so should anyone else looking for truly broad exposure to a sector.

Today’s IU Cribsheet

• There are many more positive attributes of PowerShares that I did not discuss here. And as I understand it, there are more sector PowerShares on the way. To learn more about PowerShares, visit http://www.powershares.com, and even feel free to contact them… they’re helpful on the phone.
• For more information on exchange traded funds in general (and to see just how overloaded in one stock your ETFs are), the best free site out there today is http://www.ETFconnect.com. You can also take a look at http://www.etfguide.com/
• To gain a balanced perspective on exchange traded funds, I highly recommend giving a read to Dan Denning’s new book, The Bull Hunter.

Good investing,

Steve

Related Articles:

• Stock Market Predictions for 2004-2005: The Best Stock for the Next 10 Years
• The Sad Reality of Mutual Funds
• Investment Biker Jim Rogers: Five Steps to Becoming an “Adventure Capitalist”

Return to Archives