ETF Investments

by Mark Skousen

ETF Investments: Understanding "The Dark Side" of Exchange Traded Funds

by Mark Skousen, Chairman, Investment U

Friday, August 4, 2006: Issue #567

Until now, I've been a big fan of ETF investments (Exchange Traded Funds). After all, they offer choice, flexibility, low costs and tax efficiency, among other benefits. And they're growing like wildfire

Though small compared to the 8,000 mutual funds valued at $9 trillion, there are now 253 ETFs with assets exceeding $315 billion, up 41% from a year ago. Clearly, they have fulfilled an important need.

Everybody on Wall Street is getting in on the act, too. The New York Stock Exchange, the Nasdaq, the AMEX and the COMEX; brokerage houses like Merrill Lynch, Goldman Sachs, and Lehman; the indexer Dow Jones; and the rating services Standard & Poor's and Morningstar. Even giant mutual fund companies Vanguard and Fidelity see the advantages of ETFs and are offering new ones.

Many of these exchanges and institutions are offering ETFs through iShares, PowerShares, streetTRACKS and Rydex.

But there is a downside. As I see it, two dangers threaten your ETF portfolio

ETF Investments Danger Sign # 1: The Liquidity Factor You Can Buy, But Can You Sell?

With so many new ETFs coming on market, there's real concern that you may not be able to sell.

Institutions are offering so many new ETFs that it makes your head swim. At last count, Morningstar listed 253 ETFs trading on exchanges, compared to 152 the year before. New specialized ETFs are being created every week.

There's no liquidity problem with most of the older, bigger ETFs, such as the DIAMONDS Trust (AMEX: DIA), which trades, on average, 8.4 million shares a day, the S&P Depository Receipts (AMEX: SPY), with a daily volume reaching 87 million; or the Nasdaq 100 Trust (Nasdaq: QQQQ), which trades 128 million shares on average.

But what about the 1st Trust Dow Jones Internet Index (AMEX: FDN), iShares Dow Jones U.S. Regional Banks (NYSE: IAT), the Rydex Small-Cap 600 Pure Growth (AMEX: RZG), or streetTRACKS DJ Wilshire Large Cap (AMEX: ELR)? All four had "zero" (0) trades the day I wrote this article!

Lots of other ETFs have serious liquidity problems, too, trading fewer than 10,000 shares a day. Most of these are new, such as:

  • iShares Dow Jones U.S. Home Construction (NYSE: ITB)
  • PowerShares Dyn Building & Construction (AMEX: PKB) or
  • Rydex S&P Midcap 400 Pure Growth (AMEX: RFG)

Some new ETFs, however, are extremely popular. For example

  • The new iShares Silver Trust (AMEX: SLV) trades 625,000 shares a day, priced at $116 a share.
  • The iShares COMEX Gold Trust (AMEX: IAU) trades 250,000 shares a day.
  • iShares Dow Jones U.S. Real Estate (AMEX: IYR) shares trade 2.3 million times each day.

Liquidity also depends on popularity, and it's quite possible that some hot ETFs will be difficult to unload years later.

Foreign markets are hot right now, and so are the ETFs that specialize in them. You should have no problem selling your iShares MSCI Emerging Markets Index (AMEX: EEM), which trades 7 million shares a day, or the iShares Japan Index (AMEX: EWJ), which trades 25 million shares a day. But volume on iShares MSCI South Africa (AMEX: EZA) and iShares MSCI France (AMEX: EWQ) reaches just 150,000 shares daily.

My advice: Check the average daily volume of each of the Exchange Traded Funds. Don't invest in these ETFs unless you find that there is good liquidity in both bull and bear markets.

ETF Investments Danger Sign #2: Poor Diversification

The other threat to your wealth is an incomplete ETF index. That's not a problem with the S&P Depository Receipts, which mimic the S&P 500 Index; or the DIAMONDS Trust, which imitates the Dow 30. But Merrill Lynch's Internet HOLDRs (AMEX: HHH), which was created in September 1999 - nearly the top of the Internet bubble - is heavily weighted in only three stocks: Yahoo!, eBay and Amazon.

In fact, it does not even include Google (Nasdaq: GOOG), which went public in 2004. If it had been included, HHH would have been a top performer. Instead, open-ended tech funds, such as the Jacob Internet Fund (JAMFX), have outperformed HHH in the past two years by a wide margin. (See chart below.)

ETF HHH lags behind JAMFX

Lesson: When investing in ETFs, check the holdings before you invest.

In short, don't sell your mutual funds anytime soon. Ultimately, they may have some advantages over ETF investments, especially when it comes time to sell or diversify.

Good investing, AEIOU,

Mark

Today's Investment U Crib Sheet

  • For a side-by-side comparison of stock, ETF and mutual fund benefits, read the Investment U Research Team's free report, Exchange Traded Funds Investments: Profit from the World's Hottest Markets. The report also includes three highly liquid and in-favor ETFs.

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