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Following The Money: ETFs And Your Portfolio

11/16/06 09:56:47 AM PST
by Jim Ulland

Exchange traded funds can be the best way to add exposure to your portfolio.

These days, everyone seems to be talking about exchange traded funds, or ETFs. Judging by the increase in ETF assets over the past four years, there's good reason for all the talk. Since 2002, ETF assets have nearly tripled, to almost $470 billion. Today, there are more than 200 different ETFs. They vary from the earliest ETFs, which were broad US market indexes such as the Standard & Poor's 500, to specific sectors such as the iShares Goldman Sachs Software index, and new foreign market offerings such as the iShares Singapore index.

ETFs are baskets of securities designed to give investors exposure to broad market indexes, individual sectors, and even geographic regions. In many ways, they are similar to mutual funds; however, ETFs are traded throughout the day on an exchange and bought and sold like stocks. Mutual funds, in contrast, only trade once at the end of the day and often charge penalty fees for investors who sell a fund if the funds aren't held for a minimum time period. ETFs are appealing because they are highly liquid securities.

The ability to buy and sell a security instantly is an invaluable benefit in volatile markets. Unlike the majority of mutual funds, which are to various degrees actively managed, all ETFs are passively managed, meaning they track predetermined indexes. As such, ETF products can track broad US markets like the S&P 500 or specific sectors and industries, even individual countries. The result is annual expenses far cheaper than traditional actively managed mutual funds and even relative to mutual funds that are "indexed" to a broad market average, sector, or country. For instance, Morningstar estimates that the average expense ratio for ETFs is in the 0.40% range. However, the expense ratio can be much lower for some ETFs. The iShares S&P 500 expense ratio is 0.09%, roughly half the cost of the Vanguard 500 Index Fund. Most actively managed mutual funds have an average expense ratio of 1.5%, more expensive than even the priciest ETFs. But don't forget that ETFs are bought and sold like stocks, so transaction costs apply. If you're an avid trader or if you plan on adding money on a monthly basis, you may want to calculate potential transaction costs.

ETFs should be selected as part of a diversified portfolio, and it's important to evaluate a fund just as you would with an individual stock, bond, or mutual fund. One of the biggest criticisms with ETFs is that they allow investors to jump from one hot sector to the next with little regard for fundamentals. The cash flow into some of these funds may be more about hype and marketing than common sense investing.

Don't forget that like stocks, ETFs can trade above or below their net asset values (NAV). It's important to know why that might be. Do the companies in the fund have growth rates that meet your criteria? Is the ETF concentrated in too few companies? The more information you can find, the better. Typically, however, ETFs will trade very close to NAV. If a discount or premium does occur in the ETF price, arbitrage mechanisms exist to close these gaps relatively quickly. Look carefully at the holdings of the ETFs. Investors can get a list of individual ETF holdings every day. It's important you know what securities can be found in your ETFs. Ian Salisbury of The Wall Street Journal recently noted that some ETFs aren't quite what they seem. One example he cited was the iShares Aerospace & Defense ETF, which also holds commercial satellite companies like XM Satellite Radio (XMSR) and Sirius Satellite Radio (SIRI) in the fund: companies far afield the aerospace and defense sectors. The reason: the fund performance looked better when those companies were included. The fund's NAV increased and so did the return on investment. Other ETFs might be concentrated in only a few companies. This is especially true in some of the smaller-country ETFs where there aren't as many companies to begin with.

Where does an ETF fit into a traditional portfolio of stocks, bonds, real estate, and alternative assets? When buying and selling securities, transaction costs can add up, so choosing the right ETFs or stocks for your portfolio is important. Like most securities, you want the ETFs to perform well over the long term and to supplement the overall mix of other assets in your portfolio. As money managers, we like to use ETFs to capture excess returns in markets or sectors in which we are less comfortable selecting individual securities but where the lack of correlation with other assets in our portfolio can help better diversify our holdings.

Finding and researching foreign stocks can be very difficult, not to mention expensive, as foreign company business, cultural, and accounting practices differ from US companies. The right individual-country ETFs helped us achieve inexpensive, highly liquid, and diversified foreign exposure for our clients.

So how do we find the right country ETFs? What we don't do is simply pick the fastest-growing foreign markets, although we certainly wanted to find countries with high-growth expectations. When choosing ETFs of individual countries, we considered 22 variables that included economic, political, and sociological strengths and weaknesses. Rather than focus solely on the long-term trend of a country's stock market, we wanted to find country ETFs where the economic fundamentals and geopolitical forces within the country allowed us to predict strong and stable economic performance.

Much has been made of emerging markets in Latin America and Asia. While economic growth in many of these countries has been staggering, the geopolitical risk can outweigh the potential benefit. For example, the iShares S&P Latin America, which tracks the 40 largest companies in Mexico, Brazil, Argentina, and Chile, had a three-year return exceeding 50% and is up over 45% year to date. These are strong historical numbers, but let's consider some political issues in the region.

First, elections in Ecuador and Peru have had unsettling effects on the region as protests and violence broke out in both countries in the last few months. Latin America faces another 11 major elections in the next year. Venezuela's president, Hugo Chavez, seizes control of more oil fields on a daily basis as he and his government continue to be emboldened by rising oil prices. Chavez is using oil as a weapon to attack foreign investments in Latin America. As a result, we expect more uncertainty and volatility in Latin American markets despite terrific growth the past few years.

There are countries that do not have this same level of political risk and yet demonstrate equal or greater economic growth. Austria and South Korea are two great examples of strong economies and relatively stable political situations. We like Austria as a supplier to the fast-growing eastern European economies and South Korea as a supplier to China.

Our basic premise? ETFs should help us gain exposure to markets outside our core portfolio strategy, but with an acceptable level of risk.

Over the past few years, ETFs have evolved from broad US market indexes into more highly focused ones that single out a particular sector or country — products that are attractive, even sexy, to investors because ETF designers seemingly take the work out of picking stocks. But don't be fooled: ETFs can be volatile, especially those specific to quickly growing sectors and emerging markets. Investment market research shows that making the right geographical or sector allocation decision is often more important than choosing an individual security within a sector or geography.

Always consider the underlying fundamentals of a security, whether it's an individual stock, a mutual fund, or an ETF. ETFs are the best way we've found to add inexpensive portfolio exposure for the explosive growth rates of select foreign countries, while avoiding the higher costs and the embedded capital gains problems of mutual funds.

ETF Investing Guide [2006]. "Seven Advantages Over Index Mutual Funds,", July 1.
Morris, Sonya [2006]. "Six Principles Of Smart ETF Investing,", August 17.
Salisbury, Ian [2006]. "Do You Know What's In Your ETF?" The Wall Street Journal, August 13.
Strauss, Lawrence C. [2006]. "Too Many ETFs?" Barron's, July 3.

Jim Ulland

Jim Ulland founded Ulland Investment Advisors, Inc., an independent money management firm, in 1997. The Minneapolis, MN-based firm specializes in a blend of large, mid- and small capitalization stocks. Before founding his firm, Ulland was executive vice president for portfolio administration at Kopp Investment Advisors of Edina, MN. He is the former minority leader of the Minnesota State Senate and the former Minnesota Commissioner of Commerce from 1993 to 1995. He can be reached at

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