Which market cap are you comfortable with? Large-cap, mid-cap, or small-cap?
Are you comfortable with growth stocks, value stocks, or a mix of both? There are mutual funds and exchange-traded funds that are various combinations of market cap and investing style; you"ll find some examples in Table 5.4.
Unless you"ve spotted a huge trend, today "s winner is probably not going to do so well tomorrow. Diversity within a broad portfolio is good. Feel free to add focus or increase exposure to one sector or industry about which you feel strongly. As you can see by looking at Table 5.4, ETFs let you target different areas of the market, and you can mix and match them to suit your style.
Diversity is also good across international borders. If the ETFs in your portfolio don"t have an international component, perhaps you should add an international fund.
Bonds are the anchor of any portfolio. Younger investors don"t need much of an anchor-they want to move fast. The longer your boat"s been sailing, the bigger an anchor you likely want.
One rule of thumb that many advisors use to determine the proportion a person should allocate to stocks is to subtract the person"s age from 100. In other words, the theory goes that if you"re 35, you should put 65% of your money into stocks and the remaining 35% into bonds, real estate, and cash. But that doesn"t take into account factors like whether you"re a parent or whether your spouse works. Don"t get boxed in by others" expectations-do what works best for you.
Table 5.4 ETFs Offer Market Cap and Style Choices ETFTickerExpense Ratio Large-Cap Value ETFs iShares Russell 1000 Value IWD 0.2 % streetTRACKS Dow Jones U.S. Large ELV 0.21% Cap Value iShares S&P/Barra 500 Value IVE 0.18% Large-Cap Growth ETFs iShares Russell 1000 Growth IWF 0.2 % streetTRACKS Dow Jones U.S. Large ELG 0.21% Cap Growth iShares S&P/Barra 500 Growth IVW 0.18% Small-Cap Value ETFs iShares Russell 2000 Value IWN 0.25% streetTRACKS Dow Jones U.S. Small DSV 0.26% Cap Value iShares S&P/Barra SmallCap 600 Value IJS 0.25% Small-Cap Growth ETFs iShares Russell 2000 Growth IWO 0.25% streetTRACKS Dow Jones U.S. Small DSG 0.26% Cap Growth iShares S&P/Barra SmallCap 600 Growth IJT 0.25% These are all strategies that have worked in the past. In the future, if we are descending into a time of political, social, and economic upheaval, these tried-and-true strategies may no longer apply.
This is why so many investors and traders have adopted shorter-term horizons, namely moving in to the market when they think it is in rally mode, and moving out when they think the cycles have turned and the market is headed down.
But even if you try to ride the market"s waves, it"s probably still best to diversify.
So far we"ve talked about the five emergencies that could shape the market, the U.S. economy, and the global economy for years to come; deciding which kind of investor you are; six things every stock investor needs to know; and six investor do"s.
Hedging Your Bets-Inverse ETFs
There"s one more kind of ETF you need to know about-inverse ETFs. These are designed to go up when whatever they track goes down and vice versa. There are inverse or ultra-inverse (leveraged) ETFs for the broad indices, real estate, financials, consumer goods, semiconductors, technology, and even emerging markets. They can be used in two ways:1. Speculatively, because you believe the broad market or a specific sector or commodity is going lower 2. To hedge your existing investments-for protection against declines in specific industry sectors where you are already invested Some examples:* If you have a broadly diversified domestic portfolio, you could use DOG or DXD, which move inversely to the Dow Jones Industrial Average, or SH, SDS, or RSW, which move inversely to the S&P 500 Index.
* If you have a lot of technology stocks, you could use the inverse ETF with the symbol REW.
* If you have a lot of small-cap stocks, you could use the SDD inverse ETF.
Overall, how much you invest depends on your own investing style and stomach for risk. Importantly, inverse ETFs are trading vehicles to catch short-term trends-not long-term investments.
Now, let"s look at some ETFs that could help your portfolio survive and even thrive in various disasters and trends.
ETFs for All Sorts of Markets
Some investors use sector ETFs for conservative a.s.set allocation strategies. Others use them to speculate. Whatever you prefer, ETFs can be a good addition to an active portfolio.
One aspect of them is they let you target areas of the economy you think will do well over the next few years, and you can even use them to invest for the five emergencies.
Energy. If you think a new energy crisis is coming, there are different ways to play it. Many ETFs and ETNs say they track the price of oil, but sadly, that"s just not true. Funds like iPath S&P GSCI Crude Oil Total Return ETN (OIL), PowerShares DB Oil ETF (DBO), and United States Oil Fund (USO) are being front- run by the big money on Wall Street so regularly that they lag oil"s performance rather badly. On the other hand, if oil is trending higher, these funds trend higher, too. So they"re an easy way to catch the general trend of oil, if not the total performance.
Another fund to consider is the PowerShares DB Energy Fund (DBE). It holds a basket of futures contracts on light sweet crude oil, heating oil, Brent crude oil, gasoline, and natural gas. It"s meant to track the energy sector as a whole, not just crude.
There are also ETFs that track baskets of stocks in the energy sector-the Oil Services HOLDRs (OIH), Energy Select SPDR (XLE) and SPDR Oil and Gas Exploration and Drilling ETF (XOP), just to name three. These also lagged oil in a recent two - year period, but they may have periods of out-performance.
One final idea is to invest in Canadian royalty trusts that trade on the New York Stock Exchange. They pay high dividend yields of up to 10% to 15% annually. Not only are the dividends paid monthly, which allows for a better dividend income compounding, but some of them also allow investors to purchase shares through dividend reinvestment plans (DRIPs) at discounted prices. Unlike U.S. trusts, Canadian royalty trusts can purchase new a.s.sets and make acquisitions.
U.S. investors are at a disadvantage; the Canadian government applies a 15% nonresident withholding tax on distributions to U.S. investors. The good news is that U.S. investors can apply for a refund for at least a portion of the amount withheld. Many Canadian trusts provide information for income tax filing instructions for U.S. unit holders on their web sites, so check them out before you buy.
Now for the bad news-there is a big change coming in 2011. Canada is changing the law, raising taxes on income trusts to a rate similar to corporations. Canadian royalty trusts are now under pressure to convert to corporations before the end of 2012, and that"s what many of them, like Penn West Energy Trust (PWE on the NYSE), are doing.
Other high-yield Canadian Trusts I like include Harvest Energy Trust (HTE), Enerplus Resources Fund (ERF), Baytex Energy Trust (BTE), and Pengrowth Energy Trust (PGH). If you"re interested in them, check with your accountant first to make sure the tax situation makes sense for you.
And sure enough, there is a fund that holds Canadian royalty trusts-the Claymore/SWM Canadian Energy Income ETF (ENY). It holds trusts as well as some big individual names in Canadian energy, and it pays monthly dividends.
Bottom line: I find energy ETFs are good trades if you think (1) oil is trending higher, and (2) you"re not hung up on the fact that these funds will underperform crude oil itself. They are best for short-term trades; they"re good at catching short -term fluctuations in the market, and there are inverse ETFs you can use if you think energy is going to make a short-term move to the downside.
If I had to pick energy ETFs for the long haul, I like the Claymore/SWM Canadian Energy Income ETF (ENY) for its dividend, and the PowerShares DB Energy Fund (DBE).
One more thing to consider: Everything is so interconnected now; a severe equity sell-off will probably drag down crude and energy stocks.
Water. There are a bunch of water ETFs: PICO Holdings (PICO is a water h.o.a.rding play in the Nevada desert); First Trust ISE Water Index Fund (FIW) and PowerShares Water Resources Portfolio (PHO), which are very similar U.S.-focused funds; and the Claymore S&P Global Water Index ETF (CGW), which is more global. There are others, as well.
Food. A half-dozen or so ETFs all hold various mixes of futures in grains and other agricultural products. The PowerShares DB Agriculture ETF (DBA), iPath Dow Jones AIG-Agriculture ETN (JJA), and iPath Dow Jones AIG-Grains ETN (JJG) are all good ways to play a bull market in food. If you prefer makers of agricultural machinery, there is the Market Vectors Agribusiness ETF (MOO).
And if you think agriculture prices are going lower, you can try the PowerShares DB Agriculture Double Short ETN (AGA) for a short-term trade.
Climate/Green Tech. There are carbon-trading ETFs, but at this writing they"re as illiquid as granite. Maybe they"ll perk up. In the meantime, consider solar and other alternative energy plays: Claymore/Mac Global Solar Energy (TAN), the Market Vectors Solar Energy ETF (KWT), Market Vectors Global Alternative Energy ETF (GEX), and First-Trust ISE Global Wind Energy Index Fund (FAN).
These are the same funds that should do well if the United States invests in a green-tech-led industrial renaissance like I discussed earlier. Another fund to consider is the PowerShares Cleantech Portfolio (PZD). This tracks a basket of companies in alternative energy and efficiency, advanced materials, air and water purification, eco-friendly agriculture, power transmission, and more.
Commodity Super Cycle. The iShares S&P GSCI Commodity-Indexed Trust ETF (GSG) tracks the S&P GSCI Total Return Index. This has a wide basket of components-everything from crude oil to industrial metals to precious metals, agriculture, and livestock.
PowerShares offers the PowerShares DB Commodity Index Fund (DBC),10 which tracks the Deutsche Bank Liquid Commodity Index. It holds a basket of futures on crude oil, heating oil, gold, aluminum, corn, wheat, Brent crude, copper, natural gas, RBOB gasoline, silver, soybeans, sugar, and zinc.
Both of these funds charge 0.75% in annual fees.
An ETF that holds stocks and is a play on the commodity super cycle is the Claymore/Delta Global Shipping Index (SEA). Like the name says, this fund invests in companies in the global shipping industry. A commodity bull market is a.s.sociated with higher volumes of international shipping, which should be good for the SEA. The SEA has an expense ratio of 0.65%.
Short commodity ETFs include the UltraShort DJ-AIG Commodity (CMD), but there are others, as well.
Treasuries/Debt. There are three basic reasons to consider investing in a bond exchange traded fund:1. If you"re older, you may appreciate the stability that comes from income-generating investments; they can provide a relatively steady stream of income.
2. If you want to decrease overall portfolio volatility because bonds and stocks often don"t move in concert with each other.
3. If you think bonds are going down, you can use an inverse or ultra inverse fund-a fund designed to move up when bonds go down.
Bond funds include short-term treasury bonds (SHY), medium-term treasury bonds (IEF), long-term treasury bonds (TLT), inflation-protected treasuries (TIP), and corporate bonds (LQD). If you think Treasury bonds are going lower in price (which means higher in yield-yield always moves inverse to price), you could use the UltraShort 20+ Year Treasury ProShares (TBT).
Inflation and Hyperinflation. The aforementioned TIP is a good inflation-protected fund. But if and when we get to hyperinflation, you"ll probably want to be in gold, oil, and agricultural commodity funds. You already have some suggestions for oil and agriculture. For gold, you can consider funds that hold physical metal, like the SPDR Gold Shares (GLD) and iShares Comex Gold (IAU), or a fund that holds gold miners, like the Market Vectors Gold Miners ETF (GDX).
If you think gold is going lower, you can play that with the DB Gold Double Short ETN (DZZ) or the less-liquid (and un-leveraged) DB Gold Short ETN (DGZ).
Dividends. You have to be careful-at times, value and sector ETFs pay out more than ETFs designated as dividend ETFs. In just a bit, I"ll give you a list of web sites that will help you screen ETFs for, among other things, dividend payouts.
Importantly, remember that risk is more important than yield. A 5% yield does not make up for a 20% loss. Yields can change, especially in toxic sectors.
Pros and Cons of Exchange-Traded Funds (ETFs) Exchange-traded funds, also known as ETFs, are like an improved version of mutual funds. ETFs aren"t only for stocks. Any cla.s.s of a.s.set that has a published index around it and is liquid can be made into an ETF. ETFs cover markets including bonds and real estate, commodities including gold, silver, and oil, and even currencies.
Going under the hood, ETFs are investment holding companies or futures contracts. A custodial bank holds the basket of stocks and other a.s.sets in the fund"s account for the fund manager to monitor. These baskets are normally quite large, and sufficient to purchase 10,000 to 50,000 shares of the ETF. When those holdings rise in value, so does the ETF price. When those holdings drop in value, the ETF price falls.
These funds trade throughout the day over an exchange. Most ETFs track an index, such as the Standard & Poor"s 500 index or the Philadelphia Semiconductor index. Because they are pa.s.sively managed, ETFs have low annual expenses. They are not closed-end funds, and the fund companies do not redeem shares for cash.
ETFs are generally valued at close to their net a.s.set value (NAV), although they sometimes trade at a slight discount or premium.
Five other things to consider:1. ETFs offer you the diversification, convenience, and everything else you love about mutual funds-without the high cost and trading restrictions. Unlike mutual funds, ETFs almost never demand high minimum investments; never nick you for ridiculous loads, 12-b1 fees, or management fees; and never impose limits on what time of the day you can buy or sell!
2. Expense ratios average 40 basis points for ETFs. Some cost even less. Expenses for actively managed mutual funds average more than double that-150 basis points, or 1.5%.
3. ETFs offer you loss protection. You can use stops to help protect your princ.i.p.al and your profits. You can also aim to get in cheap with limit buy orders.
4. Plus, there are now ETFs that make you money when stock prices fall. You never have to go short yourself. You just buy an ETF like any other. The more the market falls, the more money you stand to make.
5. ETFs and ETNs that hold baskets of futures contracts on commodities will generally underperform those commodities. That"s because the big players on Wall Street know when those ETFs roll over their contracts and they front-run them. However, these funds can still let you ride the general trend in a commodity, up or down.
There are exceptions to every rule. And some mutual funds have managers exceptional enough that they"re worth using. For example, The U.S. Global Investors (www.usfunds.com) family of mutual funds, run by Frank Holmes, are excellent funds that mix innovative strategies and smart investing ideas. But match any mutual fund you"re considering up against a comparable ETF if you can find one, and see which is the real bargain.
Some of the more popular ETFs include the SPDR S&P Dividend ETF (SDY), PowerShares Dividend Achievers (PFM), and Vanguard Dividend Appreciation ETF (VIG).
The Asia/China Boom. The iShares FTSE/Xinhua China 25 Index (FXI) is the granddaddy of China funds. Other options include the PowerShares Golden Dragon Halter USX China (PGJ), which primarily holds ADRs (American Depositary Receipts) of Chinese companies listed in the United States. The Hong Kong ETF (EWH) is overweighted with financial and real-estate firms based in Hong Kong, but is still good for tracking Chinese economic growth.
Web Tools for ETFs
There are some excellent free Web tools you can use to screen for the best ETFs to fit your investing style and current market conditions.
First-Morningstar"s ETF Screener. Morningstar made its name as a mutual fund site, and it"s carried that expertise over to ETFs.
Go to Morningstar.com. You"ll see a row of b.u.t.tons on top. Click on the one that says Tools. Under the heading Basic Screener, you"ll find a link to Morningstar"s ETF screener.
Here, you"ll find the screening criteria: Fund group, Morningstar Category, Expense Ratio, Year-to-Date Return, 1-year-return, 5-year return. And you can set other criteria as well. If, for example, you like natural resources, you might change the Morningstar category to Natural Resources, and put the expense ratio at less than or equal to 0.5%. All the rest of the screening criteria you would leave as any. Then, click the b.u.t.ton at the bottom to view your results.
You can also click on the categories along the top to sort the funds. Let"s say you click on Market Year-to-Date Return, because the trend is your friend. Another important category is the one on the far right, Total a.s.sets. You don"t want to get into a fund that is too small. Any fund with total a.s.sets of low double-digits or worse, single-digits, should be crossed off your list immediately.
Why is that? Because it"s just as important to be able to get out of a fund as it is to get into it. And a fund with low total a.s.sets will usually have a big spread between the bid and the ask. That means you get dinged on the way in and the way out.
Morningstar is a good screening tool, but it only shows you the most popular funds. Morningstar"s ETF research is very basic. Maybe that"s all you want. If you"re looking for more information, then you can move on to other web sites.
Let"s look at another one now-Yahoo! Finance.
Yahoo! Finance ETF Screener. Go to finance.yahoo.com. Under the Investing tab, you"ll find ETFs. There you can sort ETFs by all sorts of categories.
If you"re in a bear market kind of mood, this is a great place to find out which funds perform best over three-month, year-to-date, and other time frames. Clicking on any of the fund names takes you to Yahoo!"s Summary page on that fund, which is really best in cla.s.s.
But we"re not done yet.
MSN ETF Screener. When you use the MSN site, you should use the Internet Explorer browser, because Microsoft "s web site was apparently designed by a bunch of control freaks who hate Firefox and other non-Microsoft browsers.
Anyway, point your Web browser to Moneycentral.msn.com. Down the page you"ll see a lot of links, including one that says ETF Research.
One thing I like about this site is it tells you which ETFs are the leaders and laggards on any given day. This gives you a good idea of what is working in the market. To find this, look on the left-hand column for a link called Top Performers. Once you click on the link, you"ll find there are many different categories. You can also look at what the funds are holding, check out the Morningstar rating if the fund has one, and organize by category, price, and performance over a number of time frames.
Many of the better performers have higher Morningstar ratings. It"s funny how that works out, isn"t it? Basically, looking for a good balance between returns and Morningstar ratings is a good first step.
These are three different ETF screeners, each with its own approach to finding the best funds. I don"t have a particular favorite; and I"ve been known to use all three when I "m doing my fund research. You"ll have to explore and kick the tires, and see which one works best for you.
The Least You Can Do * Educate yourself! Define your own comfort level of risk and reward-which of the three levels that I discussed in this chapter suits you?
* If you"re going to invest in stocks, be aware of the six things every investor must know about the stock market.
* If you prefer exchange-traded funds (ETFs), see the Pros and Cons of ETFs sidebar.
* a.s.set allocation is a way to remove risk from your portfolio-and ETFs make it easier.
PART III.
BE PREPARED-GRUB AND GEAR
CHAPTER 6.
Water When the well is dry, they know the worth of water.