1. The Evolution of ETFs
The Exchange Traded Funds (ETF) world has exploded since I wrote a book on ETFs about 12 years ago. Then there were only 32 ETFs, and the amount invested in them was about $65 billion. The original ETFs included the following:
• The Nasdaq-100 Index ETF (symbol QQQQ). This index is made up of the 100 largest domestic and international non-financial companies listed on the Nasdaq Stock Market, and the sizes are based on market capitalization. The portfolio is rebalanced quarterly and reconstituted annually. There are no portfolio managers deciding which stocks go into the index; instead, the stocks put into the index are automatic.
• The Dow Jones Industrial Average ETF (symbol DIA). The stocks put into DIA are chosen by a committee. The stocks are from companies that the committee deems the most important 30 companies in the U.S. economy. The average is the oldest market index at more than 100 years old. It is called an average because it originally was computed by adding up stock prices and dividing the total by the number of stocks.
• The S&P 500 Index ETF (symbol SPY). The SPY is comprised of the stocks of 500 companies that are chosen by Standard and Poor’s portfolio managers. The S&P 500 Index is constructed to represent the U.S. economy, which is broken down into sectors. The portfolio managers decide which companies are the most important for each sector. Sector weighting is apportioned according to each sector’s importance to the economy. For instance, if the managers conclude that the energy sector comprises about 30 percent of the U.S. economy, they will put about 30 percent of energy stocks into the index. The S&P portfolio managers don’t attempt to put undervalued stocks into the index or find stocks that will go up; they just find stocks of companies that are important to the sector. Because the index is constructed to reflect general economic conditions, it is considered a passive index. This index is not made to be the most profitable for investors. Most of the other original ETFs were constructed along these lines. The S&P 500 Index is comprised of nine sectors. ETFs have been constructed for each of these sectors, such as the S&P Energy Sector SPDR (symbol XLE).
• The original ETFs included country ETFs, such as Japan (symbol EWJ) and Hong Kong (EWH). The indexes are constructed to basically reflect each country’s economy and include stocks of the largest and most important companies in each country. Like the S&P 500 Index, the index is not constructed to outperform but to increase in value as the countries’ economies grow.
• The original ETFs had an S&P small-cap ETF and an S&P mid-cap ETF. Like the other S&P ETFs, they are constructed of the stocks of the most important companies in each country. The stocks are chosen to reflect each country’s economy, not to outperform a benchmark.
Objective of the Original ETFs
The original ETFs were not constructed to outperform any benchmarks, but were constructed to include companies that were the biggest and most important. As economies expanded, it was expected that the companies in the indexes would grow and the price of the stocks in the indexes would rise. It was accepted when economies slowed down that company revenues would also drop and stock prices would probably decline. The original ETFs were almost all cap-weighted or modified cap-weighted. Cap-weighted indexes have heavier weightings of bigger companies, and price moves of those companies have a big effect on the value of the index. Because of this structure, some index makers think that cap-weighting can have a built-in risk because bigger companies might have their greatest growth behind them. If a big-cap company’s growth slows down (the bigger the company is, the harder it can be to keep growing), the company’s stock price can be vulnerable. In market downturns, this type of company can be especially vulnerable and subject to declines such as the big-cap technology companies in the bear market years of 2000 to 2003. A cap-weighted index might overweight the companies that have grown and underweight smaller companies that have not grown as much. Some index makers think that indexes should have a mechanism that sells stocks when they get expensive and buy stocks when they get cheap. These index markers think that cap-weighted ETFs can perform the worst in good markets and decline the most in bad markets.
Cap-weighting indexes have performed throughout the years and have good points or they would not have been so successful. Cap-weighted indexes allow the bigger companies in their universe, which are usually the more important companies, to have a bigger weighting. This offers more exposure to more significant companies. Also, often the bigger companies in their cap-size have more financial muscle and might be better suited to weather economic storms. In the big-cap space, the bigger companies usually have more international sales, which is important in our global-trade world. The S&P 500 Index is essentially a big-cap growth index, and this asset class sometimes outperforms other indexes.
Development of New and Different ETFs
The market has grown dramatically, and there are now more than 650 ETFs with about $1 trillion invested. This growth should continue as ETF makers anticipate what investors need and create ETFs to fill that need. The need for new ETFs continues as markets change, and money flows into new ETFs when those ETFs perform. There are ETFs that offer investment exposure previously not available, such as currencies and gold. Before these new ETFs, there were few ways to invest in asset classes that were not correlated or had little correlation to the stock market. For instance, before the new ETFs and Exchange Traded Notes (ETNs), investors and traders could not buy currency, gold, or oil through tradable securities. Before the new ETFs, it was hard to invest in emerging markets. Investors and traders before could buy only cap-weighted ETFs and not fundamental, earnings-weighted, or other weighted ETFs.
Some of the new ETFs are constructed to outperform their benchmark indexes. These new ETFs are “intelligent” in that they are constructed to perform.
The launching of new ETFs is a major reason for the growth of the ETF market. Investors and traders want exposure to varied market segments, and this leads to the continual development of new ETFs. The market is limited only by the amount of foresight of the ETF makers and the demands from investors and traders.
New ETFs offer new exposure in other ways. One example is that before the new ETFs were launched, traders could not easily short the market and they could not buy the attempt to receive two or three times the daily performance of an index, either long or short. Of course, risk exposure is greater with enhanced ETFs.
The Launch of “Intelligent” ETFs
The new ETFs have opened the door to unique and profitable investment strategies that were once available only to the richest and most well-connected investors.
In June 2002, PowerShares Capital Management launched its Dynamic Market Portfolio ETF (symbol PWC). This was one of the first ETFs designed to outperform the S&P 500 Index. PWC has about the same sector exposure as the S&P 500 Index, but PWC has only about 100 stocks, unlike the 500 stocks in the S&P index. Instead of all big-cap stocks, which is what is held by the S&P 500 Index, stocks in PWC are small-, medium-, and large-cap stocks.
Instead of constructing an index that reflects the U.S. economy, which is what the S&P 500 Index does, PWC is constructed to outperform the S&P 500. In constructing PWC, PowerShares used its Intellidex method, which chooses stocks using many factors. One factor that Intellidex uses is to choose stocks that have a synergy when included in a portfolio together. For example, if Microsoft and Intel perform well when included in a portfolio, and Microsoft and IBM do not perform as well together, then Microsoft and Intel will be more heavily weighted in the index, and IBM will have a lighter weighting or may not even be included.
PWC outperformed the S&P 500 Index, and it took little time for investors and traders to recognize its good performance. They bought it and PWC grew. Other ETF makers saw the large amount of money pouring in, calculated the management fee that was being received, and prepared to launch their own ETFs.
Around the time PWC started trading, Rydex/SGI released its equal-weighted S&P 500 ETF (symbol RSP). RSP gives exposure to the S&P 500 Index without the big-cap stocks dominating the index because each name has the same weighting. The 500th company has the same weighting as the number one company, and the 499th company has the same weighting as the number two company, and so on, each company having a 0.02 percent weight. RSP outperformed partly because smaller companies often grow faster than larger companies, and the equal-weighted construction allowed more exposure to smaller companies. Investors and traders bought RSP, and the ETF grew rapidly.
RSP is a good buy for investors and traders who want a broad-based U.S. index, but do not want the dominance of big-cap growth companies possibly slowing its performance. An investor can buy RSP and hold it long term, and let the S&P portfolio managers figure out what replacements to make in the portfolio. There should be little, if any, yearly capital gains for holders of RSP, but there is a tax consequence when RSP is sold. If held over a year, the taxes are long term.
Significant money poured into these and other ETFs that performed. More ETF makers packaged and released new investment methods and asset class exposure through the unique ETF structure.
New ETFs Use Unique Strategies
Another provider of the new ETFs is WisdomTree, which is also an index developer. Some of its ETFs are dividend-weighted and some are earnings-weighted, which are different constructions from cap-weighted indices. WisdomTree studies show that dividend-paying stocks sometimes give support in down markets and can perform better in up markets than low- or non-dividend-paying stocks. WisdomTree and some other analysts think dividends are a good way to measure a company’s health in that a company can use questionable accounting methods to hide poor earnings, but dividends are cash payments, and therefore a company must really make earnings to continue paying dividends. Dividends are not fixed and increase or decrease according to a company’s earnings. Foreign ETFs especially can experience wide dividend changes year to year.
There are WisdomTree ETFs that give exposure to faster-growing foreign ETFs. Its Emerging Markets Small Cap Dividend ETF (symbol DGS) has 50 percent of its portfolio in companies in Taiwan, South Africa, Thailand, and Korea. The dividend rate is high, at about 5.5 percent. The price/earnings multiple is 11 times, which is rather low. DGS is comprised of 23 percent mid-cap companies and 76 percent small-cap companies.
The WisdomTree Emerging Equity Income ETF (symbol DEM) has a high dividend rate of about 6.30 percent, and is comprised of companies in countries that have growing economies. Companies in Brazil and Taiwan comprise about 35 percent of DEM. The price/earnings multiple is low at about 11 times. The companies in DEM have the following cap size: 46 percent large-cap, 37 percent mid-cap, and 15 percent small-cap. Another attractive ETF is the WisdomTree DEFA Equity Income Fund (symbol DTH). Companies in France, the U.K., and Australia make up about 55 percent of DTH. The dividend rate is at about 5.97 percent, and the price/earnings multiple is 11 times, which is low.
The investment management firm Research Affiliates (RA) also thinks that there are better ways to weight than cap-weighted, and provides ETFs that use its fundamentally-weighted strategy. The FTSE RAFI US 1000 Portfolio ETF (symbol PRF) holds about 1,000 U.S. stocks, mostly large-cap. It has a low price/book ratio of 1.5 and a modest 13 times price/earnings multiple. RA also uses this strategy in its FTSE RAFI US 1500 Small-Mid Portfolio ETF (PRFZ). The ETF is made up of small- and mid-cap stocks, has a reasonable price/earnings ratio of 15.20, and has a low price/book ratio of 1.29. As far as foreign exposure, the FTSE RAFI Emerging Markets Portfolio (symbol PXH) has more than half of its portfolio in the fast-growing countries of China, Brazil, and Taiwan. PXH sells at a low multiple at just 11 times earnings.
The new ETFs have given options for investing in the S&P 500 Index, and at certain times, these other classes outperform the S&P 500. For example, in the 3-year period ending December 31, 2010, the S&P 500 Index returned a negative 2.9 percent. In this same period, the RAFI U.S. Small-Mid Cap ETF (symbol PRFZ) returned 7.5 percent, the Wisdom Tree Emerging Markets Equity Income ETF (symbol DEM) returned 8.9 percent, and the Wisdom Tree Small-Cap Dividend ETF (symbol DGS) returned 3.7 percent.
Other makers offer ETFs that give exposure to foreign markets, including emerging countries, Brazil, Russia, India, China (BRIC) countries, oil-rich countries in the Middle East, frontier countries, and other fast-growing countries. Other investment firms create ETFs that are not correlated to the stock market or bond market and are asset classes that were difficult to invest in before ETFs were created. Among these are ETFs offering exposure to gold, silver, real estate, and currencies.
A number of ETNs have also been brought to market. ETNs are not ETFs, and because of differences in their structures, there is usually a credit risk with ETNs. The new ETNs offer exposure to asset classes such as natural gas, oil, commodities, natural resources, and precious metals. ETF makers have brought out enhanced ETFs, which attempt to double and triple the daily return from chosen indexes. Of course, the potential risk is also doubled and tripled. Inverse ETFs have been launched, which offer the possibility of profiting from down markets, both on a regular daily return or on an enhanced daily return, with the risks being either regular or enhanced.
The ETF market keeps growing as new ETFs are released. Those that do not attract enough money fold, and new ones keep coming out. Different ways to use ETFs, according to the needs of investors and traders, keep increasing.
Investment Opportunity with the New ETFs
How can you make money in the market when so many choices increase your exposure choices to the point where you can’t decide which ETFs to trade? For instance, you have to decide between buying a big-cap weighted ETF versus buying a small- or medium-weighted ETF. Should you buy an equal-weighted ETF? Should you buy gold, short gold, or a short precious metals ETF?
This book clarifies what your choices are and helps you choose your best mix. You also read about what some of the brightest managers on the street are doing and their thought processes while making their decisions. ETFs are not just bought in a vacuum, but in relation to where the markets are and where they might go.