I wrote in my Trader's Corner last week (5/1/13) describing some of the risks or pitfalls of Exchange Traded Funds or ETFs, as the added costs incurred by leveraged (2X and 3X) and inverse ETF's.

Moreover, the leveraged ETFs may not achieve their stated objectives; e.g., price swings that result in 300% greater move in the leveraged ETF than the underlying index; e.g., the S&P 500.

This week I will again look at the ETF landscape and explore some potential advantages in using ETF's.

ETF HISTORY/BACKGROUND:

The first Exchange Traded Fund (ETF) that was launched was in 1993. Officially known as the SPDR S&P 500 ETF (SPY) and it of course tracks the S&P 500 Index.

Largest ETF's of all types (as of 4/30/13):

SPDR S&P 500 ETF; Symbol: SPY; 2.) Vanguard FTSE Emerging Mkt Index; Sym: VWO; 3.) SPDR Gold Shares; Sym: GLD; 4.) iShares MSCI Emerging Markets Index Fund; Sym: EEM; 5.) iShares MSCI EAFE Index fund; Sym: EFA; 6.) iShares Core S&P 500 ETF; Sym: IVV; 7.) Vanguard REIT ETF; Sym: VNQ; 8.) Power Shares QQQ; Sym: QQQ; 9.) Vanguard Total Stock Market ETF; Sym: VTI; 10.) iShares Investment Grade Corporate Bond Fund: Sym: LQD.

All the above have low expense ratios; e.g., 0.1% to .18%

The key ETF players have fund nicknames that go by different names or acronyms: Barclays brands their ETF shares as iShares. State Street Corp. calls their products SPDRs (pronounced spiders).

Vanguard Group, Inc. calls their funds Vanguard ETFs (they used to be called Vipers, which doesn't seem like a winning name exactly!) Cubes, symbol QQQ is the widely-traded PowerShares QQQ Trust, which tracks the Nasdaq 100 Index (the largest 100 non-financial stocks in the Nasdaq Composite Index and largely comprised of tech stocks, but QQQ is all tech. Diamonds: More formally known as the Diamonds Trust Series I (DIA), this ETF tracks the Dow Jones Industrial Average.

An ETF's underlying Net Asset Value (NAV) is calculated by taking the current value of the fund's net assets (the value of all securities inside minus liabilities) divided by the total number of shares outstanding. The net asset value (NAV) is published every 15 seconds throughout the trading day. But the ETF's NAV isn't necessarily its market price as bullish or bearish market sentiment can result in the ETF trading slightly more or less than its NAV for a time.

When you purchase shares of a traditional mutual fund, the NAV serves much like a stock price as the price at which shares are bought or sold from the fund company. At a traditional fund, the NAV is set at the end of each trading day.

ETFs, as noted, work a bit differently. Since ETFs trade like a stock, you buy and sell shares on an exchange at a price determined by supply and demand, which is why an ETF's market price can differ from its net asset value. Market sentiment that is overly bullish or bearish can push the ETF stock price to a greater or lesser value than the NAV. However, the way ETF shares are structured helps keep the gap between those two figures pretty tight.

Many investors, including professional traders and money managers, have taken notice of these funds. Money invested in ETFs has more than quintupled over the past five years. The number of existing ETFs has skyrocketed at the same pace – investors now have hundreds to choose from. That number is still pretty small compared to the thousands of mutual funds that exist, but it is a lot of growth. And there may be hundreds more ETF's on the way.

INVESTORS HAVE TAKEN TO ETF'S FOR SEVERAL REASONS:

COSTS: Many ETFs have lower fees compared with traditional mutual funds, even ones that merely replicate an index like the S&P or Nasdaq Composite.

The average stock fund charges an advertised fee of 1.3-1.5 percent and specialty or international funds may be costlier. Many brokers, bankers, and advisers charge an additional management fee of around 1-1.5 percent, so you can very easily be paying 2.5 percent or more for an actively managed mutual fund. ETFs in comparison are both free from sales commission loads, and boast an average expense ratio of 0.44 percent. However, actively managed ETF's, including ones that use leverage by buying and selling futures, options and Swaps will have higher expense ratios that exceed 1 percent.

You WILL pay commissions for many if not most of the Exchange Traded Funds. Some fund managers will allow you to buy a select group of ETF's without paying a commission. However, it's also then usually true that you will pay a commission for 'actively' trading an ETF; e.g., for liquidating the same ETF within 30 days. Even $8 commissions add up if you are actively trading these stocks, especially if you are trading in and out for small gains or losses.

Another way of keeping 'costs' down so to speak is that, unlike a mutual fund, you can place limit orders for the ETF stock just as you can company shares. I usually work with limit orders as there is a 'value' price that I am aiming for. I don't want to pay up with a market order during a period when some computer program drove the market temporarily higher.

TAXES: ETFs can be a winner at tax time although I don't consider this to be a major reason to be in them. As with any index fund, the manager of the ETF doesn't need to constantly buy and sell stocks unless a component of the underlying index that the ETF is attempting to track has changed. (This can happen if companies have merged, gone out of business or if their stocks have moved dramatically). And given the special way ETFs are structured, they're often considered to be more "tax-efficient" than traditional index mutual funds.

It's a personal thing, but I don't emphasize tax advantages, as good market timing can pay off far more than some minor tax advantage. It's like the guy that says he doesn't want to sell his Apple stock at $700, given his cost basis of under $100, because he doesn't want to pay the capital gains tax. WHAT!? ARE YOU KIDDING ME! Pay the 15% and keep 85% of a huge profit. Oh, better to ride AAPL back down from 700 to $500 rather than pay such a 'huge' tax. Such thinking drives me slightly crazy.

DIVERSIFICATION: Like index funds, ETFs provide an efficient way to invest in a specific part of the stock or bond market (say, small-cap stocks, energy or emerging markets) and I'll have more to say on this, as being able to choose WHICH S&P sectors you invest in of the 9 sectors of the S&P 500 can be a significant benefit. Of course a major use of index ETFs is buying the S&P 500, 100, Nasdaq Composite and big-cap Nas 100, the various Russell indexes, etc.

TRANSPARENCY OF HOLDINGS: Since the most popular ETFs and Index mutual funds track an index, you usually know exactly what's inside it or what the Fund holdings are. However, unlike actively managed mutual funds, Exchange Traded Funds also report on what they're holding on a daily basis. With traditional mutual funds, holdings are usually ONLY revealed with a long delay and only periodically throughout the year.

EASE OF TRADING IN AND OUT: ETFs can be bought or sold at any time during the day, just like stocks. Mutual funds, on the other hand, are priced only once at the end of each trading day. If you’re investing for the long-term, this doesn't really matter. It is no doubt comforting to know that you can usually get out of an ETF at any time during the trading day.

Of course being able to liquidate holdings too 'easily' can also create panic type selling that would have best been avoided. I have a friend, who is an unsophisticated investor generally, who has told her money manager to liquidate all her stocks after two different Market panic type sell offs over the years. My friend sold out at the bottom or close to it. Her kids on the other hand, kept cool and hands off so to speak and the value of their stock holdings came back strongly.

FLEXIBILITY: You can buy option contracts on many ETFs and they can be shorted and bought on margin.

DIVERSIFICATION: If you don't have the minimum investment required by some mutual funds, you can use ETFs as an alternative. You can assemble a decent portfolio with as few as three ETFs.

STRATEGY PROS:

I wrote last week on the pitfalls or cons of trading ETF's, especially the leveraged ones that have to manage derivatives such as futures and swaps. And, we know that nothing can go wrong with those strategies!

There are strategies ETF's allow that offer some of the same flexibility that options do. ETFs are a very flexible investment/trading vehicle. Not to quite the extent as options in general, but options on many ETFs are available. They can be optioned, shorted, hedged, bundled, and more. ETFs capture a variety of general stock market or economic trends without the risk of single-stock exposure and they're designed for diversity so to speak.

If you're investing for the long-term, whether novice or an sophisticated type, the best ETF strategies are probably still the simple ones of 1.) filling asset allocation gaps and 2.) replacing higher-fee mutual funds. ETFs can also lend themselves to advanced investing tactics:

BETTING ON BONDS: ETFs let you make bets on just about anything tracked by an index. Choices range from an ETF tracking the ultra-broad Lehman Aggregate Bond index to funds focusing on corporate-bond indices, inflation-protected Treasuries, or specific segments of the yield curve.

This yield curve business offers enticement to both guru and neophyte alike. A professional might use an ETF to exploit an anticipated movement in the yields of the Treasury notes of 7-10 years. An individual investor might combine these with longer duration bond ETFs for broad-based exposure to individual bonds staggered across a wide range of maturities).

PARKING CASH: If you keep a certain amount of cash on hand in your investment portfolio, you can buy short-duration bond ETFs instead of money market funds. These investments often pay double or triple money-market yields. Just don't blow a lot on brokerage fees.

AVOIDING THE 'WASH-SALE' RULE: A common tax-reduction method is to sell money losing stocks and the using the losses to offset taxable gains from profitable positions.

The tax prohibition of a "wash sale" is to sell something that has lost money and use the loss to offset taxable gains you've got elsewhere, but then buy the same or a similar security right back. That is if you not only turn around and buy the exact security you just sold, but anything 'substantially identical' as well. The universe of ETFs has given investors options that may be similar, but not substantially identical to the investments sold at a loss.

PAIRS TRADING: Pairs trading is a hedge fund favorite and ETFs have made it easier. For example you project that a given stock will outperform its sector but aren't confident on the direction that that sector will go next. To capture that stock versus sector performance differential in this case, one can buy the stock and short its sector ETF. OR, just the opposite, where you figure that a company is much worse than its peers and you short the individual stock and go long the ETF.

I don't usually advise the aforementioned strategy for the average trader/investor since to be successful requires an intimate knowledge of the stock and its sector. However, pairs trading in stock versus sector, like many options strategies, can be done in any market climate. A risk of course is that BOTH the sector AND the company stock could move in the opposite direction of what you assumed would unfold.

CREATING AN ETF-ONLY PORTFOLIO: If your goal is simply to have a mix of assets, ETFs let you do this simply and cheaply. Why sweat through finding a good tech company just because you've gotten advice to get more tech stock exposure. You can buy the Technology Select Sector SPDR (XLK) for example in the dollar amount that you want for (portfolio) balance. Of course you would miss out on the home run gains of having bought IBM or AAPL, but you also miss out on the stock-specific losses of playing only the next tech bomb.

PLAYING MARKET 'SECTORS' OR REGIONS:

I like to invest in market sectors more often than just to be in a broad index like the S&P 500 (SPX). With the S&P you have 9 sectors to choose from. More on this shortly and I'll show some SPDR sector charts.

Some international ETFs give you exposure to stocks or entire industries that you cannot buy on the U.S. exchanges. And you needn't only make feel-good positive bets: ETFs can be sold short, even on a downtick. (Regular stocks cannot be shorted if the last trade price is lower than the prior trade price.

2-year SPY versus sector performance (as of 4/30/13) relative to the SPDR S&P 500 (SPY) 2-year gain of 10.3%

Health Care Select Sector SPDR (XLV): + 17.9% - e.g., JNJ, PFE, MRK

Consumer Discretionary Select Sector SPDR (XLY): + 17.4% - e.g., DIS, MCD, AMZN

Consumer Staples Select Sector SPDR (XLP): + 17.1% - e.g., PG, WMT, CVS

Utilities Select Sector SPDR (XLU): + 15.2% - e.g., DUK, SO, D

Financial Select Sector SPDR (XLF): + 8.7% - e.g., JPM, WFC, BAC, C

Technology Select Sector SPDR (XLK): + 8.5% - e.g., AAPL, MSFT, GOOG

Industrial Select Sector SPDR (XLI): + 5.7% - e.g., GE, UTX, MMM

Materials Select Sector SPDR (XLF): + 0.7% - e.g., DD, DOW, FCX

Energy Select Sector SPDR (XLE): + .6% - e.g., XOM, CVX, SLB

Suppose you decided that the bottom 2-4 sectors listed above were less than stellar bets but you liked the overall trend in the Market. You could decide to invest the same amount of money as you would in the SPY ETF, but spread over just 5-6 sectors. How would you make such a prescient decision?

Fundamentally you are aware or learn that consumer staple and consumer discretionary stocks do relatively better than the overall Market in a slow-growth economy. You also know health care is a long-term winner. Financial stocks would be in bad shape for a long time to come. Energy wouldn't do so well in a recession and so on.

Technically, I use an example of coming into 2013 (all the following weekly charts end in the last week of 2012) and first assessing how bullish or bearish the overall market looks such as by analyzing the SPY weekly chart ahead of 2013. I then go on to an chart/technical analysis of the 9 individual sector ETF weekly charts. I'm not going to show all 9 sector charts but 3 of the most bullish and 3 sector charts that haven't cleared prior resistance, etc. and are therefore more likely to UNDER-perform the S&P 500 SPY ETF.

3 sector charts follow (XLV, XLY, XLP) I rated as bullish coming into 2013 and in line with the overall S&P 5009. 3 relatively bearish S&P 500 sector charts (XLE, XLF, XLI) follow the 3 bullish sector charts.

I suggest a strategy for longer-term investment money is to buy only the ETF S&P 500 sectors that look to perform in line with S&P and not to buy the sector ETFs that have charts that suggest they could underperform the market or act as a drag on the S&P gains going forward. Put the overall investment money that would go into the bullish SPY trend into just the most bullish looking (e.g., 6-7) sector charts instead and in this case, year to date, substantially improve overall gains.

SPY weekly chart reflects prices through 2012 ONLY …

XLY weekly chart reflects prices through 2012 only …

XLV weekly chart reflects prices through 2012 only …

XLP weekly chart reflects prices through 2012 only …

XLF weekly chart reflects prices through 2012 only …

XLE weekly chart reflects prices through 2012 only …

XLI weekly chart reflects prices through 2012 only …


GOOD TRADING SUCCESS!