Over the past decade, plain old Standard & Poor's 500-stock index funds revolutionized the way Americans thought about investing. With one cheap and simple investment, you could capture the lion's share of the U.S. stock market. Even with the market's slide over the past 12 months, the index strategy is still a winner. The S&P 500's compounded annual returns have averaged 15.9% over the past five years (through Feb. 28). Now, a proliferation of innovative products, called exchange-traded funds, or ETFs, is changing the way investors think about index investing (click here to see Barclay Global Investor Sevice's Brad Zigler talk about the benefits of exchange-traded funds).
With ETFs, index investing is no longer a purely passive strategy in which you buy and hold a broad-based index such as the S&P 500. In fact, there are now nearly 100 ETFs that track everything from the entire U.S. stock market to the industries that comprise it. They trade like stocks, mostly on the American Stock Exchange, and can be bought or sold during market hours for the cost of a regular brokerage commission.
STRATEGIC BETS. By slicing and dicing the market, ETFs give investors a simple way to make strategic bets on broad sectors, such as small-cap or growth stocks, or specific industries, such as biotechnology or energy. ETFs are global as well, with 21 devoted to individual countries and a handful focused on broader cross sections of the globe. The ETF market is like ``a candy store with virtually every kind of candy in it,'' says Ross Levin, president of Accredited Investors, a financial planning firm in Edina, Minn.
Is this better than taking a buy-and-hold approach with broad-based indexes such as the S&P 500? The jury's still out. But many market seers expect the S&P 500's returns to be far lower in the coming decade than they were in the last. So by employing ETFs to pursue market bets (without foregoing indexing's low costs), investors have a shot at improving their returns.
With that in mind, BusinessWeek asked Levin and two other advisers who use ETFs for clients to take a hypothetical $100,000 and invest it in ETFs. Thomas Mench, chairman of Mench Financial in Cincinnati, targeted conservative investors; James Kelly, chairman of Philadelphia's Addison Capital Management, handled the moderate-risk portfolio; and Levin took the aggressive approach.
All three portfolios, even the most turbocharged, put some emphasis on value stocks. ``Given the way the markets are shaping up, having a value tilt would be a good idea over the next 12-to-24 months,'' says Kelly. Indeed, many value indexes have thrived during the recent market meltdown.
Remember, too, these ETF portfolios are not buy-and-forget investments. All three advisers suggest periodically revisiting the allocations to make sure they haven't gotten out of whack, and to make changes if market conditions warrant them.
THE CONSERVATIVE PORTFOLIO
With the major stock market indexes in a bear market, a cautious value-based approach appeals to many investors. That's exactly the course that Mench pursues in the most conservative of his five model ETF portfolios. His goal is modest by 1990s standards--annual returns of 8% to 10%. But Mench aims to do this by exposing the investor to only 65% to 80% of the S&P 500's volatility.
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For The Conservative Investor
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INDEX | ETF
SYMBOL | ALLOC.
% |
|
| S&P 500/BARRA VALUE | IVE | 9.6 |
|
| S&P UTILITIES | XLU | 9.6 |
|
| DOW JONES U.S. TELECOM | IYZ | 9.6 |
|
| S&P BASIC INDUSTRIES | XLB | 9.6 |
|
| S&P ENERGY | XLE | 9.6 |
|
| RUSSELL 1000 VALUE | IWD | 9.6 |
|
| RUSSELL 3000 VALUE | IWW | 9.6 |
|
| S&P MIDCAP 400/BARRA VALUE | IJJ | 9.6 |
|
| S&P SMALLCAP 600/BARRA VALUE | IJS | 9.6 |
|
| DOW JONES U.S. REAL ESTATE | IYR | 9.6 |
|
| CASH | ---- | 4.0 |
|
| Data: Mench Financial Inc. |
Several broad-based value indexes form the backbone of Mench's 10-ETF portfolio. They include the value portions of the S&P 500, and the Russell 3000 and 1000 indexes. (The Russell 3000, comprising the 3000 largest stocks by market capitalization, represents about 98% of the total U.S. market, while the Russell 1000 contains the 1000 largest stocks.) True, these indexes have some overlap, but Mench doesn't mind. He chooses them to tilt his portfolio toward less volatile, large-cap stocks. Even Mench's small-cap choice, the S&P SmallCap 600/BARRA Value, contains stocks with a higher market capitalization--and thus less volatility--than the alternative Russell 2000 Value index.
Mench also uses ETFs to cover utilities, basic industries, real estate, and energy--all traditional value plays. He thinks the badly beaten telecommunications sector is attractive, too. Although this conservative portfolio can have as much as 20% in overseas investments, it doesn't now because Mench believes the best opportunities are in the U.S.
What's unusual about Mench's plan is the equal weightings he gives each of the ETFs. (The remaining 4% cash cushion is more than enough to cover fees and expenses.) Mench reviews the portfolio monthly to see if any changes are warranted. But to keep costs down, he trades at most only once per month.
THE MODERATE PORTFOLIO
The basic building blocks of the moderate risk portfolio that James Kelly designed for BusinessWeek are ETFs that track the three most widely known market measures. Kelly puts nearly a third of his $100,000 into the S&P 500. He splits another third between ETFs that track the Dow Jones industrial average and the Nasdaq 100.
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For The Moderate Investor
|
|
| INDEX | ETF
SYMBOL | ALLOC.
% |
|
| S&P 500 | SPY or IVV | 32 |
|
| DOW JONES INDUSTRIAL AVERAGE | DIA | 16 |
|
| NASDAQ 100 | QQQ | 16 |
|
| S&P 500/BARRA VALUE or DOW JONES U.S. LARGE CAP VALUE | IVE or ELV | 8 |
|
| S&P MIDCAP 400/BARRA VALUE | IJJ | 4 |
|
| S&P SMALLCAP 600/BARRA VALUE or DOW JONES U.S. SMALL CAP VALUE | IJS or DSV | 4 |
|
| MSCI EUROPEAN MONETARY UNION or S&P EUROPE 350 | EZU or IEV | 8 |
|
| MSCI AUSTRALIA, MSCI HONG KONG, MSCI JAPAN and/or MSCI TAIWAN | EWA, EWH, EWJ, EWT | 8 |
|
| MSCI CANADA, MSCI BRAZIL and/or MSCI MEXICO | EWC, EWZ, EWW | 4 |
|
| Data: Addison Capital Management |
Kelly also emphasizes value indexes. He commits 8% to large-cap value, and 4% each to mid- and small-cap value. But Kelly avoids sector funds because placing bets on industries runs counter to what he believes a core--or basic--portfolio should do.
With the trend toward more choice in the ETF marketplace, many ETFs cover similar terrain. For example, you can buy the S&P 500 with the iShares S&P 500 or the Standard & Poor's Depositary Receipts (SPDR), better known as the Spider. The difference comes down to dividends, which the iShare reinvests continuously and the Spider reinvests quarterly. When the market rises, the Spider's unreinvested cash causes it to lag behind the iShare. But when the market falls, the situation is reversed.
In the international arena, where Kelly puts the remaining 20% of his portfolio, the pickings are slimmer. There, Kelly recommends one of two broad-based European ETFs, depending on your needs. One is focused on the EMU (European Monetary Union) and the other comprises the 350 largest European stocks. Although regional ETFs are in the works, you have to buy an array of single-country ETFs to get exposure to Asia and South America. That can be costly, because the more ETF issues you buy, the more you pay in commissions.
THE AGGRESSIVE INVESTOR
Ross Levin designed this portfolio for the aggressive--not the reckless--investor. So, rather than load up on ETFs that track the Nasdaq 100, Levin concentrates 40% of his money in the broad-based Russell 3000. Still, Levin argues that aggressive investors can't afford to ignore tech's potential for long-term growth. So he puts 5% into the Nasdaq 100 and 10% into the Nasdaq biotechnology index.
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For The Aggressive Investor
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|
| INDEX | ETF
SYMBOL | ALLOC.
% |
|
| RUSSELL 3000 | IWV | 40 |
|
| NASDAQ 100 | QQQ | 5 |
|
| NASDAQ BIOTECHNOLOGY | IBB | 10 |
|
| RUSSELL 1000 VALUE | IWD | 5 |
|
| RUSSELL 2000 VALUE | IWN | 5 |
|
| DOW JONES U.S. TELECOM | IYZ | 5 |
|
| MSCI EUROPEAN MONETARY UNION | EZU | 22 |
|
| MSCI TAIWAN | EWT | 2 |
|
| MSCI SOUTH KOREA | EWY | 2 |
|
| MSCI SINGAPORE | EWS | 2 |
|
| MSCI UNITED KINGDOM | EWU | 2 |
|
| Data: Accredited Investors Inc. |
To partially offset the portfolio's emphasis on growth stocks, Levin puts 5% into both large- and small-cap value indexes. Another 5% goes into telecommunications stocks, which Levin thinks are poised for a rebound.
On the international front, Levin is especially enthusiastic about investment opportunities in Europe. He devotes 22% to the broad-based EMU index. He adds a 2% allocation for Britain--not an EMU country. To cover Asia, he puts 2% of his portfolio into each of three ETFs that track Taiwan, South Korea, and Singapore.
Aggressive investors might be tempted to short ETFs--or sell borrowed shares in the hope of replacing them at a profit when prices fall. Because the market rises more than it falls, Levin cautions that shorting is too risky--even for those who aren't afraid of risk.
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Copyright 2001, Bloomberg L.P.
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