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OCTOBER 9, 2006
An ETF For Every Nest Even with product overload, investors are finding smart ways to use these index-based funds In the time it takes you to read this story, another exchange-traded fund probably will be launched in the U.S. More than 100 ETFs have been introduced this year, and the ever-expanding ETF universe is nearing 325 funds with more than $350 billon in assets, according to Banc of America Securities (BAC ). That's up from 102 funds and $83 billion only five years ago. These ETFs range from the truly innovative -- a currency fund pegged to the euro -- to the fifth copycat biotech portfolio. The latest wave is funds based on fundamental indexing, an approach that has been attacked from some quarters. In case you've haven't been paying attention or need a refresher course, here's what you have to know: Most ETFs are index funds that, unlike mutual funds, can be bought and sold through the trading day. Since they mimic indexes, their expenses are low, as little as 0.09% a year for a fund based on the Standard & Poor's 500-stock index. Expenses for international, sector, and specialty ETFs are much higher, but they're all far less expensive than the average 1.42% expense ratio on equity mutual funds. Barclays Global Investors dominates in the ETF universe, with more than 140 funds available under its iShares name. Even with product overload, smart investors are discovering innovative ways to use these vehicles. "The ETF market is evolving very rapidly," says Milton Balbuena, chief investment strategist at Contango Capital Advisors, a money management firm in Berkeley, Calif. "The evolution is making it easier to implement strategies that are more interesting and more sophisticated." REAL-WORLD HEDGES As energy prices were rising last year, Alan Haft, a financial adviser in Boca Raton, Fla., thought he could use an ETF to help his clients in the chillier climes offset their expected higher heating bills. So in July he shifted 5% to 10% of their money into the iShares Dow Jones U.S. Energy Sector Index fund (IYE ) (IYE), whose top holdings include ExxonMobil, Chevron, and ConocoPhillips. Haft's clients held the position for five months, logging a 10% aftertax gain. Haft is now exploring ways to use ETFs to hedge against falling real estate prices -- short selling the iShares Dow Jones U.S. Home Construction (ITB ) (ITB) homebuilders' index, perhaps? (To sell short, you borrow shares in anticipation that the price will fall and replace the borrowed shares later at a lower cost.) ETFs provide a way to hedge currencies, too. For example, if you are planning a trip to Italy next summer but you think the dollar will fall further against the euro by the time you embark, you can stash some money in the new Euro Currency Trust (FXE ) (FXE). That, in effect, lets you buy euros at today's prices. INVESTMENT HEDGES Either through work or inheritance, some people end up with a huge chunk of their net worth tied up in a single stock. That's something Paul Coan, managing partner at Wealth Planning & Management, an advisory firm in Indianapolis, sees often with clients who work at nearby drugmaker Eli Lilly (LLY ). "They never, ever want to sell," Coan says. To provide them with some downside protection, he sells short an ETF that tracks the drug industry, usually in an amount equal to 5% to 10% of the value of the client's holdings. Last summer, Eli Lilly fell 1%, while the sector fell even more, and so the short position in PowerShares Dynamic Pharmaceuticals Portfolio (PJP ) (PJP) gained 3%. Coan has since shifted to the iShares Dow Jones U.S. Pharmaceuticals Index fund (IHE ) (IHE), which has a lower expense ratio. The growing number of bond ETFs lets investors hedge their fixed-income investments. For investors who are concerned about rising interest rates and eroding principal, Contango Capital's Balbuena matches the portfolio with a corresponding ETF. For example, for a long-term bond portfolio, he sells short the iShares Lehman 20-year Treasury Bond fund (TLT ) (TLT). If rates rise and the value of the bond portfolio declines, that loss will be partially offset by the shares sold short. MANAGING TAXES With the end of the year approaching, ETFs can be handy tools to help execute some tax-related strategies. Typically, investors take losses to offset other capital gains or generate write-offs even if they still believe in the investment. So if you're taking a loss in, say, Intel (INTC ), you can replace your stock with an equal value investment in the iShares Goldman Sachs Semiconductor Index fund (IGW ) (IGW). That preserves your stake in the industry just in case the sector takes a big leap forward. After all, if you buy back the stock before 31 days have passed, the Internal Revenue Service would bar you from taking the loss. So on the 31st day, you sell the ETFs and buy back the original holding. Jeff Layman, an adviser in Springfield, Mo., uses ETFs this way all the time. For clients with large Pfizer stakes, he substitutes the iShares Dow Jones U.S. Sector Healthcare fund (IYH ) (IYH). PLUGGING LOSSES Here's a ploy stock traders use that would be impossible with conventional mutual funds. Marc Collier, an adviser at Pinnacle Capital Management in Boston, had a client who was bullish on Chinese stocks but, recognizing their volatility, wanted to limit his risk. So in April, 2005, Collier put $25,000 of his client's $900,000 portfolio into the iShares FTSE/Xinhua China 25 ETF (FXI ) (FXI) at about $55 and set a stop-loss order at $49. A stop-loss order lets you buy or sell a security when it hits a predetermined price. As the ETF rallied, Collier raised the stop-loss trigger, always keeping it about 10% below the ETF's price. In May, 2006, the ETF hit $80, but then it fell to $73 in June, and that triggered a sale. "We gained about 33% on the [original] position, but were never at risk for a loss of more than 10%," Collier says. GETTING INTO COMMODITIES Commodity ETFs zoomed in popularity, fueled mainly by their heavy weighting in energy. That raises a red flag for those who might invest in them. Right now, energy makes up about 75% of the iShares GSCI Commodity Indexed Trust (GSG ) (GSG) and half the PowerShares Deutsche Bank Commodity Index Tracking Fund (DBC ) (DBC) ETF. If you want gold or silver, better to invest in the ETFs dedicated to each. A good alternative to these ETFs are exchange traded notes (ETNs), which are debt securities backed by Barclays Bank. When you buy an ETN, you get a promise from Barclays that your investment will match the index the ETN tracks (minus expenses), which a Morgan Stanley study found that one in five ETFs fails to do. The new ETNs are all on commodity indexes, but eventually others will be launched to track all sorts of indexes.  By Lauren Young Get BusinessWeek directly on your desktop with our RSS feeds.  Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | |
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