ETFs Unplugged
Below is a MRR and PLR article in category Finance -> subcategory Other.
ETFs Unplugged
Exploring ETFs: Are You Missing a Key Element?
Exchange-traded funds (ETFs) are valuable investment tools, yet there's a common oversight that investors and advisors often miss. Let's dive into the intricacies of ETFs and explore some innovative new products.
Understanding ETFs
ETFs are essentially index funds that trade like stocks. Their simplicity, flexibility, low cost, and tax efficiency have spurred rapid growth. In fact, last year, the Barclays iShares ETFs attracted more new investments than Fidelity's mutual funds.
The Importance of Diversification
Many investors and advisors build ETF portfolios without closely examining where their money is going. Diversification is a critical goal, yet many ETFs lack it. Often, companies within an ETF are weighted by their market value, leading to an unbalanced concentration of risk and performance.
Despite the theoretical basis for market cap weighting, it often defies practical sense. In constructing global portfolios, I downplay its importance.
A common misconception is that bigger companies make better investments. Take the S&P 500 index, for example. Contrary to popular belief, investing in the S&P 500 doesn't mean equal distribution among 500 companies. In reality, 22% of your investment goes to the ten largest companies, and 60% to the top 50.
Unequal Weighting, Unequal Returns
That's why I advise clients to consider the Rydex S&P 500 Equal-Weight ETF (RSP), which allocates investments equally among companies. In 2003, this equal-weight ETF outperformed the S&P index by 11%, and by 5% in 2004. Year-to-date, it's slightly up while the S&P index declined.
In my book, "The New Global Advisor," I pose a provocative question: If you want exposure to the dynamic biotechnology industry, would you invest primarily in a few large biotech firms or spread your investment across thirty companies? The former might lead you to the iShares Nasdaq Biotechnology ETF (IBB), where 25% of your investment targets three companies. For broader exposure, I recommend exploring Powershares, a new family of ETFs.
Innovative ETF Options
Powershares ETFs create their own indices based on rules-based quantitative analysis, referred to as "intelligent indexes." This approach seems more useful than blindly following market cap-weighted indexes. Here are two Powershares ETFs I particularly recommend:
1. Biotech Powershare (PBE)
PBE includes 30 biotech companies. Instead of two companies dominating over 60% of holdings, your investment spreads across 30 companies, with no single company exceeding 5%. It diversifies exposure with 30% in large cap, 26% in mid-cap, and 43% in small cap companies. While aggressive, it's a smart play for capital appreciation in the biotech field, with an annual fee of just 0.60%.2. International Dividend Achievers Powershare (PID)
PID comprises 42 ADRs traded on U.S. exchanges. Although I typically avoid ADRs due to premium pricing, they offer investor comfort by meeting U.S. reporting standards. ADRs in this Powershare must show five consecutive fiscal years of dividend increases. Top holdings don't exceed 5%, ensuring strong diversification.Achieving Global Diversification
One issue with the popular MSCI Europe, Asia & Far East Index (EAFE) is its concentration in Japan and the UK, which comprise nearly 50% of its value. Conversely, exposure to promising markets like Ireland and Hong Kong is under 2%. Last year, this Powershares index outperformed the MSCI EAFE by 7% and achieved a 29% average return on equity. The index rebalances quarterly, charging a 0.50% annual fee, with 67% large cap, 20% mid-cap, and 13% small cap companies.
Conclusion
Crafting the right ETF portfolio requires time and effort. Remember, not all ETFs are created equal, so choose wisely.
You can find the original non-AI version of this article here: ETFs Unplugged.
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