Tradecraft – The Trouble With ETFs

TRADERS BELIEVE THERE’S money to be made, somewhere, in any market environment. You’ve got to be where the action is. And because there are numerous times in which individual sectors trend while the broad market treads, sector allocation has become a hot concept among investors and money managers alike.

To suit the sector-allocation crowd, Wall Street has developed a number of sector-based exchange traded funds, known broadly as ETFs, which give you exposure to an entire sector or industry simply by buying a single share. Marketed as iShares, Sector SPDRs or StreetTracks, the products are essentially open-ended mutual funds that trade throughout the day, just like stocks. These sector-based ETFs have all sorts of interesting advantages over both individual stocks and mutual funds. But they also aren’t quite what they appear to be, and that can pose problems for investors who buy them thinking they’re getting something they aren’t.

First introduced in the early 1990s with the successful listing of the Standard & Poor’s Depositary Receipts (or SPDRs, pronounced “spiders”) on the American Stock Exchange, ETFs have become some of the hottest investing products on the Street. The American Stock Exchange, where most ETFs trade, has become virtually dedicated to supporting and developing these rapidly growing tools. There are well over 120 ETFs now trading, with more being introduced almost on a daily basis. (more…)

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Tradecraft – The Diversification Delusion

LIKE A WARM BATH or high thread-count sheets, nothing feels quite as comfortable as money in the bank. And with the major equity indexes down year-to-date, I’m surely not the only one who finds a sweet satisfaction in watching interest payments tumble in each month to a plain old money-market account. Cash (and cash equivalents like money-market accounts, certificates of deposit or Treasury bills) are often referred to as earning the “risk-free” rate for obvious reasons. Cash provides a predictable, but paltry, return. And while cash deserves a place in everyone’s portfolio, you can’t just hide in a money market all your life. There are other ways of dealing with risk besides hiding your money under the mattress. The name of the game is wealth creation: In order to make some money, you’ve got to make some moves.

And while it took a 68% drop in the Nasdaq to finally sink in, most investors are now realizing that the most effective way of reducing risk in their portfolio is by diversifying among various types of assets. Diversification lowers a portfolio’s volatility and can even enhance returns. And while index funds that track the S&P 500 give the illusion of diversification, because they are weighted by market capitalization they are essentially focused on large-cap stocks. Owning Cisco Systems (CSCO), Intel (INTC), General Electric (GE) and an index fund exposes you to as much diversity as a potluck dinner at David Duke’s house. (more…)

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