And although I’ve bought my share of sour stocks, once in a while I’m fortunate enough to come up with a few winners as well. While I’d love every investment to show a profit, you only need a handful of smart ideas each year to put together a respectable return.

So far this year, one of my best-performing trades has been in utilities, a sector that’s shown exceptional strength since I started pounding the table last fall. As regular readers, along with those who watch me on Fox News Channel’s “Cashin’ In”, can attest, this has long been a favored sector, one in which I’ve been able to experience the best kind of success — that which you can spend.

And while finding winners is difficult enough, managing them is oftentimes even more challenging. Once you’re fortunate to have one, you’re immediately faced with the conundrum of just what to do with it. In my case, I’m confronted with the winner’s curse: Should I pull the plug on my beloved utilities, or take a risk by holding on to them with the hope of even more electrifying returns?

Probably the hardest element of managing a winning trade is simply having the gumption to stay in it. Grabbing a profit, especially a generous one, achieved over a relatively brief period of time is extremely tempting. But as I’ve often pointed out, it’s the losers, not the winners, that should be routinely cut from a portfolio. It takes time, effort and money to establish a winning position. Once you’ve got one, don’t be foolish enough to quickly trade it away.

To that end, I believe the worst strategy in dealing with winning trades is to sell them too soon. Yet I often hear from investors who make it a point to dump investments simply because they’ve hit targets 30% above the purchase price. To me, that’s downright asinine. Just think of all the traders who sold Microsoft (MSFT) or Sun Microsystems (SUNW) in 1996 for no other reason than because they’d booked a good profit. How many thousands of basis points were left on the table just because investors were overanxious to hear the cash register ring?

Even more common is the downright bizarre practice of “portfolio rebalancing,” in which losing allocations are methodically bought and winning trades are sold. This approach, popular with many financial planners, is a recipe for underperformance because it systematically replaces strong allocations with weak ones — all in the name of diversification. Considering the market doesn’t “know” where you got in, why trade away big positions in stocks that have the wind at their backs? That’s precisely where the gravy is made.

So the most notable way to deal with a winning trade is to do your darndest to stay with it, riding the gains for as much of the move as possible. And when a big bet does pan out, you’ll find that small trades grow to become a dominating influence on your overall portfolio. For me, that’s occurred in big-cap utilities like Duke Energy (DUK), Allegheny Energy (AYE), Exelon (EXC), Southern (SO) and California Water Services Group (CWT). Trades that started as 2% to 3% of my fund have appreciated, in some cases, to encompass 6% or more. It’s a problem most of us would be happy to have.

Instead of dumping winning trades just because they’ve grown, I’ll instead start to diversify the portfolio’s risk by deliberately fishing in other pastures besides utilities. Existing trades aren’t abandoned, but assigned specific stop-loss levels. New money can be directed toward different types of investments.

For example, with all the bad news surrounding hedge funds that trade convertible bonds, I’ve begun looking for value in this volatile and relatively underowned asset class. For individual investors, I believe funds remain the best way to achieve exposure. Closed-end choices such as TCW Convertible Securities fund (CVT), Advent Claymore Convertible Securities & Income fund (AVK), Nuveen Preferred and Convertible Income fund (JPC) and Ellsworth Convertible Growth and Income fund (ECF) all boast attractive dividend yields and trade at a discount to their underlying net asset values. This is an appealing new area for me in which I’m just beginning to put money to work.

Also, amid all of the anxiety last week surrounding terrorist bombings in London and damage from Hurricane Dennis, it’s worth noting that smaller-capitalization stocks continued their outperformance, with the Russell 2000 index notching a new all-time high. So if you were heavy into large-cap utilities, diverting new money toward smaller-cap names in other sectors would keep your skin in the game while spreading the risk.

As I’ve written before, it makes sense not only to follow the market but also the slow-moving herd, whose arrival almost always heralds a trade’s imminent unraveling. If you’re making money, then it’s never too long before the crowd shows up wanting to hop on for the ride. Once that process has begun, it’s usually an ideal time to begin to move on from the trade.

While we can graph price action and economic fundamentals down to the decimal point, evaluating public perception (a.k.a., the herd) is a much more difficult and subtle process. Amid the strong performance for utilities, I wait each week for the Barron’s cover story or the BusinessWeek feature article touting the red-hot gains. When that finally happens, it will likely serve as an excellent point to begin paring back positions. Case in point was a recent Newsweek cover story on the falling dollar, which ironically turned out to be a great moment to go long the greenback.

At the moment, however, it appears the public is still more indifferent than indulgent when it comes to investing in most utilities. Right now, the group appears to inhabit an investment no-man’s land: too expensive for the value investors, yet not flashy enough for growth players. I don’t see the trend in utilities reversing just yet, and with winning positions already established, I’m content to hold on for the ride.

In the market, when you’re on a roll you sure as heck better sop up the gains while you can, because the good times never last. Unless you learn to exploit winners fully, there’s really no sense in unearthing them in the first place.

– Originally on Jul 11, 2005 by Jonathan Hoenig

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.

ETFs — both those based on broad indexes like the S&P 500 or the Nasdaq 100, and those based on specific sectors — took off because of several benefits. Unlike mutual funds, the shares can be bought or sold any time during the trading day — just like a share of stock. And capital gains (or losses) occur only when an investor sells his shares, not when a fund manager distributes capital gains.

Added to this mix of flexibility and control was the perceived advantage of index investing, which more and more investors have come to believe is the most prudent way in which to own stock. Not only are the fees low, but the inherent diversification an index affords means that you don’t have to pick the right stock — just the right sector.

The problem is that many sector ETFs aren’t really based on indexes. They purport to be diversified sector bets, but most are actually rather narrowly constructed large-cap proxies that are primarily based on a handful of specific names.

As is true with most index products, instead of owning a truly diversified portfolio, the index’s administrators use a technique known as portfolio sampling. Just as A.C. Nielsen doesn’t survey everyone actually watching television to come up with an accurate estimate of who is tuned to “West Wing”, the indexing firms develop what they believe to be a representative sampling of a particular sector or group. The idea is that while it doesn’t include all the companies within one industry, it should ideally reflect their price movements nevertheless.

In addition, because it’s much easier for a big institutions to accumulate shares of the largest companies, many sector ETFs are overwhelmingly dominated by giant-capitalization stocks, which is precisely the ilk that’s currently out of favor on Wall Street.

By contrast, small-capitalization stocks not only ended 2001 with a gain, but also still trade at comparatively reasonable valuations to their large-cap counterparts. These days, all things being equal, if I had to buy a stock I’d buy a smaller cap. You won’t find them using most sector ETFs.

Forget “buy what you know” and try “know what you buy.” Most people are clueless as to just how skewed many of the ETFs are toward large-cap stocks. Consider iShares Dow Jones U.S. Technology (IYW), which judging from its name would appear to provide broad exposure to a number of companies poised to benefit from a rise in technology stocks. And while the broad description of “technology” incorporates everything from Red Hat (RHAT) to Rambus (RMBS), you aren’t going to see the performance of those comparatively small names reflected in the price action of this ETF. Fully 16% of its assets are pledged to Microsoft (MSFT) and a hefty 11% are invested in shares of IBM (IBM).

And although Clarus (CLRS), Copper Mountain Networks (CMTN) and CacheFlow (CFLO) are all very promising companies, they could each double without having a meaningful impact on the overall index.

Indeed, for most of the sector ETFs, it isn’t uncommon for 65% of the fund’s assets to be pledged to just 10 names — most to the top five or so. So you aren’t really betting on a sector, but betting that the large-cap names in that sector (and a relatively small and unimaginative selection at that) will be the best companies to own.

Even more troubling is the fact that in many cases, what you see might not be what you ultimately get. While a recent regulation from the Securities and Exchange Commission mandates that mutual funds adhere to “truth in labeling” practices, the truth is that general sector names such as “technology” or “consumer cyclicals” are an exceedingly broad way to classify individual investment opportunities.

For example, General Electric (GE) makes up more than 28% of iShares Dow Jones U.S. Industrial (IYJ), even though the stock generally tends to trade like a financial. Priceline (PCLN) is included as a noncyclical within iShares Dow Jones U.S. Non-Consumer Cyclical (IYK), but when it comes to its actual price performance, it’s probably best represented by the iShares Internet Index fund (IYV), of which it also makes up a negligible percentage.

Probably the worst offender in this regard is iShares Dow Jones U.S. Energy (IYE), which is essentially a call-OPEC’s-bluff bet on Big Oil companies. Exxon Mobil (XOM), ChevronTexaco (CVX) and Schlumberger (SLB) make up almost 60% of the fund’s holdings, with Exxon Mobil specifically weighing in at over 40%. Natural-gas companies such as El Paso (EP) and Williams (WMB) are also included in the portfolio, but not with an allocation that can have a serious impact on the overall index. Combined, they represent less than 6% of the fund.

This top-heavy portfolio design is emblematic of most of the sector ETFs — a fact that means their performance is generally tied to a couple of “make or break” names. iShares Dow Jones U.S. Telecommunications (IYZ), for example, has over 50% of its assets in Verizon (VZ) and SBC (SBC) while iShares Dow Jones U.S. Chemicals (IYD) has well over 50% tied up in DuPont (DD) and Dow (DOW). From a portfolio perspective, you essentially take on a potentially ruinous amount of the stock’s risk while optioning off the unfettered upside thanks to a patchwork of negligible positions.

Because the sector ETFs are less diversified than meets the eye, they also present a large number of stock-specific risks not normally associated with index investing. One is company risk, or inherent possibility that a company’s particular fortunes might be more tied to its management than its sector classification.

For example, within the retail sector, thanks to aggressive cost-cutting and an artfully directed turnaround, Sears’ (S) return far outpaced Wal-Mart’s (WMT) last year, but because Wal-Mart makes up 10% of iShares Dow Jones U.S. Consumer Cyclical (IYC) to Sears’ roughly 1%, that performance differential didn’t have a big effect. The biggest instance of company or “management” risk can be found within the two leading real-estate ETFs, both of which hold over 15% of their assets in Equity Office Properties (EOP) and Equity Residential Properties (EQR). Sam Zell serves as chairman of both companies, making a bet on either of these “diversified” index plays really just a bet on Sam Zell.

Finally, because most ETF sector funds track U.S. stocks, investors face the risk that the real performance within a particular sector might come from overseas. For example, DaimlerChrysler (DCX) looks more promising to me than Ford (F) or General Motors (GM), and while Fox News Channel (a unit of Australia’s News Corp. (NWS)) is beating the pants off AOL Time Warner’s (AOL) CNN, you aren’t going to find either company within the iShares sector portfolios. Foreign stocks are by and large excluded from sector ETFs altogether.

It isn’t so much that you shouldn’t use ETFs in your portfolio, but rather that you understand how you use them. In an environment of sector rotation, where the major indexes tread water, focusing on one or two particular sectors is smarter than just holding the good ol’ S&P 500. There are a number of ways to appropriately tailor sector exposure using ETFs and ways to do it without them as well.

The most effective way to mitigate some of the exposure to the handful of large-cap stocks that dominate most ETFs would be to construct a spread, which we’ve previously discussed within the context of both closed-end funds and Japanese stocks. Generally speaking a spread consists of a long position paired with a short position in a correlated sector.

For ETFs, one idea might be to buy a particular ETF while shorting a smaller position of the fund’s largest holding. So if you wanted exposure to U.S. financial stocks through iShares Dow Jones U.S. Financial Services (IYF), but were worried about the weighty 16% allocation to Citigroup (C), you could buy IYF while simultaneously shorting Citigroup, expecting that the gains from your long position in the broad index would outpace the short sale in Citigroup. You’d be essentially negating Citigroup’s influence on your total return.

In addition to spreading you might try supplementing — buying the ETF as a core holding while also adding positions in smaller names not represented in the major index. So if you bought shares of iShares Dow Jones U.S. Real Estate (IYR), you might also take positions in a number of smaller real-estate plays. Using the Smartmoney.com Select Stock Screener, you can easily isolate companies within both a particular sector and market cap. A screen for diversified real-estate companies under $400 million in market cap yields over 30 candidates, several of which, including Entertainment Properties Trust (EPR) and One Liberty Properties (OLP), make particularly compelling buys at current levels.

To benefit from a sector trend that includes global stocks, you might consider adding a position in a foreign company’s American depositary receipts to a core holding of a U.S.-based ETF. Both JPMorgan and Bank of New York offer excellent sites highlighting foreign companies traded on U.S. exchanges, and the Smartmoney.com Stock Screener will also allow you to screen specifically for non-U.S. shares.

Although active management gets a bad rap next to the cold efficiency of indexing, there are many scenarios in which professional stock pickers can add significant value. While I abhor paying loads when it comes to buying mutual funds, Fidelity Investments offers a number of sector funds that are professionally managed and not driven solely by an index. Several firms also offer sector-specific funds that not only rely on the performance of one industry, but the stock-picking acumen of a knowledgeable professional.

– Originally on Jan 14, 2002 by Jonathan Hoenig

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.

Among financial planners and mutual-fund companies these days, diversification has become synonymous with buying small-cap and midcap stocks. And for most people’s portfolios, that’s a healthy start: Both small-caps and midcaps have outperformed as of late, and should be considered as part of a stock portfolio. But what most financial planners don’t realize is that investing in a range of market capitalizations doesn’t solve the real diversification dilemma. The problem is correlation.

Let’s define some terms: Correlation measures how closely two assets relate to one another. In this case, it refers to how closely two stocks tend to move in the same direction. For example, Cisco and the Nasdaq are very highly correlated. Cisco and the S&P 500 are less correlated, but still tend to move in similar fashion.

A perfect correlation would be expressed as 1.0, and would mean that changes in XYZ would result in identical changes in ABC. When XYZ zigs, so will ABC. A perfect negative correlation is expressed as -1.0, and indicates an identical inverse relationship. When XYZ zigs, ABC zags by exactly the same amount. A correlation of zero means there’s no relationship between the two securities. A movement in one has no bearing or predictive qualities on the other.

And while small-cap and midcap stocks don’t move in exactly the same direction to exactly the same degree as large-cap stocks, historically, they’re darn close. Using some of the low-cost index proxies available to the individual investor, I have created a correlation table to demonstrate just how tightly linked small-cap and midcap stocks are with their big-cap brethren. The Vanguard Small Cap Index fund (NAESX) (which mirrors the Russell 2000) is strongly correlated with both the Dow and S&P 500, and even more so with the Nasdaq. The S&P MidCap 400, represented here by the exchange-traded MidCap SPDR (MDY), is even more closely correlated with the major indexes. By adding smaller stocks, you will diversify your portfolio away from large caps, but not from the market itself. From a risk-management perspective, it’s like adding pepper to an already spicy bowl of chili.

When it comes to diversifying your portfolio, simply holding a broad array of stocks won’t reduce your overall risk profile. You’ve got to focus on holding noncorrelated assets — that is, something that will zig while the rest of your portfolio zags. Among market scholars, creating that perfect “mixture” of assets has become known as the “efficient frontier.” Not avoiding risk, but dealing with it. Elimination by mitigation.

Bonds are a perfect place to start. While they don’t boast the historical returns of stocks, bonds have outperformed the broad market for more than a year and are still sorely absent from many investor’s portfolios — especially those who are in it for “the long haul.” According to the Investment Company Institute, stock mutual funds still contain roughly four times as many assets as bond mutual funds. While the returns of individual bonds can be highly volatile, bond mutual funds, even those tracking corporate and junk issues, are statistically uncorrelated with the equity market.

But bonds are just the beginning. Commodities, currencies, precious metals, real estate and international securities are all generally uncorrelated with stocks. And thankfully, the ever-crafty mutual-fund industry has developed products to allow even the sophomore-sized Soros to take positions in each, spreading bets around among uncorrelated asset classes — just as hedge funds do.

The Oppenheimer Real Asset fund (QRAAX) invests in futures and fixed-income instruments that move in relation to commodity prices, and is highly uncorrelated with the stock market (0.01 for the S&P 500 and Dow, 0.04 for the Nasdaq). The fund is off about 8% year-to-date after gaining 36% in 1999 and 44% in 2000. From a macroeconomic perspective, it’s one way to benefit from rising fuel prices, since the fund’s underlying index (the Goldman Sachs Commodity Index) is highly sensitive to fuel prices.

The Franklin Templeton Global Currency fund (ICPGX) holds money-market instruments denominated in three or more of the world’s major currencies, and is one of the few ways most investors can quickly hedge themselves against fluctuations in the U.S. dollar. Even more important, it’s negatively correlated with the stock market, meaning that when the market falls, the fund should rise. Sadly, the fund has been recently closed to new investors, and will soon be merged into the company’s global bond fund, which has much less favorable correlation statistics, as high as 0.32 with the S&P 500.

An alternate option could be a precious-metal fund, as gold tends to be negatively correlated with both the dollar and the major equity markets. The Vanguard Gold & Precious Metals fund (VGPMX) is a cost-effective way to get exposure to precious metals. This has been a perennially poorly performing group — but its low correlation to stocks means that it has posted a slightly positive return so far this year.

Real estate investment trusts, or REITs, continue to boast solid returns and low levels of correlation with the equity market. The iShares Dow Jones Real Estate Index fund (IYR) can be traded like a stock and offers immediate, diversified exposure to REITs, albeit with an emphasis on the index’s two biggest names, Equity Office Properties (EOP) and Equity Residential Properties (EQR).

Finally, international investing is often suggested as a way to diversify a portfolio away from domestic stocks. But as markets have become more advanced, so have the correlations that link them. Most developed European and Asian stock markets tend to be positively correlated with those in the U.S. Among the notable exceptions is the iShares MSCI Austria fund (EWO), which boasts a low correlation with all major U.S. indexes and is up 10% year-to-date.

– Originally on Apr 26, 2001 by Jonathan Hoenig