Now, years later, the deutsche mark is gone, replaced by a single European currency used by 400 million people in 22 countries. The euro is the world’s most liquid and actively traded currency behind the U.S. dollar. It’s also the benchmark for a new New York Stock Exchange-listed security that I believe is poised to become a huge success.

Three years ago, I heralded the launch of fixed-income exchange-traded funds as a major breakthrough. More recently, I covered gold ETFs as a huge development in portfolio opportunity. Last week, Rydex Investments introduced the Euro Currency Trust (FXE), a currency-based ETF that trades on the NYSE. Although only recently launched, this landmark innovation represents a major victory for capital-market participants world-wide. That’s why it gets my vote as perhaps the best trade of the new year.

Simply put, this new ETF offers an effortless way to bet on (or against) the euro. Trading under ticker symbol FXE, each share represents 100 euros plus accrued interest. If the euro strengthens relative to the U.S. dollar, then the price of FXE will rise. If the euro weakens, then FXE falls. Because euros held in the fund earn interest, the fund also boasts a dividend (although a portion of the yield will be lost to the 0.4% annual fee paid by investors to the fund’s sponsor, Rydex). The ETF can be sold short or bought on margin, with investors paying a brokerage commission to trade it just like any other similar security. Both the prospectus and fact sheet are worth reviewing.

The opening up of foreign exchange to individual investors represents a landmark achievement. The forex market is huge, trading more than $1.8 trillion each day with a quarter of that occurring between the dollar and euro. Yet unlike equities, forex trading occurs “over the counter” with no centralized marketplace. Most transactions range between $5 million and $50 million, making it impossible for all but the biggest players to participate. Spreads and commissions in the opaque “spot” market are also difficult obstacles to profitably overcome.

Currency futures, while exchange traded and more readily accessible to the retail customer, present their own shortcomings, including the need to constantly roll positions forward as contracts expire. FXE, on the other hand, trades on the NYSE and never expires, so it can be held for as long as a trader’s capital allows.

Like the gold and fixed-income ETFs, FXE democratizes an entire asset class that, for the average investor, was almost impossible to directly participate in. In recent years, foreign-bond funds like Templeton Global Income (GIM) and American Century International Bond (BEGBX) have become popular ways to play a weakening U.S. dollar, although those funds presented additional exposures in the forms of credit and interest-rate risk. FXE offers a “pure play” on the euro and makes getting specific exposure as easy as buying shares in General Electric (GE).

Most of us are familiar with the need to diversify our equity and fixed-income portfolios. Yet the difficulty in playing the dollar has kept us from having to think too much about currency risk — the potential that the value of the dollars in your pocket (or bank account) might fall in value relative to other world currencies. And while there are thousands and thousands of mutual funds that own the same handful of large-cap U.S. stocks, this is one of the few products that allows individual investors to diversify into an entire new asset class.

As I wrote a while back, more than stocks, bonds or any other asset, Americans live, think and breathe in dollars. We hold them in our pockets, and in savings and checking accounts. Our paychecks and bills are paid in dollars. So regardless of your view on the economy or President Bush, most of us are “long” dollars in a big way. This new ETF offers an efficient and easy way to diversify that risk.

For the more active investor, I predict the security will likely become a major trading vehicle. It’s already off to a busy start, averaging roughly 400,000 shares traded a day. Even more notable, the market has been incredibly liquid, with five- to 10-cent spreads and markets 50,000 shares deep. If you ask me, it won’t be long before FXE, not unlike StreetTracks Gold Shares (GLD), will be routinely trading a million shares a day.

Although it has recently weakened, much to Warren Buffett’s dismay, the U.S. dollar mounted a strong recovery against the euro in 2005. (One euro currently equals about $1.20.) Regardless of what 2006 has in store, I believe FXE is on the road to becoming the first of a series of widely successful currency-linked ETFs. Unlike the dozens of copy-cat funds mirroring large-cap benchmarks, the security presents investors of every size an effortless entry into a particularly important yet cumbersome corner of the capital market. It is certainly a ticker to watch in the year ahead.

– Originally on Dec 19, 2005 by Jonathan Hoenig

Like a four-star film, a successful trade is carefully planned, meticulously researched and delicately executed. And when it comes time to put money on the line, investors should not only like the trade, but also the product they’re trading. Making the right trade at the right time using the right product well, it feels like heaven on earth.

Despite the paternalistic tone coming from nervous regulators these days, new investment products continue to be developed at a speedy clip. Keeping abreast of the latest innovations is critical so that, like Batman, you can pull them out of your utility belt at just the right time.

Some products are outright flops. Folios have been moribund since their much-heralded inception a few years back. The same goes for the Chicago Mercantile Exchange’s bankruptcy futures and the Chicago Board Options Exchange’s options on mutual funds, neither of which gained sufficient volume to justify their existence.

Oftentimes, however, investment products look like flops at first simply because they’re a bit ahead of their time. For example, while the Standard & Poor’s Depositary Receipt, or Spider (SPY), was introduced in 1993, it didn’t really take off until the later half of the 1990s, when the market became much more index driven. International exchange-traded funds, or ETFs, got their start as New York Stock Exchange-listed “Country Baskets” and American Stock Exchange-listed “Webs” (World Equity Benchmark Shares) — both of which languished as world markets underperformed the U.S. during the late 1990s. Webs have since been remarketed as “iShares” and have enjoyed steady (although not spectacular) interest from individuals and institutions alike.

While they’re still in their infancy (with more still to come), I believe the recently introduced iShares fixed-income ETFs are the most exciting new products since the Nasdaq-100 Trust (QQQ). Although bonds have a decidedly ho-hum reputation, the new ETFs’ low-cost, ease-of-use and liquidity offer stock jocks trading opportunities previously available only to futures traders or big institutions.

Although Morningstar’s Christopher Traulsen considers trading bond ETFs “about the dumbest idea we can think of,” I believe using the new iShares to better understand, track and (gasp!) trade the bond market represents a major opportunity for income investors looking to take their game to the next level.

While bonds are usually thought of strictly as stable income investments, their prices do fluctuate — often quite dramatically. Since April, the average 30-year bond fund has gained almost 10%, thanks to a major drop in long-term interest rates. Indeed, despite the national obsession with the Federal Reserve, it’s the market that sets interest rates. And because the market can be volatile, bonds — like stocks — can be traded for short-term profit.

Although there are thousands of bond mutual funds to choose from, with the exception of the CBOE’s thinly traded interest-rate options and Merrill Lynch’s soon-to-expire Bond Index Note (BNX), I can’t think of a (non-futures) product that offers individual investors the ability to short sell bonds (that is, bet on higher interest rates) as easily as the new fixed-income iShares. While investors in years past could buy gold funds or short utility stocks to capitalize on rising interest rates, shorting bonds (or bond fund ETFs) outright is much more of a pure play on higher rates.

In addition to serving as long vehicles for income or short vehicles as hedges against higher rates, the new fixed-income ETFs will probably be used in conjunction with another instrument as one leg of a spread. We’ve previously discussed spreads within the context of both closed-end funds and Japanese stocks. Generally speaking, a spread consists of a long position paired against a short position in a correlated sector.

The new instruments will allow you to game the yield curve just as institutions do, going both long and short various maturities in accordance with your own expectations regarding rates. In addition, trades can be developed that isolate particular types of risk. For example, pairing a long position in Goldman Sachs InvesTop Corporate Bond (LQD) or a similar open-end bond fund against a short position in the Lehman 7-10 Year Treasury (IEF) can expose a portfolio to business risk while minimizing interest-rate risk.

We’ll unpack a number of trading ideas over the next few months. The important thing to realize now is that this new ability to go long and short specific points on the yield curve (without a futures account) represents a major step forward in portfolio flexibility, no matter how big or small that portfolio might be.

– Originally on Aug 19, 2002 by Jonathan Hoenig

Whatever the reason, it’s okay to downshift your risk from time to time — as long as you do it right. For most people, “playing it safe” means selling their entire portfolio and stuffing their assets into a seemingly risk-free investment — most likely a CD or money-market or savings account. But even leaving aside the tax bite that comes with selling long-term positions, stuffing your money in the proverbial mattress is a losing move.

There’s no such thing as a free ride. Savings accounts and CDs are insured, but you’re paying for every bit of that safety in the form of mediocre returns. Even uninsured money-market funds are paying a record low 1.35% interest. The return becomes even more depressing after taxes.

It’s human instinct to go to extremes, but the best portfolios aren’t black or white, but shades of gray. There are ways an equity investor can tone down risk without abandoning it altogether. With an eye toward minimizing transaction costs, taxes and stress, here are a few ideas to bring your portfolio down a notch:

Keep in mind that “playing it safe” isn’t necessarily about what you buy, but rather how you trade. And a defensive portfolio shouldn’t be devoid of all stocks, but all big positions. We can never say it enough: Size matters. When someone tells me they lost money in stocks, chances are it was because of their position size, not stock selection.

So start by trimming your exposure, not killing it altogether. If a position takes up 10% of your portfolio, cut it to 5%. If it makes up 4%, cut it to 3%. In short, take some money off the table, but don’t leave the casino. By reducing the size of your positions rather than eliminating them outright, you aren’t turning off the music, just lowering the volume.

For those stock positions you do keep, a series of protective stop-loss orders can automatically lessen your risk if the market doesn’t go your way. So if you’ve got 1,000 shares of XYZ at $50, sell a third off the top and place orders to sell another third if the stock trades below $44. Sell the final third should the stock trade under $40.

Not only have you defined your downside, but you’ve protected your upside as well. If XYZ moves higher, you’ve sold only one-third of your position and are still poised to participate in the move. The best part about the technique is that with the exception of that initial sell, it’s the market that’s determining when you get out, not your own emotions. You can take the money and run without running away entirely.

Selling stock generates cash, and although the returns on cash are dismal, it does serve as useful drag on an overall portfolio when you’re looking to reduce risk. It’s one of a few common hedges we talked about a few months back.

Like a weight belt or flat tire, a cash allocation immediately lowers a portfolio’s overall volatility while still allowing you to take reasonable risk on more speculative plays. In short, instead of putting $10,000 into a portfolio of “safe” stocks, I’d keep 80% in cash and put 20% on some promising growth names — even in highly volatile areas like emerging markets or small-cap stocks.

In addition to selling stock, another way to create a cash drag in your portfolio is to simply add new cash, effectively diluting the potency of your holdings.

In addition to paychecks and other noninvestment income, you can also create a cash drag by directing your mutual funds to pay interest, dividends and capital gains in cash, rather than reinvesting them directly. Although the idea is pooh-poohed by financial planners in it for the “long haul,” it’s one way to gradually begin increasing your liquidity while decreasing your overall portfolio risk.

A final strategy would be to focus new purchases primarily on fixed-income and income-oriented stocks. Although most investors have been weaned on growth stocks with no dividends, a large part of the market’s long-term return has actually come from dividend yield, not price appreciation, as we pointed out a few months back. Say you bought the Dow in 1975, when the last bear market was finally starting to bottom out and the dividend yield was 6%. Based on price appreciation alone, the index would’ve returned 1,526%. Not bad. But factor in the dividends and that number jumps to 4,198%.

So instead of hiding in a money market, you might consider diversifying a portion of your assets among a number of the most attractive dividend plays.

You might also consider other income-oriented investments. We first started talking about bonds last summer, and although I’m cautious on U.S. Treasurys here, I do believe emerging-market bonds still offer serious upside despite their recent run. We’ve highlighted a few emerging-market bond funds in recent weeks, including Templeton Global Income Fund (GIM), Templeton Emerging Markets Income Fund (TEI) and Morgan Stanley Global Opportunity Bond Fund (MGB).

Among equities, there are several income-oriented sectors worthy of consideration at current levels. Real estate investment trusts (REITS), which we first covered in depth last fall, continue to march higher, and this is one of the few sectors that I believe deserve a place in every portfolio.

Although there are a number of exchange-traded funds (ETFs) that track REIT shares, investors should consider supplementing an ETF allocation with some small-cap names. The real estate ETFs (and actively managed REIT mutual funds for that matter) tend to be overweight in both Equity Office Properties Trust (EOP) and Equity Residential Properties Trust (EQR), the industry’s two largest players. Some of my favorite smaller-cap plays include One Liberty Properties (OLP), Entertainment Properties Trust (EPR) and Sovran Self Storage (SSS).

Financials are another income-oriented sector that presents opportunities at current levels. As with most stocks these days, I think the biggest bang will come from the smallest stocks. After all, Citigroup (C) trades at 18 times earnings and four times sales. It sports a dividend yield of only 1.29%, pretty puny compared with those of some of the regional banks or small S&L’s.

Toning down the volatility of your portfolio from time to time is a necessary if frustrating evil. In the great game of the market, sometimes you just have to play defense.

– Originally on Mar 18, 2002 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