For those of you that do not know what Exchange Traded Funds (ETFs) are here is a short description.
What are ETFs
Think of an ETF as a mutual fund that trades like a stock thus experiencing price changes throughout the day as it is bought and sold. You can short sell them or buy them on margin as well. ETF tracks an index, a commodity or an index fund.
ETFs offer diversification, high trading flexibility, low expense ratio and tax efficiency in a flexible investment. An ETF does not have its net asset value (NAV) calculated every day like a mutual fund does. When buying and selling ETFs, you have to pay the same commission to your broker that you’d pay on any regular order.
With the basic knowledge of ETFs, let us look at different variety of ETFs available in the market. You will be surprized by the options one has.
Investors in ETFs with a copper or mining focus should be aware that the demand for this metal will continue. Economic expansion in BRIC countries such as India and China mixed with the U.S. housing demand will keep the need fueled. Copper is used in every major industry such as transportation, housing, and machinery. Over the last few years the price of copper has gone from $0.50 to $6.00. China, the biggest consumer of copper, is expected to import more copper. China will need copper to sustain their growth. Although there isn’t a pure copper ETF, there is the PowerShares DB Base Metals
(DBB), which holds one-third each of copper, aluminum and zinc.
The gold actually purchased will depend on how investors view the world; politics, oil supply, and the strength of the dollar all come into play. Whenever the dollar goes through a rough patch, gold prices rocket. Additionally ETFs that buy gold have also helped raise the price. Gold ETFs such as streetTRACKS Gold Shares (GLD) and iShares Comex Gold Trust (IAU) were up 8.69% and 8.57% respectively in 2007.
There is a strong possibility of a platinum ETF to hit the market, atleast in the UK to begin with. The world’s platinum markets are very tight, and new investment demand from a platinum ETF could push prices up. ETF Securities, the commodity ETF leader in Europe, rolled out new physical ETFs tied to platinum, palladium, silver, gold and a combined basket of those four metals.
Large-cap Basic Material ETF
ETFs that focus on large-cap companies with exposure to basic materials have had nice returns for the year. Materials Select Sector SPDR (XLB) and Vanguard Materials ETF (VAW) have returned 7.5% and 8.3% respectively.
The dollar is looking less important day-by-day. There will be a time when dollar will not be the world currency; and that position will be shared with few other currencies like euro and the yuan. Foreign countries need dollars to buy some of the things they consume. If those things become available in other currencies there will be less demand for dollars leaving the dollar weaker. This makes currency ETFs an attractive investment. Deutsche Bank and PowerShares has issued PowerShare DB U.S. Dollar Index Bullish UUP and the PowerShare U.S. Dollar Index Bearish UDN ETF. These ETFs offer investors access to the performance of the dollar against global currencies.
Healthcare is one sector that has strong ETF presence. Barclays offers global, broad US sector, and main industry group ETFs as part of its iShares family. StateStreet offers a broad US sector ETF and ETFs covering the main industry groups. HealthShares offers ETFs containing 22-25 stocks covering specific therapeutic areas and healthcare business activities. Global healthcare ETF such as iShares S&P Global Healthcare Sector Index Fund (IXJ) has returned 7.92% in 2007. U.S. healthcare ETF such as Vanguard Health Care ETF (VHT), Health Care Select Sector SPDR Fund (XLV) and iShares Dow Jones U.S. Healthcare Sector Index Fund (IYH) were all up at 8.38%, 7.97% and 7.81% respectively in 2007.
The Germany ETF iShares MSCI Germany Index (EWG) is up 12.5% year-to-date. The German economy is booming and not directly dependent on the U.S. economy, and therefore wont be affected by any U.S. slowdown. Germany is 1/5th of the economic activity in the European Union with projected growth of 2% this year. Although U.S. is an important consumer for Germany, Germany’s success is driven by Russia and the former Soviet countries. Their total exports within Europe are 5 times that which are shipped to the U.S. EWG has broad diversification with top holdings of 10% in Allianz, 7% in Deutsche Bank and 6% in Daimler Chrysler.
Until 2002, Canadian market performed similarly to U.S. markets. However from 2003 onwards, Canadian market has outperformed U.S. markets by a big margin. iShares Canada ETF (EWC) is one way to track the Canadian markets.
Emerging Market ETF
Broad and Regional Emerging Market ETFs cover multiple emerging countries’ stocks in a single ETF. Those markets include countries in Eastern Europe and South America, as well as developing countries in Asia such as China and India. These ETFs are typically dominated by large cap stocks. Emerging market ETFs such as iShares MSCI Emerging Markets Index Fund (EEM) and Vanguard Emerging Markets ETF (VWO) were up 7.87% and 8.64% in 2007.
International ETF With High Risk/Reward
Some international ETFs expose themselves to as much as 24.5% in a single stock. This means less diversity and more risk. This also means more rewards.
Country ETFs with excessive exposure to the stocks of individual companies include:
MSCI Mexico Index Fund (EWW) with 24.5% in America Movil SA de CV-Class L
MSCI Belgium Index Fund (EWK) with 24.5% in Fortis
MSCI South Korea Index Fund (EWY) with 17.8% in Samsung
The utilities ETFs were one of the top performing sectors for the 2007. Valuations for the industry are steep and there doesn’t seem to be any serious correction in coming quarters. Utilities are defensive in nature and make a good dividend play, which could keep them in high demand. Utilities Select Sector SPDR (XLU) was up 13.2%, iShares S&P Global Utilities Sector (JXI) was up 10.5%, where as PowerShares Dynamic Utilities (PUI) gained 9.6%.
After a 5 year run in commodities and companies that mine, transport, process and sell them, commodity-based ETFs are maintaining a growth spurt. Both domestic and global economies continue to expand, creating more demand. At the same time, the lack of infrastructure to support the growth puts a strain on supply. If there were a measurable slowdown in demand for economic fuel and/or a de-escalation in supply, they could trigger a downslide. PowerShares DB Commodity Index Tracking Fund
(DBC) is comprised of light, sweet crude oil, heating oil, aluminum, gold, corn and wheat. The ETF is down 0.6% year-to-date and up 9.5% for the past year. iShares GSCI Commodity Indexed Trust
(GSG) is down 1.5% year-to-date and holds 24 types of commodities.
During the recent market correction, energy sector along with utility sector has held well. The price of crude oil is rising, helping energy ETFs to see positive gains. iShares S&P Global Energy (IXC) was up 4.77% for the year 2007.
Natural Gas ETF
U.S. Natural Gas Fund (UNG) was recently launched by Victoria Bay Asset Management which is the first natural gas ETF. The price movement of this ETF will depend on the price of natuaral gas delivered at the Henry Hub, Louisiana. The fund will invest in natural gas futures contracts. UNG does not use leverage in its portfolio. This fund will fall under the commodity sector. The fund is Victoria Bay’s second; its first fund, United States Oil Fund ETF (USO), tracks the price of crude oil.
Dividend ETFs track indexes in which stocks are weighted by their dividend payments. Some of these ETFs also take account of the dividend yield, whether the dividend has been sustained or risen over time, and for how long the stock has paid a dividend. Dividend ETFs cover broad indexes, US and foreign stocks, and individual sectors. Broad US dividend ETFs are those that pick the dividend paying stocks from the broad US indexes, and cover multiple sectors in a single ETF. Dividend ETFs such as iShares Dow Jones Select Dividend Index Fund (DVY) and SPDR S&P Dividend ETF (SDY) were up 4.78% and 3.96% respectively in 2007.
High Yield ETF
High-yield bonds are a unique, paying a high yield but offering significant volatility as well. Bonds can appreciate sharply during good times, when defaults are low and risk discounting is reduced. When markets sour, however, credit spreads can widen and high yield can bear the brunt of the downturn. iShares rolled out its new iShares iBOXX $ High Yield Corporate Bond ETF (HYG) which tracks a index of 50 high-yield corporate credits. It seems to be the right time to roll this fund with all the concerns about weaker credit markets. The 50 or so bonds in this ETF sector have an average yield to maturity of 7.43% which will catch the eye of yield hungry investors.
The 2006 U.S. defense budget was $442 billion with $79 billion of that for equipment acquisitions and $70 billion for research and development. President Bush has already requested a 15% increase in defense spending in 2007. Over the next two years, analysts project the defense budget will rise an additional 4.7% annually. The defense contractors have seen strong profits as a result of increased defense spending, which led to solid performance of defense ETFs. Defense ETFs such as iShares Dow Jones U.S. Aerospace Fund (ITA) and PowerShares Aerospace & Defense Fund (PPA) were up 9.54% and 8.35% respectively in 2007.
Homebuilder ETFs are not doing well. Infact they are facing a downward trend. Analyst predict the new-home prices will continue to decline due to high supply and low demand in the market. With subprime lending going bust, and high foreclosure rates, homebuilder ETFs have suffered. SPDR S&P Homebuilders (XHB) is down 6.16% for the year 2007.
Conclusion: A great reason to consider ETFs is that they simplify index and sector investing in a way that is easy to understand. If you feel a sector is going to do well in the near future, go buy it. If however, you think that a sector is going to slump, go short it.
We has looked into a variety of ETFs at investors disposal ranging from metal, basic material, gold, emerging markets, healthcare, utility, commodity, energy, high dividend, defense to homebuilders. Hope this post has helped reader understand the options available to them. Would love to hear from readers of other interesting ETFs i missed out.
(Source: Seeking Alpha, Yahoo Finance)