Lessons from the Pros

This Week’s Market Movers – More Fed Torture

At the top of the list of potential market movers must be the March Fed meeting. The smart money is betting on another quarter point hike and at least one more after that in May. Odds of this increased last week as the PPI core came out hotter than expected.

In terms of economic reports, we will get a good glimpse at the consumer with consumer confidence on Tuesday and both personal income and sentiment on Friday. Look for the revision of the GDP Q4-05 report on Thursday to possibly ripple the waters as well. That report came in absolutely anemic – and it is suspect precisely because of that. Lastly, factory orders will be watched closely for any rebound – they were down sharply and unexpectedly last month.

Hedging Your Bets With Matt
Davio:
ETF Frenzy

As the market continues to ebb and flow with multiple breakouts in the smaller Dow industrials and the NDX and SPX lagging, I got to thinking about the many new products that have evolved over the past half dozen years in US markets. Much like mutual fund indexing, which was the hot financial product in the 80-90′s at the heart of the Bull Market, we now have a new (!) hot product – the Exchange Traded Fund (ETF).

An ETF is a fund that tracks an index of specific sector stocks. Investors can do just about anything with an ETF that they can do with a normal stock, such as short selling. And because ETFs are traded on stock exchanges, they can be bought and sold at any time during the day (unlike most mutual funds).

The pitch you hear about ETF’s is that they are more tax-efficient than normal mutual funds and that they have very low operating and transaction costs. There are no sales loads or investment minimums required to purchase an ETF. And while this all sounds find and good, I do think there is a downside in ETF’s that most retail investors overlook – a lack of liquidity.

In this regard, there are literally hundreds of ETF products that you can trade. They cover sectors ranging from Banks, Energy, and Semi Conductors to Biotechs, Domestic and Foreign Exchanges, and Gold. There is even a Commodity Index…Heck, even Water and Nanotech have their own ETF’s.

What I find interesting is that although some are very liquid like QQQQ, most are extremely illiquid, sometimes only trading a few thousand shares daily. The point: Watch out for the liquidity squeeze in some of these names!

More broadly, the thing that I find most interesting is that the ETF’s are marketed as devices to spread and reduce risk while still providing exposure to the sector. But is this really the case? Let’s look at a few of the more widely held ETF’s.

We’ll start with BBH – the Biotech ETF. Is there really diversity in this index? 97.3% of this index is made up of only 10 stocks. The Top 3 names in the BBH make up 74% of the total price movement. That would be Genentech (DNA), Amgen (AMGN), and Gilead (GILD). I ask the question – what would happen if any one of those names took a header and its price dropped significantly? Of course, your biotech investment would tumble with the direct correlation between the top 3 holdings and the overall price of the index. And the same goes for the upside….what if one of the major holdings of your favorite ETF were to experience an extreme price increase, yet within the ETF, it would be held back because of it’s relation to it’s lagging ETF brethren. What I’m saying is that if you like those names on their own merits, go take ownership and handle the risk. But diversity and risk control is not what BBH offers its owners. I think overall you will find similar ratios across most ETF’s.

Allow me to illustrate this point with this first chart of BBH. In 2005, BBH rose about 61% from valley to peak. Not a bad return. But let’s look at the top holding within BBH – Genentech (DNA). DNA makes up 38.78% of the BBH. DNA went from $45 in early 2005 to $100 in the fall of 2005…..close to a 122% gain. And with the volatility (beta) in these names being quite similar (BBH = .977, DNA = .924), it begs the question about the benefit of “diversifying” with an ETF.

The same situation arises in the Semi Conductor Holder (SMH). The top 3 names in this index make up 48% of the pricing of this ETF. These stocks are Texas Instruments (TXN), Intel (INTC), and Applied Materials (AMAT). Again, if you think these are solid names, go own them in your own basket and hedge accordingly. In 2005, SMH had risen from valley to peak about 33%. During the same period, Texas Instruments (TXN) went up 62%. Can ya hear me knockin’?

Based on this analysis, I would encourage investors to dig deeper into any ETF you might want to hold and see what makes up the funds and their weightings. You may find that truly owning one or two of the top tier firms in the ETF may work to generate the same return you are looking for without taking on unnecessary risk that could implode your returns by overlooking the makeup.

As a final note of caution, the ETF’s have also become vehicles for hedge funds to spread and evaluate more complicated risk scenarios and have become in essence stand alone trading vehicles that may be more short-term oriented than the longer-term investor may be looking at. Always match your time discipline to your risk horizon when evaluating your investments. This should help evaluate better risk/reward scenarios…which is what the game is about, right?