EXCHANGE-TRADED FUNDS

Exchange-traded funds (ETFs) are like index mutual funds that behave like stocks. They trade all day on recognized stock exchanges such as the American Stock Exchange, and some trade during extended hours. These funds are not actively managed; they are like index funds that are passive. They replicate an index, such as the S&P 500 index or a growth stock index, without trying to outperform that index.
The trustee updates the holdings every few seconds to keep the net asset value of the ETF in line with the market. This is a lot of updating, so you obtain better tracking results with a smaller index like the Nasdaq-100 than you do with a large one such as the ONEQ that tracks every Nasdaq stock. As with any trust, there is a custodian who holds the securities that the trustee buys.
There is a lot of free education about ETFs on the Internet now that the public has joined hedge funds in trading these instruments. Nuveen Investments has a web site, ETFConnect, at www.etfconnect.com; and, as usual, Yahoo.com has extensive information on this popular new trading vehicle.
Exchange-traded funds are important to us for two reasons. First, they provide a way for our model portfolio to invest in two potentially lucrative assets: the Nasdaq Composite index and gold bullion. There is no Nasdaq index fund and there is no convenient way to trade gold. Exchange-traded funds are the only way to put these two investments into a real portfolio. Second, they expand our options for sector investing. Both functions are equally important to our model portfolio.
Before we examine the details of ETFs, however, let us inject a little Wall Street wit.
Nicknames for some of the first ETFs reflect this industry’s penchant for dry humor. The first ETF appeared in 1993 with the objective of replicating the total return of the S&P 500 index. The name of the trust is Standard & Poor’s Depositary Receipts (SPDR). Its stock symbol is SPY, and it quickly earned the nickname “spider.” Newspaper advertisements for this fund, or trust, featured a spider building a web of financial security. It is the same with the first ETF for the Dow Jones Industrial Average. The symbol is DIA; the nickname is “diamonds,” and the advertisements include gemstones. Vanguard, which started the indexing trend with their family of mutual funds, created a group of ETFs called Vanguard Index Participation Equity Receipts (VIPERs). The Nasdaq-100 ETF has the symbol QQQQ and the nickname “cubes.” Wall Street loves nicknames.

EQUITY ETFS
Standard & Poor’s Depositary Receipts offer a convenient way to implement the trading decisions generated by our model portfolio. Each SPDR owns all 500 of the stocks in the S&P 500 index in their market capitalization weight. We can trade the SPDR all day and into extended hours; we can buy and sell options on it; and we can leverage it in the futures market. There is a price for all this flexibility; your broker will still charge a commission when you buy any ETF. If you are charged about $30 and you are investing less than $30,000, you are better off in an index fund directly from Vanguard. Larger investments, obviously, benefit from economies of scale in trading commissions.
Vanguard does not, however, offer a mutual fund that replicates the 3,000 stocks in the Nasdaq Composite index. This index is one of the investments that gave us outstanding returns in our model portfolio, but until 2003 there was no way to buy that index. The only way to capture all of the Nasdaq stocks in one trade is to buy the Fidelity Nasdaq index fund called the ONEQ. Its management fee of about one-half of 1 percent causes it to underperform its benchmark a little, but we finally have a way to invest in the Nasdaq Composite index.
Other equity ETFs track a myriad of sector indexes that help us with our sector rotation investing and our selection of individual stocks.
Index ETFs are true index funds as opposed to the sector mutual funds. Those sector funds may hold only 80 percent of their assets in their sector, but ETF’s have as much money as possible invested as a mirror image of their index. Because exchange-traded funds are truly passive, many of them have lower fees and better tracking results than traditional sector mutual funds.
The new exchange-traded funds offer hundreds of ways to track indexes in all of our asset classes. They also include the four styles: large and small capitalization and value or growth stocks. Then, of course, there are ETFs offering indexes of blended styles.

FIXED-INCOME ETFS
Fixed-income ETFs fall into two categories: international and domestic. Barclays Bank is the trustee for a family of foreign fixed-income ETFs that allows investors to choose among several points along the yield curve. Like a traditional bond mutual fund, an ETF will never mature; so investors are just choosing whether they want short-, intermediate-, or long-term investments. In effect, they are buying perpetual bonds of a particular duration. Goldman Sachs acts as trustee for an ETF that mirrors its corporate bond index, and Lehman Brothers is the trustee for several U.S. government security funds. These funds may be one of an investor’s better opportunities to get institutional prices for bonds.

REAL ESTATE ETFS
The fund selector on Yahoo.com identified four real estate investment trust ETFs. Each one tracks an index for different parts of the domestic REIT market. The oldest one is the iShares Dow Jones U.S. Real Estate ETF that came out in 2000 when the yield curve inverted. The fund went from $55 per share at inception to $123 per share four and a half years later and earned an average annual return of 20 percent. As you know, the stock market lost 20 percent during those four years. Whoever made that new product decision at Dow Jones probably uses the same yield curve analysis that you and I do.

GOLD BULLION ETFS
Gold ETFs are one of the few ways that people can invest in gold bullion near a price that is usually available only on an exchange. These ETFs buy gold bullion and store it in a vault. This is very different from gold mutual funds that own shares in mining companies but do not own the gold itself.
The two investments behave quite differently during a crisis. Mining companies trade like any other stock when investors panic and sell equities indiscriminately. At a time like this, gold stocks decline along with all the others. The physical commodity of gold, however, often provides a safe haven during uncertain times and makes money when stocks crash.
The first gold bullion ETF appeared in November 2004 and attracted a phenomenal $1.3 billion in assets during the first two months. This gold ETF, StreetTracks Gold Shares, uses the symbol GLD. Unlike most ETFs, it trades on the New York rather than the American Stock Exchange.
Yahoo.com shows two performance numbers for each ETF: that of the ETF itself and that of the index it replicates. Investors can see how well their fund is doing its job of tracking its benchmark, and StreetTracks Gold Shares appears to lag the performance of gold by about one-half of 1 percent. This discrepancy is probably due to the cost of storing the gold. Owning an ETF may be the cheapest way to buy and store gold because economies of scale allow the trust to buy gold near the price on a major exchange, such as the COMEX in New York, and spread the storage costs among so many investors.
Now that we have investment vehicles that represent gold on the COMEX and the Nasdaq Composite index, we can use them in our model portfolio instead of cash and the S&P 500 index. For the sake of simplicity, however, we will use our usual trade dates rather than buying gold when the 10-year, three-month yield spread exceeds 10 percent. We will start after 1973 when the price of gold was allowed to fluctuate (see Table 1).
All of our returns look better with our new starting date; even the S&P 500 index improves a couple of percentage points compared to previous graphs. The more aggressive equity investment, the Nasdaq index, provides one-third more return even without active management; including dividends on the larger index would have closed this gap a little. As Figure 1 shows, trading two aggressive instruments, Nasdaq and gold, more than doubled the return of the unmanaged S&P 500 index.
The dollar amounts of the three portfolios are vastly different because of the impact of annual compounding at different rates (see Figure 2).
The returns might have been even stronger if we had used foreign currencies.

FOREIGN CURRENCY ETFS
Foreign currency ETFs are similar to international equity index funds except that they may own stocks in a global index. There are many global indexes, and the term includes the United States. If your objective is to own nothing but foreign currencies, make sure that your ETF does not include U.S. investments. The web site ETFConnect is one of the few that allow you to search their databases by investment objective, and a search for global investments found 37 funds matching that description.
The difficulty with mutual funds and ETFs is that convenient products like these usually become available a little late in the investment cycle. Cutting-edge investors often have to do their own homework and invest directly in stocks in order to get in at the beginning of each new cycle.
Investing directly in stocks provides the opportunity for greater returns than investing in an index fund. Of course, the risks are greater as well, but our market timing model should allow you to focus on the right sector. Once you become familiar with the business and the companies in a sector, you are in a good position to buy a strong security. Sector investing provides the background you need as well as a list of companies from which to select your investment.

SUMMARY
There is a wide variety of new funds that provide inexpensive diversification with a minimum of homework. Exchange-traded funds add to our flexibility for trading throughout the day, and some of them take advantage of extended trading hours. Many of them have lower fees than sector mutual funds that may impose a sales charge or marketing expense. Unlike mutual funds, however, ETFs incur a brokerage fee as if they were a stock.
These funds are important to us because they complete the tools we need to implement our model portfolio. Up to now we have been able to invest in all asset classes except for gold bullion and most equities except for the Nasdaq Composite. Two of these new funds fill those gaps. One fund, StreetTracks Gold Shares with the symbol GLD, gives us a chance to own gold bullion near the price it trades on the COMEX division of the New York Mercantile Exchange. Another ETF, the ONEQ, allows us to own all 3,000 stocks in the Nasdaq.
The rest of the exchange-traded funds offer hundreds of ways to invest in industry sectors and styles with low portfolio management fees. They open a window on a segment of the business world and supply us with a list of companies to study in depth. Once we have mastered an industry, we are ready to choose one of the stocks on this list to buy.

J. Weir