ETFs: Helping Investors Deal With Uncertainty

The markets are filled with uncertainty over Iran, the next development in the EU debt crisis and future tax hikes. ETF investors are well positioned for these uncertainties as the ETF vehicle itself provides investors with the access, efficiency and transparency to address uncertain times.

ACCESS

ETF investors have access to many types of asset classes that traditional investors in mutual funds are shut out from. Physical commodities like gold and silver are great examples of assets that ETF investors can access and mutual fund owners cannot. Gold and silver are not considered “securities,” a requirement to be held by a typical mutual fund. Instead mutual fund investors can own funds focused on gold and silver mining and exploration stocks. While these indirect approaches are not poor investments they can offer big differences in performance. For example, in 2011 when physical gold gained over 9%, gold mining stocks were off as much as 30%. The access through an ETF made all the difference.

EFFICIENCY

The average ETF charges around 55bps while the average mutual fund is close to double that figure. ETFs, when compared with mutual funds in the same asset class, are more cost efficient. In addition, most ETFs are structured in a way that makes them more tax efficient than the average mutual fund. No one likes to pay more taxes and being in a tax efficient product structure helps investors keep more of their gains.

TRANSPARENCY

The majority of ETFs reveal their holdings every day. This transparency allows investors to know what they own and why they own it. This level of transparency is unique in the secretive investment world. Mutual funds, for example, are only required to reveal their holdings on a quarterly basis. Quick question/scary thought…how can an investor properly asset allocate or assess their risk levels when they only know what they own four times a year?

ETFs are not a perfect investment vehicle but they do offer some built in features that make investing in uncertain times a little more palatable. Perhaps that’s why 2011 saw ETFs take in more new assets than mutual funds, despite the mutual fund industry being about seven times larger.

 

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Fear Factor: Investment Edition

Just saw the new promo for the updated version of the show “Fear Factor.” (warning it does contain some gross content) Yes, the producers have found new ways to amp up the fear of contestants and viewers — from eating a new variety of unsightly forms of life to apparently being strapped to the front of a moving semi. This formula worked well in the past for Fear Factor because humans are emotional in nature. It is just how we are wired.

Watching the preview for the show, I couldn’t help but relate it to the market events we have experienced the last week, month or even few years. It seems a new fear factor challenge is just around the corner for investors to experience and react to. Unfortunately, unlike a television program where reactions range from disgust to turning the channel, the market’s fear factor challenges are causing many investors to react with devastating financial consequences. From seeking “safety” and missing rallies to embracing a “buying opportunity” only to see further declines, many investors are flailing due to fear.

The jump this Fear Factor contestant is making isn’t that far removed from the fearful reactions of many investors.

 Taking a step back, moments of great fear in the markets have always and eventually been great buying opportunities. Times like this require a plan, the discipline to stick with it and a long term perspective. Without it, investors are no better off than the average contestant on Fear Factor.

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A Market Ripe For ETFs

The markets are ripe for the ETF structure to be exploited. The efficiency, transparency and flexibility ETFs offer make them a premier packaged product choice. Mutual fund investors require more transparency of holdings, lower fees and more liquidity options than end of the day pricing and ETFs are delivering. For individual stock investors, ETFs offer the liquidity of stocks AND the diversification of funds — the best of both worlds.For doomsday “investors” buying gold coins and melting down the family jewelry, there are attractive physically backed gold ETFs — solutions that just don’t exist in the mutual fund world — priced at .25 bps a year!

As the fiscal drama unfolds the future will only be brighter for ETFs. Higher taxes coming? ETFs are a tax advantaged structure, just read the prospectus. Lower return environment looming? ETFs are at the cutting edge of fee compression and fees matter more in a lower return environment. Searching for alternative strategies? ETFs are delivering access and ETPs (exchange traded portfolios) are expanding the set even further. Need to hedge? Geared ETFs are liquid and trade millions of shares a day in all types of asset classes.

Perhaps that’s why ETFs, with an asset base about 12% the size of mutual funds and minimal access to the defined contribution market, took in more than 30% of all inflows into funds in the first half of 2011.

ETFs are the future and the future is now.

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Oil ETF Crystal Ball: More Turmoil Ahead

According to Bloomberg, fears over oil supply disruptions have led to the price of oil likely rising higher this week than in any other week over the last two years. In fact, this week Nomura Holdings put out a research note pointing to a possible $220 a barrel scenario should supply disruption grow in Libya and move into Algeria. All this drama seemed to have peaked oil prices earlier this week but now oil is rebounding going into the weekend of February 26th.

As of Friday afternoon February 25th, Oil ETFs are predicting more turmoil and higher oil prices. A quick look at three key oil related ETFs — USO the United States Oil Fund, DBO the PowerShares DB Oil Fund and XOP the SPDR S&P Oil and Gas Exploration and Production ETF — show them all trending upward mid day. See chart below:

Market participants are likely hedging their oil exposure leading into the two day weekend as further developments occur in Libya as well as other Middle Eastern hotspots.

The three oil ETFs highlighted above have been a decent investment this year, although their performance year to date differs considerably. See the year to date chart below:

 

How could one oil ETF be up 10% this year while another is just breaking even? It’s all in the details people. XOP, the only product that invests in the companies that are involved in oil and gas exploration, has seen the biggest rise year to date in part because contango has not been an issue diminishing performance. DBO, a oil futures product that employs an optimised approach to selecting which oil futures contract to invest in, has successfully mitigated some of contango’s effects. Finally USO, which robotically purchases the next month’s oil futures contract, has likely suffered the most from contango. As you can see, the underlying approaches of all three ETFs yield substantial differences in performance and it pays to understand them before making an investment. For more information about contango, see the recent U.S. News and World Reports story Magoon Capital contributed to.

For now it appears oil’s behavior will continue to be closely tied to the latest headlines and video from the Middle East — not the global economic recovery — and that has Wall Street hedging its bets.

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Insider Sentiment: Extreme Selling!

One way to assess corporate valuations is to keep an eye on insider transactions, especially those that involve buying more shares. After all, there are a lot of reasons someone may sell their corporate stock but really only one reason behind buying it. To review, insider buying is generally a bullish sign that people who know most about the inner workings of the business feel the stock is undervalued. On the opposite side, insider selling — unless in the extreme range — is generally not a bearish sign due to the many reasons that could be driving it. Nevertheless, moderate insider sales activity should raise cause for closer examination.

All that being said, CNBC’s Fast Money broke a story  this week about extreme insider selling activity which could indicate a correction in store for the equity markets:

The latest report from Vickers Weekly Insider, a publication that makes investments based upon these transactions, shows that total insider sell transactions relative to purchases on the New York Stock Exchange are running at a ratio of more than four to one over the last eight weeks. The normal reading, because of options selling and other factors, is about 2 sales for every buy, according to Vickers.

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