Profits without pain

An exchange-traded fund (ETF) gives market returns without the dangerous impact of falls in individual stock prices. More importantly, ETFs can be actively traded to deliver returns that outperform the underlying market.

 

When everybody wants “alpha” perform­ance – performance that is better than the underlying market performance – then why settle for “beta” performance, just matching the gain or loss in the market?

 

There are three parts to this answer.

 

● Matching market performance is a better result than that of around 90% of fund and investment mangers. In a bull market around 90% of managers deliver lower returns than that of the market. In a bear market, 95% of fund mangers lose more than the market fall. When their management fees are added, the performance results are even worse.

 

● The myth that the market always rises is only true when trading an ETF. The compo­sition of most indexes changes regularly. The components of the XJO index (companies included in the S&P/ASX 200) are adjusted every quarter. Underperforming stocks are dropped, outperforming stocks are added. The index is only ever made up of winners and, in this sense, the market (index) always rises.

 

● You could track this index performance if you buy every stock within the index. How­ever, you need to buy and sell regularly to keep your portfolio components exactly the same as the index. Apart from cost, time and effort, there is a significant taxation and bro­kerage impact.

 

The ETF does all this work, and presents a single instrument with a single buy or sell price set by the market.

 

Personally I use ETFs in my superannua­tion retirement fund because they reduce individual risk and replace it with a lower systemic risk. In all market conditions they tap directly into the dividend stream. The extension of the strategy is to trade foreign market performance and use this to diversify risk globally from a single security group.

 

An ETF “shadows” or replicates, the per­formance of a particular market, index or sector. They’re baskets of stocks that enable you to buy or sell a portfolio of securities in a single purchase. Unlike funds, you can trade ETFs just as you would an individual stock. You can buy and sell them at intraday prices. This is a liquid market.

 

The ETF offers investors a diversified way to play economic sectors, global financial trends, market events and other so-called “special situations”. For individual investors, ETFs are among the most innovative and most powerful investment instruments to hit the financial markets in recent years.

 

There are four key benefits with ETFs:

 

If you want to succeed as an investor or trader it’s important to understand that it’s not the stock you buy, but the sector you play that is important. While the resources sector has enjoyed a bull run, many individual resource stocks have either underperformed the sector, or moved opposite to the sector rise.

 

More than 50% of any gain an investor realises in an individual stock is due to the sector it’s in, not the stock itself.

 

ETFs are so well focused they allow you to play the sector, theme, or global trend that will generate most of your gain. Since they are a type of “fund,” the ETF offers risk diversifica­tion that individual stocks could never offer. If you identify a great global trend to play for a profit but pick the wrong stock, you could actually incur major losses, despite having chosen a winning trend.

 

Individual stocks may be subject to an earn­ings disappointment, a liability lawsuit or a financial crisis. The sector is immune from these individual problems.
 

I follow many markets as a result of my work with CNBC Asia. Often I come across oppor­tunities in individual stocks. Starting October 2008, the China market roared back into life, adding 100%. Our analysis suggested China was a good long-term investment opportunity.

 

We found many great-looking charts that also had good fundamental backgrounds. These were great investments but the China market is closed to foreign traders. Individual traders cannot trade this market.

We did find another investment that held a big stake in many Chinese companies with the same kind of potential. It was the ETF called iShares China. Using our analysis of a double bottom rebound trend continuation in March, we entered in anticipation of the China market recovery continuing.

 

Buying the ETF provided a way to capture profits that were essentially unavailable to us by any other means. As a bonus, it also provides exposure to the performance of the entire market.

 

We buy into the market in a single order, and exit the market with a single order.

 

Liquidity is always available which is why ETFS are increasingly used by major funds. Citigroup and Susquehanna are the market makers in the ASX iShares. Market makers are required to make two-sided markets in the iShares within the maximum spread and the minimum quantity specified by ASX.
 

ETFs, because of their built-in diversification, are automatically safer than individual shares. With individual stocks it’s possible to buy into the right trend and not make any money, because you bought the wrong stock. One stock in a hot sector can crash and burn because of problems unique to the company.

 

That will never happen with an ETF. Because they are actually a diversified fund, if you pick the hot sector or hot market, you pick up the profits that go with it. You never get burnt just because one stock failed.

 

The structure of the ETF means that as stocks are dropped from the index they are also dropped from the ETF and as stocks are added to the index, they are added to the ETF. The ETF always trades with the market-lead­ing stocks that make up the index.
 

The ETF also pays the accumulated dividends paid by each of the stocks in the index. This generates a steady income stream in addition to any capital gain. ETF analysis leads to 16 analysis and selection strategies.

 

These strategy combinations turn an ETF into a trading opportunity that outperforms the market. It gives profits without the pain of individual stock risk and selection.
 

 

Daryl Guppy is founder and director of Guppytraders.com Pty Ltd, an international financial market education and training organisation with offices in Darwin, Singapore and Beijing. He is a presenter at the Trading & Investing Seminars & Expo.

 

Source: Money Magazine, September 2009