The Trouble With ETFs

To suit the sector-allocation crowd, Wall Street has developed a number of sector-based exchange traded funds, known broadly as ETFs, which give you exposure to an entire sector or industry simply by buying a single share. Marketed as iShares, Sector SPDRs or StreetTracks, the products are essentially open-ended mutual funds that trade throughout the day, just like stocks. These sector-based ETFs have all sorts of interesting advantages over both individual stocks and mutual funds. But they also aren't quite what they appear to be, and that can pose problems for investors who buy them thinking they're getting something they aren't.

First introduced in the early 1990s with the successful listing of the Standard & Poor's Depositary Receipts (or SPDRs, pronounced "spiders") on the American Stock Exchange, ETFs have become some of the hottest investing products on the Street. The American Stock Exchange, where most ETFs trade, has become virtually dedicated to supporting and developing these rapidly growing tools. There are well over 120 ETFs now trading, with more being introduced almost on a daily basis.

ETFs — both those based on broad indexes like the S&P 500 or the Nasdaq 100, and those based on specific sectors — took off because of several benefits. Unlike mutual funds, the shares can be bought or sold any time during the trading day — just like a share of stock. And capital gains (or losses) occur only when an investor sells his shares, not when a fund manager distributes capital gains.

Added to this mix of flexibility and control was the perceived advantage of index investing, which more and more investors have come to believe is the most prudent way in which to own stock. Not only are the fees low, but the inherent diversification an index affords means that you don't have to pick the right stock — just the right sector.

The problem is that many sector ETFs aren't really based on indexes. They purport to be diversified sector bets, but most are actually rather narrowly constructed large-cap proxies that are primarily based on a handful of specific names.

As is true with most index products, instead of owning a truly diversified portfolio, the index's administrators use a technique known as portfolio sampling. Just as A.C. Nielsen doesn't survey everyone actually watching television to come up with an accurate estimate of who is tuned to "West Wing", the indexing firms develop what they believe to be a representative sampling of a particular sector or group. The idea is that while it doesn't include all the companies within one industry, it should ideally reflect their price movements nevertheless.

In addition, because it's much easier for a big institutions to accumulate shares of the largest companies, many sector ETFs are overwhelmingly dominated by giant-capitalization stocks, which is precisely the ilk that's currently out of favor on Wall Street.

By contrast, small-capitalization stocks not only ended 2001 with a gain, but also still trade at comparatively reasonable valuations to their large-cap counterparts. These days, all things being equal, if I had to buy a stock I'd buy a smaller cap. You won't find them using most sector ETFs.

Forget "buy what you know" and try "know what you buy." Most people are clueless as to just how skewed many of the ETFs are toward large-cap stocks. Consider iShares Dow Jones U.S. Technology (IYW), which judging from its name would appear to provide broad exposure to a number of companies poised to benefit from a rise in technology stocks. And while the broad description of "technology" incorporates everything from Red Hat (RHAT) to Rambus (RMBS), you aren't going to see the performance of those comparatively small names reflected in the price action of this ETF. Fully 16% of its assets are pledged to Microsoft (MSFT) and a hefty 11% are invested in shares of IBM (IBM).

And although Clarus (CLRS), Copper Mountain Networks (CMTN) and CacheFlow (CFLO) are all very promising companies, they could each double without having a meaningful impact on the overall index.

Indeed, for most of the sector ETFs, it isn't uncommon for 65% of the fund's assets to be pledged to just 10 names — most to the top five or so. So you aren't really betting on a sector, but betting that the large-cap names in that sector (and a relatively small and unimaginative selection at that) will be the best companies to own.

Even more troubling is the fact that in many cases, what you see might not be what you ultimately get. While a recent regulation from the Securities and Exchange Commission mandates that mutual funds adhere to "truth in labeling" practices, the truth is that general sector names such as "technology" or "consumer cyclicals" are an exceedingly broad way to classify individual investment opportunities.

For example, General Electric (GE) makes up more than 28% of iShares Dow Jones U.S. Industrial (IYJ), even though the stock generally tends to trade like a financial. Priceline (PCLN) is included as a noncyclical within iShares Dow Jones U.S. Non-Consumer Cyclical (IYK), but when it comes to its actual price performance, it's probably best represented by the iShares Internet Index fund (IYV), of which it also makes up a negligible percentage.

Probably the worst offender in this regard is iShares Dow Jones U.S. Energy (IYE), which is essentially a call-OPEC's-bluff bet on Big Oil companies. Exxon Mobil (XOM), ChevronTexaco (CVX) and Schlumberger (SLB) make up almost 60% of the fund's holdings, with Exxon Mobil specifically weighing in at over 40%. Natural-gas companies such as El Paso (EP) and Williams (WMB) are also included in the portfolio, but not with an allocation that can have a serious impact on the overall index. Combined, they represent less than 6% of the fund.

This top-heavy portfolio design is emblematic of most of the sector ETFs — a fact that means their performance is generally tied to a couple of "make or break" names. iShares Dow Jones U.S. Telecommunications (IYZ), for example, has over 50% of its assets in Verizon (VZ) and SBC (SBC) while iShares Dow Jones U.S. Chemicals (IYD) has well over 50% tied up in DuPont (DD) and Dow (DOW). From a portfolio perspective, you essentially take on a potentially ruinous amount of the stock's risk while optioning off the unfettered upside thanks to a patchwork of negligible positions.

Because the sector ETFs are less diversified than meets the eye, they also present a large number of stock-specific risks not normally associated with index investing. One is company risk, or inherent possibility that a company's particular fortunes might be more tied to its management than its sector classification.

For example, within the retail sector, thanks to aggressive cost-cutting and an artfully directed turnaround, Sears' (S) return far outpaced Wal-Mart's (WMT) last year, but because Wal-Mart makes up 10% of iShares Dow Jones U.S. Consumer Cyclical (IYC) to Sears' roughly 1%, that performance differential didn't have a big effect. The biggest instance of company or "management" risk can be found within the two leading real-estate ETFs, both of which hold over 15% of their assets in Equity Office Properties (EOP) and Equity Residential Properties (EQR). Sam Zell serves as chairman of both companies, making a bet on either of these "diversified" index plays really just a bet on Sam Zell.

Finally, because most ETF sector funds track U.S. stocks, investors face the risk that the real performance within a particular sector might come from overseas. For example, DaimlerChrysler (DCX) looks more promising to me than Ford (F) or General Motors (GM), and while Fox News Channel (a unit of Australia's News Corp. (NWS)) is beating the pants off AOL Time Warner's (AOL) CNN, you aren't going to find either company within the iShares sector portfolios. Foreign stocks are by and large excluded from sector ETFs altogether.

It isn't so much that you shouldn't use ETFs in your portfolio, but rather that you understand how you use them. In an environment of sector rotation, where the major indexes tread water, focusing on one or two particular sectors is smarter than just holding the good ol' S&P 500. There are a number of ways to appropriately tailor sector exposure using ETFs...and ways to do it without them as well.

The most effective way to mitigate some of the exposure to the handful of large-cap stocks that dominate most ETFs would be to construct a spread, which we've previously discussed within the context of both closed-end funds and Japanese stocks. Generally speaking a spread consists of a long position paired with a short position in a correlated sector.

For ETFs, one idea might be to buy a particular ETF while shorting a smaller position of the fund's largest holding. So if you wanted exposure to U.S. financial stocks through iShares Dow Jones U.S. Financial Services (IYF), but were worried about the weighty 16% allocation to Citigroup (C), you could buy IYF while simultaneously shorting Citigroup, expecting that the gains from your long position in the broad index would outpace the short sale in Citigroup. You'd be essentially negating Citigroup's influence on your total return.

In addition to spreading you might try supplementing — buying the ETF as a core holding while also adding positions in smaller names not represented in the major index. So if you bought shares of iShares Dow Jones U.S. Real Estate (IYR), you might also take positions in a number of smaller real-estate plays. Using the Smartmoney.com Select Stock Screener, you can easily isolate companies within both a particular sector and market cap. A screen for diversified real-estate companies under $400 million in market cap yields over 30 candidates, several of which, including Entertainment Properties Trust (EPR) and One Liberty Properties (OLP), make particularly compelling buys at current levels.

To benefit from a sector trend that includes global stocks, you might consider adding a position in a foreign company's American depositary receipts to a core holding of a U.S.-based ETF. Both JPMorgan and Bank of New York offer excellent sites highlighting foreign companies traded on U.S. exchanges, and the Smartmoney.com Stock Screener will also allow you to screen specifically for non-U.S. shares.

Although active management gets a bad rap next to the cold efficiency of indexing, there are many scenarios in which professional stock pickers can add significant value. While I abhor paying loads when it comes to buying mutual funds, Fidelity Investments offers a number of sector funds that are professionally managed and not driven solely by an index. Several firms also offer sector-specific funds that not only rely on the performance of one industry, but the stock-picking acumen of a knowledgeable professional.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund. At the time of writing, his fund was long shares of Entertainment Properties Trust, One Liberty Properties and Equity Residential Properties, and short shares of General Electric.

Have a question about trading, portfolio strategies or other issues in investing? Drop Jonathan an email and he'll consider it for discussion in a future column.