ETF's are pools or baskets of securities that track a specific index or sector; similar to an index tracking mutual fund, but usually at a far lower cost. The first Exchange Traded Fund (ETF) was introduced in the US in 1993, and ETF's have been growing ever since. The S&P 500 index tracking ETF (SPDR or SPY) was the first ETF offered, followed later by the NASDAQ 100 Index Tracking Fund (QQQQ) and the Dow Jones Industrial Average Index Tracking Fund (DIA). These early ETF's were known as the Spiders, Cubes, and Diamonds respectively. Since the inception of these early ETF's, the growth and popularity of the ETF industry has exploded. As of this writing (May 2008) there are approximately 700 US registered ETF's available with nearly $600 billion in assets under management. ETF's are traded on major US and Worldwide exchanges.
As ETF's have matured over the years, they have been tailored to track increasingly smaller portions of an index. For instance, the S&P 500 index is made up of 500 different companies or component stocks that should, in theory, represent the broad stock market. Many of the more specialized ETF's now offered represent a portion of this index or a sector. The S&P 500 index is comprised of sectors of stocks, such as the Energy sector or the Retail sector. Examples of the Energy sector include companies Exxon Mobil, Sunoco, Chevron and Halliburton. When you buy an ETF for a particular sector, you are getting many different companies that are representative of that sector but at less risk than getting a single stock to represent that sector. Generally it is unlikely that the entire basket or pool of stocks in an ETF would all experience a large loss in a single day, though it is very possible for a single stock to take a large loss. This more limited risk is probably the biggest advantage of ETF's.
Currently, the offering of ETF's consists of what are called "passive" ETF's. The basket of stocks that make up the "passive" ETF index are bought and held but not actively traded within the fund. Several hundred more ETF's are in the registration process. Some of the ETF's in the registration phase are for a new type of ETF that will be "actively traded"; something new to the ETF industry. Currently GreyLock does not utilize these "actively traded" ETF's in portfolio construction. We will wait for them to establish a track record to see exactly how they perform. If they prove themselves to perform well in a given portfolio, we look forward to incorporating them into client's portfolios.
Mutual funds are considered to be a good investment, but generally carry many expenses. Some expenses are obvious and some are quite cryptic and difficult to understand. The additional expenses cost the investor a portion of their portfolio. Anything that can be done to protect and retain as much of the client portfolio is a plus. Also, mutual funds have the disadvantage of only being able to be traded at the end of the trading day. If the stock market as a whole starts to decline early in the day, the investor must wait until the market closes to trade a mutual fund. Because ETF's are traded on the major markets and Worldwide exchanges, they can be traded at any moment of the trading day, long or short. This is a huge advantage. Many of the same orders to trade stocks can be used to trade ETF's. These include—but are not limited to—stop orders, limit orders, order-cancels-another. There are no hidden fees either. You pay a commission to the broker just as you would if you were trading a single stock. The management and administrative fees to maintain the fund are also generally far less than mutual fund management fees. For a client with a high tolerance for risk and an aggressive portfolio, ETF's also offer the advantage to move quickly and easily in and out of the market or even switch sides of the market in an instant from a long position to short position and vise versa. Many ETF's have options available similar to individual stocks. This is something that mutual funds simply do not offer. The ability to deploy different option strategies in a portfolio can greatly increase returns, limit risk, or both.
ETF's make it easier to build the diversified portfolios once the criteria and expectations of the client are known. For a client wanting fixed income, a bond ETF can be chosen to meet the fixed income requirements of the portfolio. There are several bond ETF's to choose from, and you can get a good, balanced mixture of high quality bonds in a single ETF without the additional research and constant monitoring of a single bond offering. The same goes for stocks. If you want quality, dividend-paying stocks, there is an ETF available for that. Because of this diversity, the portfolios are interesting to watch as they move and grow to their full potential. Using individual stocks and bonds to construct portfolios can be difficult, time-consuming and expensive. Each individual stock or bond would need to be thoroughly researched before choosing then adding it to a portfolio, and constant attention must be paid to these individual investments. Reallocation also may need to occur more often with individual securities than with ETF's.
In a simple core-satellite style portfolio an S&P 500 index ETF may be chosen as the core position (fund). Satellite positions would then consist of sector ETF's that make up a portion of the S&P 500 or lie outside the S&P 500. For instance, if the Telecom, Health, and Technology sectors of the S&P 500 were doing well, a long position might be established in these specific sectors.
In a more aggressive portfolio, we might look for the sectors of the S&P 500 that were not expected to do well—perhaps Transportation, Retail, and Real Estate—and establish short positions in these sectors. This simple strategy alone could substantially increase the growth rate of the portfolio. Adding still further to the mix of this portfolio, we could include a currency ETF and perhaps a commodities ETF. This combination would be difficult to do without the aid of ETF's. These markets are very different than the more common stocks and bonds markets. The costs of entering these markets individually would require a high degree of expertise and dedication, and may even require separate accounts. At GreyLock you only need one account to achieve all this diversity! No need to track separate accounts and statements.
An option strategy—selling option calls and puts against the long and short positions to collect the premiums on the options—could be added to this portfolio for an even more aggressive approach. Again, this can further increase the returns of the portfolio. Please bear in mind that transaction costs will effect returns in an active portfolio such as this example (risk), but probably not to the extent that it would hamper returns to a larger degree (reward).
As with almost all portfolios, reallocation is necessary from time to time. The frequency of reallocation is determined by many factors. Maintaining a specific allocation percentage within an individual portfolio, not achieving a specific goal or target, and market and economic conditions can all be reasons to reallocate a portfolio. Entering or exiting a specific portion of a market or an entire market—such as the S&P 500—are easier and more cost effective with ETF's.
Along with equity-based ETF's (stocks) many hedging strategies are available in ETF and/or ETN (Exchange Traded Notes) form. Recently a few new ETN's have come to market that track hedging strategies such as the Powershares S&P 500 Buy/Write portfolio. This ETN tracks the Chicago Board Options Exchange (CBOE) S&P 500 Buy/Write index measuring the total rate of return of the S&P 500 covered call strategy. These are somewhat complicated strategies that an investor could run themselves, or pay the management overhead of a hedge fund (if the investor could even qualify to enter the hedge fund). With the use of the ETN fund, investors can enjoy the benefits of this somewhat complex and expensive strategy for a fraction of the cost. The investor also gets the convenience and liquidity of trading a single stock!
Hopefully, this overview has enabled you to see the advantages and possibilities of building a investment portfolio with ETF's. If you have questions regarding the content of this or any other portion of the website, please feel free to contact us at: