Wednesday, February 2, 2011

Instant Diversification: Buy an ETF!

One of the most difficult things about trading stocks is the ability to properly diversify your portfolio.  An improperly diversified portfolio will expose an investor to risks that can be very damaging to their performance.  For example, a friend of a friend of mine recently cashed out his 401k and invested 100 percent, including emergency savings, of their cash into one biotechnology company.  Now, this person might do very well if that biotech company gets a new drug approved or has some kind of inordinate success.  However, it is more likely that the company will have average returns and there is a high likelihood that they will lose money.  If the company becomes a disaster, this investor stands to lose ALL of his money.  This could be very bad considering the fact that the man has just recently retired and is now in his seventies.

With this case-in-point in mind I would like to suggest that this investor would have been much wiser to have invested in a biotechnology fund or Exchange Traded Fund (ETF).  ETFs are instruments that trade much like individual stocks, the difference is that they are baskets of stocks that are being managed by a professional fund manager.  ETFs are generally designed to correlate, or track, with a specific market sector.  For example the XBI is an ETF that is designed to "before expensed, seeks to closely match the returns and characteristics of the S&P Biotechnology Industry Index."  This kind of instrument would provide our friend with a great deal of stability that he doesn't have with his single investment.  The XBI has investments in 31 different companies.  In this case, if one company does very poorly, the performance of the entire group will likely not be affected as much.

The beauty of investing in an ETF like this is that the diversification is taken care of.  As small investors it would be very challenging to manage investments in 31 different biotech stocks.  Each of them have individual issues and risks that need to be evaluated.  Why not let the ETF manager do that for you?  All we have to do is buy a few shares of the ETF and we have instant diversification within that market sector.  Pretty cool right?

Now the XBI is just one ETF in one market sector.  There are probably thousands of ETFs on the market now that cover nearly every sector and niche that exists.  The trick is to pick a few solid ETFs from each sector that you want exposure to.  This will reduce the number of transactions that you make substantially.

My favorite sectors for ETF products are:  Small Cap Equities, Large Cap Equities, Financials, Precious Metals, Emerging Markets, Developed Markets, Technology, Real-Estate and Energy.  There are several very good ETFs within each of these sectors that I trade on a regular basis.

Here are a few rules to keep in mind with regard to picking an ETF:

1. Expense Ratio.

The expense ratio tells you how much you are going to have to pay in fees each year.  I have seen expense ratios as high as 2.00 percent.  With a little searching you can find funds with expense ratios as low at 0.2 percent.  Check Vanguard's site to see what a good expense ratio looks like.

2.  ETF Size.

Make sure that the fund you are buying has sufficient assets under management.  Look for a net asset value of greater than $100 million.  A fund with very small asset size is a good indication that they are not well trusted yet.  Asset size tells you a lot in this business.

3.  Reputable Company.

Asset managers are a dime-a-dozen.  Make sure that you are dealing with a company that has experience and a valid track-record.  Here are a few to start with:
4.  Volume

A good ETF will have millions of shares traded in the market on a daily basis.  If you find one that meets all of the first three criteria, they will have good volume too.  An ETF with low trading volume could present some liquidity problems in adverse market conditions.    

As with any financial instrument, it is imperative to understand exactly what you are spending your money on.  Understand the risks and the potential rewards.  I am confident that ETFs can provide a lot of help for small investors that want to diversify their portfolios without all of the expense associated with traditional diversification strategies.  Do your homework!  Happy Trading!