How to Stop Worrying and Love ETFs

Roger Nusbaum submits:

An in-depth investigation at one of the stock market television networks has uncovered that some ETFs have large weightings in individual stocks, which at times can be problematic for fund holders. It turns out that investors should look at what these ETFs actually own. Needless to say, this is blowing the lid right off the ETF industry.

Okay, enough sarcasm. In the wake of the Steve Jobs news from Apple (AAPL), CNBC had a segment with an ETF strategist from one of the wire services pointing out some examples of ETFs that take single-stock risk by virtue of weightings as large as 20% for individual names in the fund; he also offered substitutes with less single-stock risk. One example he gave was to buy the iShares DJ Financial ETF (IYF) instead of the Financial Sector SPDR (XLF), the latter being more concentrated.

It is shocking and disappointing that index composition is still not a front-burner issue for mainstream ETF coverage. I’ve been writing about ETFs since 2004. My first article for TheStreet.com in 2005 was about iShares Austria (EWO); back then the weightings favored Erste Bank at 16.5% of the fund. This was “great” on the way up, as from the March 2003 low through to the peak in October 2007 Erste Bank ADRs were up 389% versus 335% for EWO. From that peak to the March 2009 low, the ADRs dropped 83% versus 69% for EWO, so the exposure was “bad” on the way down.

This provides a great full-circle example for the need to initially assess and then continue to follow both the holdings and the news. On the way up, the heavy financial exposure was the catalyst, because the Austrian banks were lending to Central and Eastern Europe, which were booming. At some point along the way, the catalyst soured for all the reasons you (hopefully) know about and the theme fell apart.

(As a side note, the fund gave plenty of warning in the market as it traded sideways while making a series of lower highs for many months before cascading lower as the market went into panic mode. The technical damage, combined with deteriorating fundamentals, provided plenty of time to get out.)

So it is now with any ETF: You need to understand the top/down story of the niche and know what is going on under the hood. Anyone buying the iShares DJ US Telecom ETF (IYZ) needs to pay a little attention to AT&T (T) at 15% of the fund and Verizon (VZ) at 12% of the fund ... but I would not worry about USA Mobility (USMO) at 0.85% of the fund.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Complete Story »

Alecia Elliott Kat Von D Ana Paula Lemes Vanessa Simmons Chyler Leigh