A New Concept in the Evolution of Investing 

Can you remember those exciting days when some of the first broad market ETFs appeared?  You know, the giants of the new era investment world – the Spiders (Ticker: SPY), Diamonds (Ticker: DIA), PowerShares Nasdaq-100 Trust (Ticker: QQQQ), and Vanguard Total Stock Market ETF (Ticker: VTI). What a refreshing beginning and we wondered if it could ever get better!

Then the flood of new issues appeared, more concentrated in on than their parents, more specialized in their functions, and more intellectually appealing to the entrepreneur and speculator. These ETFs began to fill the demands of the restless market player seeking a quick and honorable fortune. Sectors were parsed, indexes created, inverse funds leveraged, and the economy particularized.

These new ETFs were and are exciting, but they clearly elevate risk. Volatility ramped up, uncertainty colored our riches, and many new ETFs tended to favor new highs and new lows. With many of these creations we traded short-term opportunities for diversity and stability. How did this happen?

Diya Gullapalli, writing for the Wall Street Journal (July 3, 2007), is close to the answer. He shows that where there are mutual fund counterparts to top and bottom performing ETFs, the ETFs tend to be more directed in their aim – more “concentrated.” The ETF iShares FTSE/Xinhua China 25 (Ticker: FXI), for instance, rests on only 25 underlying securities, whereas the comparable mutual fund Eaton Vance Greater China Growth is based on 65. Thus, the ETF is more concentrated. It is also more volatile. The 12 month return for the ETF is 55% compared to 47% for the mutual fund. The ETF is a better candidate for higher (and lower) returns. Said another way, we can achieve higher returns with the concentrated ETF, but we have more control over risk with the mutual fund.

In a more general sense, the trend in the world of ETFs is away from diversification and toward higher returns, greater volatility, and elevated risks. The gap between Bid and Ask prices is greater and some of the valued transparency with regard to net asset value (NAV) is lost. Long-term perspectives bend toward short-term reactions to the daily market bounce and the investor’s choices are compressed in time. The excitement builds, but so do the dangers.

The Pendulum Swings

Many investors believe that long-term perspectives are critical for investor success. In many ways we are shaped by the market, but we are also shaped by the tools at our command. As our surroundings go, so our attitudes grow. The very presence of specialized ETFs is demanding that we shorten our view of the market. Unfortunately, the macro forces that ultimately drive the market tend to be lost in the immediate scramble for profits. This perspective bothers a lot of people.

Fortunately, we may be returning to a better balance in our structuring and use of ETFs. There appears to be a growing appreciation for funds that span more than a single sector and that decrease their concentration. This appears to be a healthy alternative to the current trends.

For example, Richard Widows of TheStreet.com identifies 10 diversified ETFs that give full exposure to all major industrial sectors, including energy, technology, communication services, finance, health care, utilities, consumer habits, and other areas. They are not necessarily new funds, but they do provide welcome diversity, broad economic representation, and long-term returns. Here are the 10.

iShares Russell 2000 (Ticker: IWM)

iShares S&P Small Cap 600 (Ticker: IJR)

Vanguard Small Cap ETF (Ticker: VB)

Vanguard Small Cap Value ETF (Ticker: VBR)

iShares Morningstar Mid Core (Ticker: JKG)

iShares Russell Mid Cap Growth (Ticker: IWP)

Vanguard Extended Market ETF (Ticker: VXF)

SPDR 500 (Ticker: SPY)

iShares S&P Global 100 (Ticker: I00)

streetTracks Dow Jones Stoxx 50 (Ticker: FEU)

Other alternatives, even more intriguing, are becoming available. Claymore/Zacks Sector Rotation ETF (Ticker: XRO) is based on the 100 best sector candidates from the 1,000 largest U.S. equities and the American Depository Receipts listed on U.S. exchanges.