Thursday, September 02, 2010

Read This Before You Trade Your Next ETF

Guest Article

Whether it’s soaring or slumping — and it often does both during the course of a week — the financial sector never falls far from investors’ radar.

That’s not news, of course. But what you might not know is that there are many ways to trade this sector, none of which involves buying or selling a single stock but, rather, making a single play on the industry as a whole.

How can you make one trade that gives you exposure (whether long or short) to banks, brokerages, insurance companies and other types of asset-management outfits? By adding Exchange-Traded Funds (ETFs) and ETF options to your investment arsenal, you only pay one commission (because you’re only buying/selling one position) to be exposed to the upside (or downside) of its various component stocks.

Know Your ETF Holdings

ETFs (and their options) have exploded in popularity in recent years. They offer securities that trade like stocks but are micro-focused in almost every sector in the markets (including international, commodity, short, ultra-short, etc.).

But there can be a great difference in the holdings, diversification and trade strategy of ETFs, even within one particular sector.

Let’s take a closer look at some of the various financial-sector ETFs “out there” so that you can see some of the many choices you have when you’re ready to add sector plays to your portfolio.

Among the group of financial ETFs are:

* iShares S&P Global Financials (IXG)
* iShares Dow Jones U.S. Financial (IYF)
* iShares Dow Jones U.S. Financial Services (IYG)
* Financial Select Sector SPDR (XLF)
* Vanguard Financials (VFH)
* Rydex S&P Equal Weight Financials (RYF)
* PowerShares FTSE Rafi Financials (PRFF)
* First Trust Financials AlphaDEX (FXO)
* PowerShares Dynamic Financials (PFI)

This list does not even include international, bank, insurance, preferred and other types of financial-related ETFs like the short and ultra-short ones that aim to give you even-greater leverage on smaller moves.

With so many choices, which one represents the smartest way to play the sector at any given time?

Weigh(t)ing Your Options

Not all ETFs are created equal, and that’s a good thing. The more choices we have, the more control we have over the performance of our portfolio.

Remember, the biggest benefit of trading ETFs and/or their options is that, instead of spreading your capital among several individual trades, you can bet on (or against) an industry with just one investment. That said, your responsibility is to learn exactly which underlying stocks make up each individual ETF.

And, to take it one step further, you should know just how the stocks are “weighted” within each ETF. That is, if 10 stocks are included one ETF, you probably won’t see each of them “weighing” an equal 10% of the overall ETF but, rather, some stocks will represent a bigger percentage than others.

Let’s examine the diversification and top holdings of the above-mentioned ETFs. (All data from Yahoo! Finance.)

IXG — Top 10 Holdings are 24.44% of assets.
Top 3 Holdings:
JPMorgan Chase (JPM) — 3.66%
HSBC Holdings (HBC) — 4.05%
Wells Fargo (WFC) — 3.36%

IYF — Top 10 Holdings are 37.91% of assets.
Top 3 Holdings:
JPM — 7.9%
BAC — 7.76%
WFC — 6.92%

IYG — Top 10 Holdings are 57.68% of assets.
Top 3 Holdings:
JPM — 12.38%
BAC — 12.15%
WFC — 10.67%

XLF — Top 10 Holdings are 51.15% of assets.
Top 3 Holdings:
JPM — 9.87%
BAC — 9.47
WFC — 8.76%

VFH — Top 10 Holdings are 36.86% of assets.
Top 3 Holdings:
JPM — 8.2%
WFC — 7.26%
BAC — 5.02%

RYF — Top 10 Holdings are 17.01% of assets.
Top 3 Holdings:
SLM Corp. (SLM) — 2.15%
Morgan Stanley (MS) — 1.92%
Federated Investors (FII) — 1.78%

PRFF — Top 10 Holdings are 48.19% of assets.
Top 3 Holdings:
JPM — 11.15%
WFC — 8.59%
Berkshire Hathaway (BRK/B) — 6.34%

FXO — Top 10 Holdings are 14.51% of assets.
Top 3 Holdings:
W.R. Berkley (WRB) — 1.85%
Allied World Assurance Holdings (AWH) — 1.6%
PartnerRe Ltd. (PRE) — 1.47%

PFI — Top 10 Holdings are 25.73% of assets.
Top 3 Holdings:
Ameriprise Financial (AMP) — 3.12%
MetLife (MET) — 2.85%
Unum Group (UNM) — 2.71%

Now, all ETFs have different rules regarding re-balancing of holdings, discretion of holdings, focus, etc. — and some are more-liquid than others, both in stock and option volume.

Recent massive market capitalization changes in individual stocks have certainly made an impact of the relative weightings of holdings in this sector, as well.

But certainly, the active investor would be wise to know what they are buying when they invest or trade in one of these ETFs or the options on them. For example, the likes of IYG, XLF, and PRFF have around 50% of their holdings in their top 10 assets — meaning, they are not very diversified.

In addition, on IYG for example, around 25% of the holdings are in JPM and WFC alone (based on the data utilized above). So, the performance of that ETF will be greatly affected by just two securities.

In one way, you could say that is much more risky. But from another perspective, you could view this as getting more “bang for the buck.”

Then there are the very diversified ETFs, some of which attempt to equal-weight — such as RYF and FXO, where the top holdings comprise about 15% of assets and the top holdings are around 2% of assets. In the current market environment, we have seen many sectors move “en masse” quite a bit — more than what is normally the case. So, these ETFs may also move as a group.

Also remember that supply and demand is a big factor in ETF performance, because they trade as stocks, not on the actual value of their assets. But as the market settles down into more of a “stock-picking” environment — and if arbitrage-type discrepancies are seen in various ETFs vs. individual stocks, etc (as has been seen recently in preferred vs. common, closed-end funds, etc.) — then you may begin to see more price performance disparity in ETFs based on their holdings and diversification.

The bottom line is that, when you’re gearing up to invest in or trade an ETF or options on an ETF, you should examine the holdings, structure and goals of the ETF to see which one most matches the expectations (short or long term) you have for that sector.

Trade Well,
Andrew Hart

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