By now, you’ve probably heard a lot about exchange-traded funds (ETFs). Since their inception in the early 1990s, the financial world has been aflutter with investors hungry for the efficiency and ease of buying ETFs. Want to know how you can cash in on the ETF craze? Here’s a look at exchange-traded funds…

If you’re wondering what an ETF is, you’re not alone. ETFs are portfolios that you can buy and sell ownership in. Basically, an ETF is a lot like a mutual fund that trades on an exchange like a regular stock. That’s an important distinction, because unlike open-ended funds, which buy back their own shares, ETF owners can sell their funds to anyone in the stock market who’s willing to buy. That and higher levels of transparency make for an investment that trades much closer to its actual value than a regular mutual fund.

Advantages of ETFs

There are a few reasons why ETFs look good… ETFs offer instant diversification, lower costs, and ease of purchase that you can’t find anywhere else.

As an investor, one of the smartest things you can do with your portfolio is diversify. That’s because a diversified portfolio can make more gains at a lower risk than a single investment. Since ETFs own a bunch of different securities (like stocks and bonds), when you buy an exchange-traded fund your portfolio is instantly diversified.

Besides diversification, one of the biggest reasons to get into an ETF is cost. For starters, ETFs can substantially reduce the transaction costs associated with diversification. Instead of paying commissions for each individual stock you buy to diversify your portfolio, when you buy an ETF, you only pay commissions for the ETF itself. ETFs also have considerably lower expense ratios than mutual funds.

Expense ratios are the management fees funds charge to their investors. With an ETF, expense ratios are generally between 0.1% and 1% — compare that to the 1% to 3% generally charged by mutual funds, and it’s clear that ETFs are the winner here.

One of the reasons ETFs have been so successful is their accessibility. ETFs trade on stock exchanges, which means that any investor has access to them without minimum investments restrictions. That means that they’re the easiest way to get into a managed fund investment.

Kinds of ETFs Available

Today, new types of ETFs are springing up, giving individual investors more investment options than ever before. Here are some of the main types of ETFs:

Stock Index ETFs: The most common type of ETF today. These funds are designed to track major stock indexes like the S&P 500 or the Dow Jones Industrial Average. In fact, the most popular ETF of all-time, Standard & Poor’s Depositary Receipts (SPY: AMEX), is an ETF that tracks the performance of the S&P 500.

Bond funds: Another type of investment represented by ETFs. Funds like the iShares Lehman Inter Govt/Credit Bond ETF (GVI: NYSE) aim to match Lehman Bros. bond indices (which continue to operate under Barclays ownership).

Commodities ETFs: A category of exchange-traded fund that has popped onto the scene recently. Commodities — like oil, gas, grains, and gold — were once a tougher market to get into for small investors. Now commodities plays like the U.S. Oil Fund (USO: AMEX), which significantly outperformed the S&P 500 in 2008, are showing the financial world that opportunities abound in the ETF world.

Managed ETFs: In 2008, the Securities and Exchange Commission decided to allow actively managed ETFs for the first time, meaning that ETFs weren’t relegated to tracking an index or commodity. The first group of actively managed ETFs was put out by PowerShares in July 2008.

Finding Small-Cap ETFs

As a penny stock investor, small-cap ETFs are a very interesting idea. There are a number of index ETFs that invest in small-cap plays, including the iShares Russell 2000 Index ETF (IWM: NYSE), the Vanguard Small-Cap ETF (VB: AMEX), and the iShares Morningstar Small Core ETF (JKJ: NYSE).

We’ll continue to pour through the hundreds of different funds available to small-cap investors. We’ll let you know when we find something worth investing in. Until then, be sure a keep an eye out for an upcoming opportunity called Retirement: Plan B, which will focus on investments such as these.

Cheers,
Jonas Elmerraji

October 30, 2008

Small-Cap Investor’s Guide to Exchange-Traded Funds (ETFs) was originally featured in the Penny Sleuth.

Defense, in particular, is still a very strong investment theme and it’s not going to go away anytime soon.

Democrats are clearly trying to distance themselves from the war in Iraq. Some are even calling for greatly curtailed spending on the campaign, which will likely never find much support as long as American soldiers are under fire on foreign soil.

Even if America leaves Iraq, equipping it with only the guns and equipment that local forces claim they need desperately, the fact is that the United States is and will be on a war footing for years to come. Securing the home front – whether through offensive or defensive means – will continue and money will flow to defense contractors at a healthy rate. Anyone who thinks that this sector will not be a major ongoing magnet for investment capital believes in a peacetime we’re probably not going to see for a while…

In fact, just last Tuesday, Northrop Grumman tested a laser missile defense system on a FedEx plane flying out of LAX. The Department of Homeland Security has funded a lot of the development in this technology that will ultimately trickle down to commercial jets. Initial costs guesses are $1 million per plane for a defense system, with more than $350 per flight in maintenance costs. And that expense has to be spread over the nearly 7,000 planes in the current U.S. fleet…

And that’s why we’ve been so bullish on defense, even in light of the massive run up in these stocks. Spending will continue and we still think there are some defense stocks out there that do not fully reflect the business that will be coming their way.

For The Sleuth this week, I want to bring to your attention a great way to dip your toe into the defense stocks arena.

It’s not a targeted approach like our individual defense stock recommendations.

It’s an exchange traded fund (or ETF), and typically I wouldn’t feel comfortable even mentioning such a watered-down approach to investing in a theme in which I feel so strongly about.

But the reason I mention this ETF is that I have done due diligence on almost all of the stocks within it, and many are still attractively priced. But first, let me tell you about the fund…

The PowerShares Aerospace & Defense Portfolio (PPA) tries to mirror an equity index called the SPADE Defense Index. It’s extremely focused and not diversified much at all outside of defense and aerospace.

Typically, PPA invests a minimum of 80% of its total assets in stocks of aerospace and defense companies, and usually 90% or more in those that are in the SPADE Index.

The SPADE is comprised of about 50 U.S. companies, with a lot of large- and mid-caps as well as a fair representation of small caps.  Here is a sample of the stocks included, and remember, the S&P 500’s earnings multiple right now is 21.1x, so many of these assets are trading at a discount to the broader market.

I encourage you to contact PowerShares directly or your broker for more information on this fund. In the meantime, we’re actually doing our homework on a new defense stock that company insiders have been quietly plowing their own money back into… It might just be one of our new recommendations for Small Cap Insider.

Until next time,
Craig
January 18, 2007

Defense Stocks was originally featured in the Penny Sleuth.

This sure has been a rough couple of months for equities. Since making highs for 2006 back in the early part of May, all of the major broad-based indexes have taken it on the chin.

Fortunately, in MST Trader we’ve been focusing on the short side for the last couple of months. But some traders — and most investors — don’t like to consider playing the short side of the market. Most people are more comfortable buying things. Heck, even in MST Trader we BUY puts to position ourselves on the short side of the market.

So, most people do have a bias to buying — as opposed to shorting — when trading or investing. I’m not completely sure why that is. It could be rooted in the fact that, despite frequent ups and downs, over time our economy does continue to expand. And the stock market is a great reflection of the health of our economy.

The reason most people would rather buy than short could be even simpler than that. Many people just do not understand the concept of shorting. It’s counter-intuitive. I know I’ve wracked my brain trying to come up with a simple, clear explanation for shorting a stock. I still have yet to come up with one that’s universally successful.

The bottom line is that people are much more inclined to buy stocks than they are to short them. So, if you are one of those folks, what do you do when the environment for equities has been as rough as it’s been for the past 11 weeks?

One thing you could do is cut back on your holdings and wait for a more favorable climate before putting more of your cash to work. I suggested that approach in my July 6 Sleuth column. If you missed that issue, or want a refresher, you can view it here…

But what if you want to be fully invested? That’s a little trickier. I’m a big believer in following the trend. And let’s face it — the trend has clearly been pointing down. I’ve read estimates that approximately 75% of stocks move in the same general direction as the overall market. So, in times like these, by staying fully invested you are fighting an uphill battle.

Still, what if you want to find out where the most advantageous place is to invest right now? Not every single stock follows the overall market. After all, if 75% of equities are going down, that still leaves 25%, right? Where is one likely to find them?

I decided to employ the concept of “Relative Strength” to locate some of these contrary gems. Relative Strength is a term used by practitioners of technical analysis to evaluate how a stock or a group of stocks are performing in comparison to either another group of stocks or the broad market as a whole. In other words, a stock’s Relative Strength measures how it is performing on a relative, as opposed to on an absolute, basis.

I put the concept of Relative Strength into action by comparing the overall performance of several different stock market sectors. In order to conduct my examination, I looked at the performance of the nine Select Sector SPDRs that trade on the American Stock Exchange.

These SPDRs are exchange-traded funds (ETFs) that consist of separate baskets of stocks selected from each of nine general segments of the market. I chose to use the Select Sector SPDRs because, taken together, these nine ETFs represent a broad cross-section of the equities market. And each one fairly reflects the price performance of the stocks in their particular market segment. Here are the nine Select Sector SPDRs I used:

Consumer Discretionary Select Sector SPDR (XLY:AMEX)
Consumer Staples Select Sector SPDR (XLP:AMEX)
Energy Select Sector SPDR (XLE:AMEX)
Financial Select Sector SPDR (XLF:AMEX)
Health Care Select Sector SPDR (XLV:AMEX)
Industrials Select Sector SPDR (XLI:AMEX)
Materials Select Sector SPDR (XLB:AMEX)
Technology Select Sector SPDR (XLK:AMEX)
Utilities Select Sector SPDR (XLU:AMEX)

The technical condition of the market changed dramatically in early May. I’m sure any of you Sleuthers who take a buy-and-hold approach can attest to that.

Now, let’s rank each of these nine Sector Select SPDRs by their percentage return since May 9. This will show us the Relative Strength of each of these nine broad market sectors. With this information, we’ll be able to assess what’s been working in this challenging market environment. Here are the percentage returns through the close of trading on Monday, July 24:

Utilities Select Sector SPDR (XLU:AMEX)                             +6.7%
Health Care Select Sector SPDR (XLV:AMEX)                       +3.3%
Consumer Staples Select Sector SPDR (XLP:AMEX)             +1.5%
Financial Select Sector SPDR (XLF:AMEX)                           -4.0%
Energy Select Sector SPDR (XLE:AMEX)                              -4.8%
Consumer Discretionary Select Sector SPDR (XLY:AMEX)     -7.9%
Industrials Select Sector SPDR (XLI:AMEX)                           -9.6%
Technology Select Sector SPDR (XLK:AMEX)                       -11.8%
Materials Select Sector SPDR (XLB:AMEX)                          -12.9%

As you can see, in the current market downturn the best places to have been are utilities, health care, and consumer staples issues. Now, once conditions change we could well see other sectors assume leadership roles. But right now, if I were looking to invest over the short term, those top three sectors listed above would be a good place to hunt for potential winners. And if you are considering adjusting your portfolio, you could do worse in this current climate than to give more weight to your portfolio with stocks in those top three groups.

By employing the concept of Relative Strength, you are able to hone in on the best performing areas of the equities world. At the same time, by measuring the Relative Strength of different market sectors, you are able to discern which areas to trim back on and which to avoid altogether. And in this market environment, there are way too many stocks in that last group.

So, when trying to decide where to invest some cash, consider using the concept of Relative Strength. It might just help you sidestep a few bumps in the road.

Trade well,

Mark Bail
July 25, 2006

The Concept of Relative Strength was originally featured in the Penny Sleuth.

When I first wrote to you about the weakness I saw in the Dow Jones Utilities Average, the index was testing its 200-day moving average.  Since that time, the Dow Utilities has risen and fallen.  As I write this column, the index is once again challenging its key 200-day long-term support line.  The ups and downs of the last month have resulted in this averaging trace out the right shoulder of a head and shoulders chart pattern.  The neckline of the head and shoulders pattern is roughly in the area of the 200-day moving average.

Sleuthers, this sector is weak!  It might bounce again.  But I’m telling you, a good stiff market wind is likely to shut the power off on this corner of the equities world.

My last Technical Tuesday column two weeks ago was a perfect time to take a position on the short-side in utilities.  However, given the way the average has traded, there looks to be more downside ahead for this sector.  So, if you don’t know how to attempt to profit from the potential weakness in this sector, let me give you some different trading or investment approaches to consider.

First, you can simply buy a put option contract on the index itself.  That’s the purest play.  But if you aren’t an options player — or if you don’t find these options that attractive (they’re not that liquid) — there are a number of other avenues you could consider.

One approach is to short one or more of the stocks of the companies that comprise the Dow Utilities.  As I mentioned in my February 28 article on this sector, there are fifteen companies in the Dow Jones Utility Average.  Those companies are:

American Electric Power Co. (AEP:NYSE)
AES Corp. (AES:NYSE)
CenterPoint Energy (CNP:NYSE)
Dominion Resources (D:NYSE)
Duke Energy (DUK:NYSE)
Consolidated Edison (ED:NYSE)
Edison International (EIX:NYSE)
Exelon Corp. (EXC:NYSE)
FirstEnergy Corp. (FE:NYSE)
NiSource Inc. (NI:NYSE)
PG&E Corp. (PCG:NYSE)
Public Service Enterprise Group Inc. (PEG:NYSE)
Southern Company (SO:NYSE)
TXU Corp. (TXU:NYSE)
Williams Companies Inc. (WMB:NYSE)

If shorting is not your game — or if you would like the leverage or clearly limited risk offered by the options market — you could buy puts on one or more of these stocks.  All of them offer options.  In the interest of full disclosure, I should mention that I suggested in the March 7 issue of MST Trader that subscribers add CenterPoint Energy to their short-side Watch List for a possible put play.

If you are seeking more of a play on the entire utilities industry — where you can take a position in a single instrument that closely replicates the performance of the sector — there are a number of other possibilities you can choose from.  All of the underlying securities I am going to mention are traded on the American Stock Exchange.

One of these securities is what’s known as a HOLDRS — which stands for Holding Company Depository Receipts.  These Depository Receipts are designed to replicate the performance of specific companies within a particular industry, sector, or group in one security.  According to the American Stock Exchange’s website –- http://www.amex.com – there are currently seventeen different HOLDRS traded.  These HOLDRS are liquid and are actively traded. 

One of these securities is the Utilities HOLDRS (UTH:AMEX).  The UTH consists of the stocks of the following nineteen companies — most of which you will notice are also part of the Dow Jones Utility Average:

American Electric Power Co. (AEP:NYSE)
CenterPoint Energy (CNP:NYSE)
Consolidated Edison (ED:NYSE)
Dominion Resources (D:NYSE)
Duke Energy (DUK:NYSE)
Dynegy, Inc. (DYN:NYSE)
Edison International (EIX:NYSE)
El Paso Corp. (EP:NYSE)
Entergy Corp. (ETR:NYSE)
Exelon Corp. (EXC:NYSE)
FirstEnergy Corp. (FE:NYSE)
FPL Group, Inc. (FPL:NYSE)
PG&E Corp. (PCG:NYSE)
Progress Energy Inc. (PGN:NYSE)
Public Service Enterprise Group Inc. (PEG:NYSE)
Reliant Energy Inc. (RRI:NYSE)
Southern Company (SO:NYSE)
TXU Corp. (TXU:NYSE)
Williams Companies Inc. (WMB:NYSE)

You have several different alternatives here.  One possibility is to simply take a short position in the Utilities HOLDRS itself.  What’s nice about shorting the UTH is that — unlike stocks that trade on the New York Stock Exchange — it is not necessary to wait for an uptick in the price of the security for your open short order to be executed.  Alternatively, you can pinpoint one or more of the nineteen stocks in the UTH you think to be particularly weak and establish your short
position(s).

Again, if you are not comfortable with the concept of shorting — or the theoretical unlimited risk inherent in this method of trading and investing — you can purchase a put option.  You can either purchase a put on the UTF itself or on any of the individual UTH components listed above. 

In case I haven’t described enough alternatives for you, there is yet another way to bet on the downside in utilities.  There are a few other utilities-specific investment vehicles known as Exchange Traded Funds (ETFs as they is commonly referred to).   Unlike the Utilities HOLDRS — which is composed of a fixed list of stocks — the companies contained in an ETF change over time.  Thus, these securities are is more analogous to a mutual fund than a market index. 

However, Exchange Traded Funds share two important characteristics with the HOLDRS.  First, all of the ETFs related to the utilities sector may be shorted without an uptick.  Second, all these ETFs have options. 

There are several Exchange Traded Funds traded on the American Stock Exchange that are specifically tailored to the performance of the utilities sector.  One series of ETFs is known as iShares.  Thirteen of these iShares that trade on the American Stock Exchange were created by Dow Jones & Company to represent the performance of different market sectors.  One of these iShares is the Dow Jones U.S. Utilities Sector Index Fund (IDU:AMEX). 

What is interesting about the IDU is that its results are intended to correlate generally with the Dow Jones Utilities Average.  So, if your intent is to find a security that most closely tracks the performance of the Dow Utilities, the IDU is probably your ticket.

Another popular ETF created to track utilities industry stocks is the Utilities Select Sector SPDR (XLU:AMEX).  The Utilities Select Sector SPDR is one of nine different Select Sector SPDR Funds that trade on the American Stock Exchange.  These funds consist of a portfolio of stocks designed to reflect the performance of a particular sector’s companies within the S&P 500 Index.

There are two other Exchange Traded Funds trading on the American Stock Exchange intended to reflect the general performance of stocks in the utilities industry — the PowerShares Dynamic Portfolio (PUI:AMEX) and the Vanguard Utilities VIPERs (VPU:AMEX).  Both of these Exchange Traded Funds have options.  However, both of these securities have much lighter volume than the ETFs or the HOLDRS mentioned above.  And the options on both of these ETFs lack the liquidity of the alternatives described earlier.  So, you would be better off sticking with other, more actively traded investment vehicles.

There may be other ways you can play the vulnerability inherent in the utilities sector.  However, I have listed a host of possible choices from which you can design a successful short-side strategy.  Just decide upon the method with which you are most comfortable, pick a good entry point, choose you risk threshold, and select a profit target.  Then, go after it — before they shut the power on these utilities stocks.

Trade well,

Mark Bail
March 14, 2006

Short-Side Utilities Choices for When They Shut Down the Power was originally featured in the Penny Sleuth.