S&P500 is market cap based index. The top 28 companies have 40% contribution to the index, while top 45 companies provide 50% contribution, and top 180 companies provide 80% contribution. As an investor it really does not help to invest in index hoping to have exposure to US economy. In last couple of years, Exchange traded funds (ETFs) as an investment vehicle has gained momentum among individual investors. In addition, we can also see never ending queue of new ETF based funds either being launched or waiting in the wings. There are few key aspects such as low expenses, trading ability during normal market hours, and relative transparency. Let us take an example of S&P500. We expect that buying S&P500 based ETF fund will provide us exposure to US economy.

• In S&P500 index, the bottom 320 companies have only 20% contribution. As an investor, do I really need to be part of 320 companies for only 20% exposure?
• The top 10 companies in S&P500 index (which have approx. 20% weighted) earn close to 40% of the revenue from foreign and/or emerging markets. If we take the full gamut of 500 companies, it is likely (and probably safe to assume) that more than 50% of the revenue comes from markets outside US. So as an investor it does not seem to provide exposure to the US economy.
• The index consists for array of companies who weightage is based on market capitalization. In case of S&P500, the top 10 has a significant contribution to the index and it can sway it performance even with small change. However, a set of 10 companies on the bottom rung, will not impact S&P500. Even if these 10 companies are doing good and maintaining consistency performance, profitability, and good financial management, there will be no visible impact on the index. As an investor, the value of our investments will be at the mercy of large companies.
• The index is an attempt to capture a wider base of business in the economy; it is difficult to have all good quality companies. Index will have good quality and bad quality companies. Even though we as an investor may not like a company, we get exposure to it by default.

This is quite intriguing. It may be good indicator for the economy and provide a ‘relative’ comparison tool in different time periods. However, as an investor, its applicability and use in our portfolio is limited to structure.

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In last five years or so, Exchange Traded Funds (ETFs) have grown in numbers and it asset values. In my view, ETF is another form of investing vehicle available (among many others) to investing or trading community. The major attraction for ETF has been low cost expenses and fees in comparison to mutual funds and ability in trade during market hours. Like any other investing vehicles, I believe ETFs are good vehicles depending upon how/why an individual investor uses in its portfolio. The simplicity with which you can buy and sell an ETF makes it even more difficult to understand how it is structured, what are its constituents, etc., So before you buy an ETF you much understand why you want to buy it and what role it plays in your portfolio. Broad market exposure and access to alternative assets are two important roles ETF can play in your portfolios.

• Broad Exposure: ETFs are very good investment vehicle for hedging against broad market performance, broad industry sector, broader country exposure, or any particular asset class. When investing in ETF, investors need to make sure that it represents its intended objective. Many ETFs just invest in few bunch of stocks and expect only those small number of stocks to provide broader exposure. In my viewpoint, ETFs for broad exposure should consist of more than 250 or 300 stocks.

• Access to Alternative Assets: This is one the significant benefits depending upon how the ETF is constructed. E.g. ETFs based funds for leverages, currencies, commodities, futures, etc are being made available. However, I believe that such ETFs are high risk opportunities. I am not advocating the use of such assets, but merely pointing the fact that such asset classes were not available earlier. Whichever theme one chooses, I believe the asset in ETFs should be basket of stocks or businesses dealing in those particular domains.

ETFs can play these two roles successfully if investors are investing for long haul and understand their structure.

• Time Horizon: Investment in ETFs should be for long haul. The time horizon should be in the order 10 years, 15 years, or even more. The true benefit of investing ETF is derived when investing for long term. One of the methods to invest in ETF is dollar cost averaging over a period of time. There is a school of thought that investors should buy when an ETF is below intrinsic value or relative PE is less than one. In my view for individual investor, it is next to impossible or futile to go into this exercise. Keep it simple, and hence buy and/or continue to add when it is below 200 day and 365 day moving average.

• ETF Structure: Understand what an ETF consists of, e.g. common stocks, futures, options, leverages, etc. Many ETFs are closed end funds with high expenses, many provide dividends that include return of capital, many provide short term gains distributions (tax implications), many consist of only 30 or 40 stocks based on capitalization, etc. In addition, investors need to more careful for ETF focusing on emerging markets. Many funds just invest in ADR/GDR/ADS, which is locally available in US and still charge high fees, many only have less than 100 stocks, etc.

Strategically, ETFs can provide a means to strengthen investors portfolio and help in asset allocation. At this point in time, I believe ETFs are the best investment vehicles to get exposure to a broader emerging markets. Investors do not need to worry about identifying countries or individual companies in emerging countries. They not only provide individual investors a means to invest, but also a mechanism to buy and sell easily during trading hours.

What role does ETF play your portfolio?

This article was first published on The DIV-Net on October 16, 2009.