ETF’s – If it looks like a duck…

A good friend sent in the following comment and questions. I am copying them here with the attribution of his initials in deference to his right for privacy. If you email your comments instead of linking them here, please let me know if you would like recognition or some form of privacy. Also, let me know if you would like a link to your website included.

“I am in total agreement with the long-term approach and believe it is necessary to identify the industries and sectors positioned to dominate the economic landscape for the next decade. The obvious question being which sectors are these? How long do you think the finite resources game will last? Is a good idea to set up a portfolio which is long oil, natural gas and other commodities at the same time it is long alternative energies, biotech and environmental awareness. How about water as the next scarce resource?” – CK

By far the easiest way to capture industries and sectors in your portfolio is to purchase large blocks of ETF’s (Exchange Traded Funds). As “C.K.” indicates, buying these industries/ sectors and holding them as they dominate economic activity is a way to benefit from obvious macro trends.

An exchange-traded fund is usually an open-ended mutual fund that trades intra-day on the exchange (like a stock) for retail investors (us), but allows large institutional investors to purchase large blocks of new shares for cash. This greatly decreases the cost of the fund by reducing customer interaction, limiting the amount of cash it needs to retain for share redemptions, etc.

The method by which the price of ETF’s are kept in line with their underlying NAV (Net asset value) is so cool that it will be a math problem for my seniors this coming school year. Anyway, the arbitrage process of the institutional investors does keep the price of an ETF very close to the price of it’s underlying investments.

An Example:
You believe the June 13th issue of the Economist (page 101) that “if the world continues to produce oil at the same rate as last year, global oil supplies will last another 42 years… US oil reserves will last 12.4 years…” Therefore you expect oil prices to rise relative to the dollar for the next twenty years. During that same time you expect people to begin to diversify their energy supplies and wish to profit from oil price appreciation as well as alternative energy capital allocation.

Solution:
Buy a block of VDE (Vanguard Energy ETF) http://www.vanguard.com/us/FundsSnapshot?FundId=0951&FundIntExt=INT&Source=JMPE&Select=PEVDE

This ETF captures a beautiful cross-section of the energy sector. That means you would “own” shares of some of the most profitable companies in a very profitable sector during a time when their product (energy) increases in price relative to other goods.


Now to “C.K.’s” big question, “How about water as the next scarce resource?”

Here I am a little reluctant to recommend VPU (Vanguard Utilities ETF) as I think it is under-represented in water but it is a nice way to profit from regulated markets. Utilities are often regulated monopolies with terrific pricing power and consistent returns.


So, it sounds great. Why not just build a portfolio of ETF’s and risk-free return assets and then balance as time goes forward? Well, for many investors this would be a reasonable approach. ETF’s are cheaper than most mutual funds (no 12b-1 fees) to own and have lower tax consequences (managers don’t have to redeem shares to let investors out of the fund).

However, they are still tennis rackets when we want fly swatters. ETF’s are massive funds purchasing large blocks of diverse holdings in a given industry, sector, or asset class (for example treasuries). That means they are pouring money into companies that may be over-paying management, chasing short-term results, or generally mismanaging their capital. As an ETF owner you don’t have discretion over which energy company you are buying, when you buy the sector expect to see Exxon (good) and Duke (not so good) both in the mix.

What does that mean? Basically, by buying ETF’s you are making broad bets about macro economic trends and hoping that the individual companies (or governments) are wisely using their capital. If instead you want to look for a margin of safety, buying shares of great companies at good prices that may be currently over-looked, then you still need to do some homework and buy selectively.

What will win out in the long run? I don’t know, but giving everyone in the class the same grade (capital) just because I think the whole class will do well this year seems like a bad policy for teaching and probably a bad way to invest your hard-earned money.


Remember, investing is a highly moral activity, whereby you delay gratification today (saving versus consumption) in return for more authority (capital) for choices in the future. You must decide whom to trust with your savings. You must decide if they are using your money wisely.

Next time, Bonds versus Stocks, have we been sold a bill of goods?