ETF Basics
What are ETFs?
Exchange Traded Funds (ETFs) are index funds that are listed on an exchange and can be bought and sold like any other listed security.
What are the advantages of ETFs?
Their expenses are low, they are easy to buy and sell, and they offer tremendous transparency, liquidity, and opportunities for diversification. Also, because capital gains distributions happen very rarely with ETFs, these funds have built-in tax efficiency and are excellent to use in your taxable account.
What are ETF fees, generally?
ETF fees are generally half those of conventional index funds, and they are 75% cheaper than fees charged by actively managed mutual funds.
How many ETFs are there? What markets do they cover?
There are currently over several hundred ETFs, with more being issued each week. ETFs today cover a broad range of market sectors, including bonds, utilities, value, growth, small-cap, technology, technology sub-sectors, energy, gold, overseas markets, and many more. Unfortunately, there are now too many repetitive ETFs, so it has become more critical for investors to choose their ETFs carefully.
Who are the major sponsors of ETFs?
The four major issuers of ETFs are Barclay’s, State Street, PowerShares, and Vanguard. You will find links to these and other ETF sponsors on our External Resources page.
How do ETFs compare with mutual funds?
First, ETFs carry very low management fees. The fee for the QQQQ, for example, is only 0.20%. Given the poor performance of fund managers during the recent bear market, individual investors may wonder why they should pay high management fees to mutual fund companies. Second, ETFs are more easily purchased and sold than most mutual funds. Since they trade just like stocks, there are no cumbersome redemption issues or penalties to deal with. Third, the ongoing mutual fund scandals have made low-fee, fraud-resistant ETFs an even more attractive alternative. For more on this topic, see my essay “The Mutual Fund Scandal and the ETF Alternative.”
What do you think of “actively managed” ETFs?
Many traditional mutual fund companies are seeking to issue “actively managed” ETFs that have the dubious characteristic of being mysterious “black boxes” not linked to indexes. Such funds would be a serious and significant departure from traditional index-based ETFs. Technically oriented investors like me won’t be able to use these ETFs since they will have no transparency (no index to track), making trading discipline impossible.
No doubt fund companies are feeling competitive pressure as assets are shifting from mutual funds to ETFs. But why sacrifice the transparency and tracking benefits of index-based ETFs just to allow entry to fund companies? Just say no!
PowerShares, on the other hand, has brought to market some interesting ETFs that are more actively managed but also have an index link. From my perspective, these ETFs have potential to bring performance levels comparable to that of higher Beta stock funds, so I am beginning to incorporate them in my analyses.
Do ETFs have automatic dividend reinvestment options?
Dividend reinvestment is not available yet.
Who started ETFs? How long ago?
While working in new product development for the American Stock Exchange in the 1980’s, Nathan “Nate” Most had an idea for index funds that would trade like stocks. He met with Vanguard chief John Bogel and was discouraged from the project, most likely because ETFs would compete directly with non-exchange transacted index funds managed by Vanguard. But Nate persevered and in 1992 launched the first ETF – SPY, which is now well-known as “spyders.” ETFs became more popular as time passed, and their trading volume increased dramatically after the mutual fund trading scandals of 2002-2003.
Nate Most passed away in 2004 at the age of 90; however, he lived to see his brain child grow to enormous success. A few months prior to his death, the Digest staff and I had the pleasure of meeting him over lunch. He was a gentleman who even in the twilight of his years was still creating new ideas that he wanted to pursue. In one of his last press interviews, Nate acknowledged that he never received a dime of royalties from the products he invented. True to form, he was quick to make a joke of the situation. “Gosh, I wish I did,” he said. “If I had a tenth of a basis point of the ETF business, believe me I’d be out there sailing a yacht.”
Using ETFs
How can I use ETFs?
ETFs can be an excellent substitute for more expensive and cumbersome conventional index and mutual funds. Since they have grown so dramatically in diversity, ETFs offer investors a unique opportunity to diversify investments among a wide range of issues.
In the near future, I believe we will see the release of currency ETFs, crude oil ETFs, and inverse ETFs, which will allow individual investors to add more uncorrelated sectors to their portfolios and to create their own hedge funds using ETFs. This is where it’s all going in my opinion.
As an overseas investor, how can I use ETFs?
Many overseas market indexes have their own domestic ETFs related to various internal market indexes. For example, London has ETFs for the FTSE Index, Australia for the ASX Index, and Hong Kong for the Hang Seng Index, to name a few. Individuals should consider dealing in those through online discount brokers within their own countries.
Overseas investors who wish to engage in transactions in US ETFs may open an account with any online US discount broker. A form W-8 needs to be signed by the individual investor, and an account is then opened and ready to trade.
Where do you put cash while trading your ETF portfolios?
I just leave it in the money-market fund with my broker. It’s best to maintain a short duration money-market fund so that when you need to move, you can.
Can you lend any insight on the lack of shorting capability for individual investors in most of the new ETFs?
The simple answer is that issuance of new ETFs has exceeded brokerage loan departments’ ability to keep up. It costs them money to hold stocks for lending. Sponsors like Barclay’s IShares, State Street, and PowerShares have no financial incentive to help retail investors short. Sponsors make fee income only when more shares are issued – not when the same shares in float are shorted. So, they don’t want small investors to short. Institutions, on the other hand, can go to sponsors and have new shares issued in 50-100K denominations, and the sponsors love this because it brings more fee income. The small investor looking to short even 1K shares is scoffed at. The exchanges want you to trade options, since that is more lucrative for them, so they too have little incentive to assist individual, or “retail,” investors.
The rub, of course, is that all ETF sponsors state in their promotions that one of the benefits of these funds is that they can be sold short, even on a downtick. So the sponsors appear to be breaking promises and providing two different levels of service – a very good level for institutions while retail investors get the short shaft.
Individuals who wish to short ETFs will have to confine their activity to the half dozen or so largest ETFs until “inverse” ETFs are issued. These are in the works and should solve the problem.
Using Dave’s ETF Digest
What kind of investor is most likely to benefit from the ETF Digest?
This service is dedicated primarily to individuals interested in an intermediate-term investment process that does not require intense intra-day management.
What kind of broker can best serve me as a subscriber who follows your Digest?
Everyone should be using a broker who offers excellent service with the lowest possible execution costs. ETF Digest programs will feature many transactions during the year, and subscribers need to make sure that commission costs at their brokerage firms are low.
If I invest in more stocks than ETFs, is this Digest useful to me?
Yes. Some subscribers use my systematic trading signals as a tool for managing their non-index shares. For example, investors who own individual stocks with high correlations to the IWM (Russell 2000 Small Cap Index ETF) may find that my signals help them make adjustments in that portion of their portfolios. The same could be said for individuals with holdings that correlate to other ETFs I cover, including the SPY, the QQQ, the TLT, and the EWJ.
As ETFs have proliferated, their coverage of important market sectors and subsectors has grown, and ETF Digest trading signals are often relevant to investors in particular areas. Take technology sub-sectors for instance: Subscribers who own the semiconductor heavyweights INTC (Intel) and AMD (Advanced Micro Devices), for example, might find the Digest’s signals for the SMH (Semiconductor Holders) useful when they are making buy, sell, or hold decisions for these stocks. Similar use can be made of ETF Digest signals for: the SWH (Software Holders), where MSFT and ORCL dominate; the IGN, where CSCO and JNPR are predominant; and the HHH (Internet Holders), where EBAY and AMZN are crucial.
Some investors with traditional portfolios of stocks use ETFs to add market sectors to their portfolios quickly while they are researching specific stocks for purchase. And as more subsector ETFs become available, it is likely that more investors will choose to add them to their portfolios in lieu of buying individual stocks. This type of ETF can provide undiluted exposure to a particular sector or industry group and has the ability to outperform broader indices when markets are showing strong trends.
Additionally, ETF Digest short signals can help subscribers “hedge” their portfolio risk by shorting relevant ETFs without selling their stock or bond portfolio.
If your Digest has a trading position established when my subscription starts, how should I begin?
Never start a transaction when the ETF Digest has a mature position established. Its exit signal may result in a mere giveback of profits for the Digest’s position, but a larger loss for your position than the Digest would normally withstand. Wait for a fresh signal.
How do I start using the ETF Digest?
- Start by taking our 30-day free trial.
- Hopefully, you already maintain a low-cost online brokerage account. If not, open an account at any of the well-known firms.
- Use your trial period to thoroughly evaluate the Digest’s services. This should include reading the essays I’ve posted to help subscribers understand my investment philosophy and my views on important investment topics. In addition, read this ETF Primer and FAQs page carefully.
- Review the ETF Digest Portfolios that I maintain. These portfolios take into account typical investor profiles and the range of ETFs and securities covered by the Digest.
- Evaluate the performance and characteristics of each ETF covered by the newsletter. Ascertain which ETFs best suit your unique requirements and assemble your own portfolio.
- New subscribers should wait for fresh signals before establishing positions in the markets we cover. If you start a transaction when the ETF Digest has a mature position established, our exit signal may result in a mere giveback of profits for the Digest’s position and a larger loss for your position than the Digest would normally withstand. Do wait for a fresh signal.
- If you have any questions, always feel free to e-mail the Digest staff, at [email protected], or me personally, at [email protected]
How do you manage risk in your trading programs?
Every trade has a predetermined stop. Stops are only communicated when action needs to be taken. It is important to remember that these stops are triggered only by an analysis of closing market prices. I have found that a strict adherence to a closing price discipline avoids being stopped-out because of volatile intra-day price movements.
How do you use stops? And how are they communicated in your newsletter?
Please see “The ETF Digest’s Use of Stops” for a description of my approach.
Your investment objective is “to capture two-thirds of significant market trends” – what does this mean?
You can read about this in “The Two-Thirds Objective Explained.”
Are there times when you have no position, long or short?
Yes. Based on past experience, approximately 25% of the time (and much longer for those who do not “short”) my system maintains a “cash” position, as no suitable trading signals are present.
Is there enough liquidity in the markets to accommodate your trading programs?
Yes. Before an ETF or security is included in my Digest, I carefully evaluate its liquidity and “trackability.”
Do you offer commentary about the direction of the financial markets?
As my trading system is technical and nonpredictive, I do not waste your time by trying to extend beyond my area of expertise. In the Digest, I do offer my daily observations of the state of the market, along with annotated charts. And, as needed, I give recommendations about individual ETFs and adjust the allocations within the ETF Digest Portfolios.
How do you decide to add new ETFs to your services?
The first thing I look at is the related index. Is there one? How much data is there? Also, how long is the history? Since I approach the markets on a technical basis, I ask, how does that ETF or security fit in with how I approach the markets? If back-testing the related index works well with what I do, then great – it meets one of my important requirements. If not, I’ll stop there.
The next hurdle is liquidity. There are a lot of “me too” repetitive ETF issues. The ETF market is quirky in the sense that once an issue becomes the accepted standard, a copy-cat will find attracting volume difficult. For example, SMH (Semiconductor Holders) is the most highly traded issue for that sector despite the fact that it is structured as a “Holder” versus an ETF. (A holder is a trust that can not add new issues and can only be traded in 100-share lots). One would assume that an ETF issue would attract more investors, but IGW (GS Semiconductor ETF) does not have the same following, even though it performs similarly. So institutional investors are creatures of habit and the ETF market is dominated by this type of phenomenon.
The next important question is whether the security is highly correlated with the rest of the market. In other words, is it merely trending in the same direction as everything else? Does it add value? The less correlated the better. Unfortunately, most ETF issues today are highly correlated.
Finally, if all these factors pass all of my tests, I’ll happily add the ETF or security to the Digest’s programs.
On the ETF Selection Criteria page, you’ll find more on my requirements.
Why do you short only ETFs and not individual stocks?
Margin requirements vary too much for many individual short sale candidates. This adds an extra level of consideration and risk that is not present when dealing with most ETFs. In addition, managing a wide variety of short equity positions requires an intense level of management. I feel that most ETFs provide excellent liquidity, effectiveness, and efficiency for shorting. For more on this topic, you can read my essay, “The Virtues of Shorting ETFs.”
If I don’t wish to short, can I still benefit from your services?
Yes. If you do not wish to short, you can still use the ETF Digest as a tool for your overall portfolio and asset allocation decisions. By watching the Digest’s trades unfold over a period of time, you may learn more about shorting – and possibly become more comfortable with it. However, if this activity does not suit you, do not do it.
What issues most negatively affect the subscriber who follows your system?
Impatience. Sometimes people can’t hang in there with some trades. They get nervous, fearful, or they are distracted by external noise. Some of this can be caused by a negative news climate that makes trades seem counterintuitive. Good traders steel themselves to ignore these concerns.
Systematically, a lack of identifiable intermediate and long-term trends can lead to choppy conditions and short-term losses. During the 1990’s, excellent trends were present. If these same kinds of trends are not manifested in the future, then most good trading systems will produce only modest future performance at best.
Could you explain more about the phrase “past performance is no guarantee of future results”?
The market period between 1999 and 2001 featured some of the best trends, both up and down, in market history. A system such as mine performs best in such an environment. It is extremely important to always remember that my system is nonpredictive. I am not in the business of guessing the market’s future environment or how my system will perform in any new environment that unfolds. Markets with strong trends will always be the best, while choppy conditions will be the worst.
Will there be losses?
Yes. Losses are part of doing business in trading. If you study my track record you will observe drawdowns. But while there will be times when bad trades happen, being disciplined about realizing these losses is a significant part of being successful. More importantly, acceptance of trading losses is a key factor in the making of a successful trader. There is no perfect system, and there never will be.
Why don’t you trade options or use leverage?
Options are too inconsistent in outcome, given the trading signals the ETF Digest provides. The duration of my system’s best trades is generally from 6 to 8 weeks. Therefore, one must establish an option position to coincide with that duration. However, the speculator must pay a “time premium” for the right to hold that position and this premium wastes away until expiration. If the Digest’s signal is only moderately profitable, there may be little, if any, gain from the option position, due to premium expense. More aggressive speculators should consider trading a futures contract in lieu of options. For the most part, time premiums are not as significant a factor in such trades, and the leverage is as dramatic. As for leverage – frankly, it’s an unnecessary risk given my programs’ excellent rates of return without its use.
How and when did you get started in the investment business?
About Dave
I started as a municipal bond salesman during the great financial crisis in New York City Bonds in 1975. That was an exciting period to learn about various aspects of the markets and crisis management. The stock market was in the process of completing the collapse begun in 1974, and individuals were interested in bonds. After I spent a few years in the bond business, a client introduced me to a money manager, who at the time was managing my client’s technology stock portfolio. This individual taught me the fundamentals of tech stocks. The experience whetted my appetite to learn even more.
How did you become interested in technical trading?
An associate introduced me to speculators who primarily traded futures and commodities. Very few of these speculators ever trade from a fundamental point of view. They introduced me to technical analysis and taught me the principles of this methodology. It occurred to me subsequently that many of the principles of technical analysis that were so important to these speculators could be applied to equity trading. After learning more about this technical methodology, I began to apply it to my own stock trading. But, I still had more to learn…. I’ve written more about this in “Why I Trade Technically.”
What are some of the lessons you’ve learned that you want to share?
Humility and acceptance of a strict, disciplined approach to trading. I realized when I analyzed my mistakes that there was a common thread to my errors. I was second-guessing my signals. I would hesitate and think that the signals generated were not going to work. I thought I could create a perfect system. But, of course, such a thing does not exist. A smart person once told me, “A good system, consistently implemented, will outperform a great system inconsistently implemented.” And it’s so true. After understanding this, I developed the following formula that produces success:
Experience + Discipline + Acceptance = Superior Returns.
I’ve spent over 30 years working with some of the smartest traders in the business. I know which systems work well. I understand that neither I nor anyone else can predict the future. Therefore, a disciplined “make every trade, every time” approach to trading is the only effective route. Accepting small losses is a part of any good system and will lead to larger profits in the future.
Why are you devoting time to the ETF Digest?
I’ve owned and managed complex investment companies. I disliked how difficult it was to manage highly regulated companies, employees, and all the attendant duties that took me away from people and trading. I’m now 57 years old and while I enjoy fishing and the outdoors, there’s only so much of that I can do. I love the markets and interacting with people from all over the world. I want to make money in the markets and have some fun at the same time. The Internet has made this business possible and I love it.