Exchange Traded Funds: Strategic Use Provides Asset Allocation

Exchange Traded Funds (ETF) are another form of investing vehicle available to investors. 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 have a strategic role to play in our portfolio. The simplicity with which one can buy and sell an ETF makes it difficult to understand how it is structured and what its constituents are. ETFs are good investment vehicle for broad market exposure and access to alternative assets.

• Broad Exposure: It can be used for hedging against broad market performance, broad industry sector, broader country exposure, or any particular asset class. Investors need to understand which particular ETF is structured to meet that objective (all ETFs are not created equal). Many ETFs 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 more 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 prepositions. I am not advocating the use of such assets, but merely pointing the fact that such asset classes were not available earlier.

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

• Time Horizon: The time horizon should be in the order 10 years or more. 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 when relative PE is less than one. It is next to impossible or futile to go into these 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: Many ETFs are closed end funds with high expenses, many provide dividends that include return of capital, many provide short term gains distributions, 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.

ETFs can strengthen investor’s portfolio and help in asset allocation. At this point in time, ETFs are the best investment vehicles to get exposure to emerging markets. I use Wisdom Tree ETF, EPI, for exposure to Indian economy. Investors do not need to worry about identifying countries or individual companies in emerging countries. It provides a means to invest in India markets, but also a mechanism to buy and sell easily during trading hours in US bourses.


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