From the March 01, 2007 issue of Futures Magazine • Subscribe!

Shopping for the right ETF

With the plethora of exchange traded funds (ETF), it’s hard to determine which one is right for you. Here is a break down of the various asset classes available to today’s trader and investor and the advantages of each. (For further information on ETFs, go to www.futuresmag.com for the full chapter from Todd Lofton’s book, “Getting Started in Exchange Traded Funds”).

ETFs within the same asset class tend to demonstrate similar market performance, but there are significant differences in risk and return between asset classes.

In a study entitled “Determinants of Portfolio Performance,” the results of which were published in the July/August 1986 issue of Financial Analysts Journals, author Gary Brinson concludes that more than 90% of a money manager’s successful performance can be attributed to his selection of asset class.

If the name of the ETF does not identify its asset class, it may be found online. The easiest way is to visit www.morningtar.com, click “ETFs,” then click “Name.” You will see a list of all U.S. ETFs and the asset classes that Morningstar has assigned to them. Performance data is provided too. Also, www.indexuniverse.com has a Web page for ETF asset classes, and the information is available in the summary sheets for individual ETFs at www.amex.com and at www.etfconnect.com.

Growth vs. value: The distinction between growth stocks and value stocks is not always clear. There are some stocks that fit comfortably in each category, but there are many stocks that have attributes of both growth and value. The word “blend” often is used to refer to stocks with indeterminate pedigree.

Generally speaking, the earmarks of a value stock are a high dividend yield, a low price-to-earnings ratio, a low price-to-book ratio and a modest outlook. Of these, the price-to-book ratio may be the most informative, as it captures one of the fundamental differences between value and growth stocks. Value investors believe markets are not always efficient; that it’s possible to find stocks trading for less than they are worth. They also know that value companies do not have to improve earnings to meet expectations.

Growth stocks have low book-to-price ratios. Some have no earnings at all. Others have earnings but pay no dividends; cash is instead funneled back into the company to finance expansion or new products. Investors buy growth stocks for their potential price appreciation. Growth stocks tend to lead new bull markets. The most visible growth stocks in recent years have been in the technology and Internet sectors.

In comparing returns between the growth/value stocks, the historical edge has gone to value stocks. In the 29 years from 1975 through 2003, there were 12 years when value stocks outperformed growth stocks, and six years when growth stocks predominated — based on comparisons between the S&P 500 Barra Growth Index and S&P 500 Barra Value Index.

The best year for value stocks was 2000; they gained 7% while growth stocks lost 23%. The best year for growth stocks was 1998, when the score was: growth stocks + 42%, value stocks + 13%.There is no pattern in the results, except that three of the relatively best years for growth stocks came in a row: 1997, 1998 and 1999.

The small-cap/large-cap comparison is shown in “Capping returns” (below), which depicts the relative performance each year from 1985 to 2005 (the Russell 2000 Index was used to represent small-cap stocks, the Russell 1000 Index to represent large-cap stocks). In the 20 years shown, there were 11 years when large-cap stocks outperformed small-caps, and nine years when small-cap stocks did better. The banner year for large-cap stocks was 1998, when they outperformed small-caps by 30%. The best year for small-cap stocks was 2003, when they beat large-cap stocks by about 17%. Based on this data alone, the historical odds would seem to favor large-cap (11:9) value (12:6) stocks.

The grouping of the returns in the chart is worth noting. As you can see, success came in bunches. A good year for growth stocks tended to be followed by more good years for growth stocks. Same for small-caps. The longest periods of dominance: large-cap stocks were winners each year from 1994 through 1998. For the next six years, 1999 through 2005, small-cap stocks outperformed. It doesn’t show that for the first nine months of 2006, the trend continued; small-cap stocks outperformed large-caps by about 12%.

An article by Craig L. Israelsen in the March/April 2006 issue of Journal of Indexes presents tables of comparative data for different indexes for the years 2001 through 2005. Each index is a composite of the five major indexes in that asset class. The annualized average performances were:

2001 - 2005(%)

Large-cap Value Indexes+ 3.61

Large-cap Blend Indexes+ 0.29

Large-cap Growth Indexes - 4.19

Mid-cap Value Indexes+12.85

Mid-cap Blend Indexes+ 8.43

Mid-cap Growth Indexes+ 2.82

Small-cap Value Indexes+13.68

Small-cap Blend Indexes+9.54

Small-cap Growth Indexes+ 3.47

From 2001 to 2005, value stocks outperformed blend and growth stocks in every capitalization category. Does this mean that growth stocks are due for a resurgence beginning in 2007?

Foreign stocks. There are many U.S. ETFs that track foreign stock indexes. As noted above, they are categorized as global, regional, country or sector. The largest group is country ETFs. The smallest group is the five foreign global sector ETFs, which comprise energy, financial, healthcare, technology and telecommunications.

The principal virtue of foreign securities in a portfolio is to provide diversity among ETFs. As we have said, the prices of U.S. stocks with similar styles tend to move together; they have correlations in the 90s. The correlation of the price movement between U.S. stocks and foreign stocks of similar asset classes falls between 0.42 and 0.58.

Fixed-income securities. ETFs that track fixed-income indexes are all iShares and include short-, medium- and long-term Lehman Treasury indexes, a corporate bond index, the Lehman TIPS (inflation protected) index and an aggregate index that reflects the broad bond market.

Bond ETFs perform just like their stock counterparts, except that, like all interest rate securities, their prices vary inversely with the movement of interest rates. Bond ETFs pay cash dividends monthly, and dividends may be automatically re-invested.

Even though the underlying assets are bonds, there is no fixed-rate return for the investor in a bond ETF. As with a stock fund, the total return comes from dividends and appreciation of the market price of the ETF. Because bonds in the index portfolio mature and must be replaced, bond ETFs are more likely to accrue capital gains than stock ETFs.

Real estate and gold. Gold has long been considered a store of value in times of war or economic turmoil. Historically, gold prices have moved in opposition to bond prices, as gold is used as a hedge against inflation. Likewise, real estate ETFs are all keyed to real estate values within the United States.

Specialty. The specialty group comprises funds like the KLD Select Social Index Fund, and PowerShares WilderHill Clean Energy Fund; currencies, like the Rydex Euro Currency Trust; and commodities, something this audience understands.

Todd Lofton is a past member and floor trader on the Chicago Board Options Exchange; author of Getting Started in Futures, (John C. Wiley & Sons, 1986) and a founding publisher and editor of Commodities (now Futures) magazine.

Reprinted by permission from Getting Started in Exchange Traded Funds (ETFs) by Todd Lofton (John Wiley & Sons Inc.). Copyright (c) 2007 by Todd Lofton.

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