Even in a bear market, exchange-traded funds (ETFs) are hot. This year, investors have poured $33 billion into these baskets of securities that mimic index funds but trade like stocks.
What's the appeal? In the aftermath of Enron and WorldCom, investors are increasingly skittish about individual stocks--even shares of seemingly solid companies. Because ETFs are baskets of stocks in both broad and narrow indexes, "you've greatly reduced single-company risk," says Merrill Lynch ETF analyst Benjamin Bowler. Diversification makes ETFs similar to mutual funds, but they work more like stocks. You can trade them all day, buy them on margin, or sell them short. You can also trade options on many of these funds.
Investors are finding lots of neat applications for these instruments. Here are a few of them:
With the recent launch of ETFs tied to bond indexes, it's now possible to build a portfolio that's diversified across sectors and asset classes. And you don't have to settle for the Standard & Poor's 500 Depositary Receipts (SPDR), or "spiders," as a proxy for stocks. Using ETFs that track the different sectors of the S&P 500, you can fine-tune your holdings. If you think health stocks will outpace the S&P 500 and financial stocks will lag, you can build that bias into your portfolio.
Look at the stock portfolio designed by investment adviser Thomas Mench, chairman of Mench Financial in Cincinnati (table). He invests in most of the nine sector SPDRs--each is a basket of the stocks in a different slice of the S&P 500. Mench overweights consumer discretionary, technology, and utilities stocks because he believes those sectors will outpace the market next year. Conversely, the portfolio avoids energy stocks and is underweighted in health-care and industrial stocks.
For fixed income, Lehman Brothers ETF analyst Alex Bundy created a portfolio with the Lehman Brothers Aggregate U.S. Bond index as the benchmark. Based on Lehman bond guru Jack Malvey's views, the portfolio is overweighted in corporate bonds and underweighted in Treasuries, especially short maturities.
Using sector ETFs instead of the broader index gives you more control over your asset allocation, but there's a drawback. You'll pay more in commissions if you buy sector ETFs rather than the S&P 500 SPDR. But with cheap online commissions, that shouldn't be a major hurdle.
THE SECTOR BET
You think energy stocks are a good value long term, but you are concerned that they will stumble over the next few months. You could buy now--the Energy Select Sector SPDR Fund trades at $21.90. Or you could wait until next year, but then you risk missing an upward move.
There's another approach: Sell a put option on the energy SPDR. Choose the option that expires in June and allows the option buyer to sell you 100 shares at $21 each. For that right, the option buyer pays you a fee of $1.55 a share, or $155.
If energy stocks take a near-term tumble, you may be forced to buy at $21, but the premium reduces your net cost to $19.45. And if energy stocks zoom? The options will expire unexercised. You can then buy the energy stocks at a higher price, but the options premium helps offset some of the lost profit. One caveat: Transaction costs on small trades can eat into your profits. That's why Michael Schwartz, chief options strategist at CIBC Oppenheimer, suggests doing this trade with no fewer than 10 options contracts, representing 1,000 ETF shares.
Tiptoeing back into the stock market? A combination of ETFs and options can be a smart way to do it.
Let's say you buy the Diamond Series Trust I, better known as Diamonds. That's the ETF that tracks the Dow Jones industrial average. You can buy it at $85.25 a share, but you're concerned that the Dow may drop again. So you buy put options on Diamonds with a strike price of $84 a share, expiring in January, 2005. That means for the next two years, you can always sell your Diamonds at $84. For that portfolio insurance on 100 shares of the Diamonds, you'll pay $1,180--the cost of the options contract. Sure, if the Dow rockets back over 10,000, your option is worthless--but you'll have peace of mind.
THE TAX TRADE
Now's the time of year when you want to sell stocks to generate tax losses. But what about the stocks you think still have potential? The tax code says you must wait 31 days after selling to buy back a stock or forfeit your write-off. What if the stock you sold rallies during that period?
A good strategy is to replace the sold stock with an ETF that's heavily invested in the stock you're unloading. Suppose you've lost money in Verizon Communications (VZ ), which, like most of the telecom industry, is in the dumps. You could sell Verizon and buy the iShares Dow Jones U.S. Telecommunications Fund as a placeholder. That fund has 25% of its assets in Verizon. Then, after 31 days, you can buy back the Verizon stock and sell the fund shares. Or you just might find that investing in ETFs suits you better.
By Susan Scherreik