Exchange Traded Funds (ETF)

Exchange Traded Funds (ETFs), the mutual-fund-like baskets of individual securities that can be bought and sold throughout the trading day like an individual stock, have become increasingly popular over the past few years. Depending on which source you read, you will get different statistics on the number of ETFs and the total dollar amount invested in ETFs. But, suffice to say there are several hundred Exchange Traded Funds on the market with approximately $500 billion in assets.

There are now ETFs for virtually any type of investment you want to make. Want to invest in the popular Dow Jones Industrial Average? Take a look at the Diamonds Trust (DIA). How about the Semiconductor industry? Consider the SMH. For a basket of home builder related stocks, there is the XHB. Perhaps you want to trade currencies? The FXE gives you a chance to trade the Euro. And who can do without the popular technology sector? Symbol XLK just might be for you.

Perhaps you like to invest overseas? If you like Emerging Markets, the EEM might be your next trade. Does Latin America interest you? Check out the ILF. Maybe you want to invest in specific countries? Here are a few countries with their corresponding ETF symbols:

  • Brazil (EWZ)
  • Mexico (MXE)
  • China (FXI)
  • South Korea (EWY)
  • Germany (EWG)
  • Spain (EWP)
  • India (IIF)
  • Sweden (EWD)
  • Indonesia (IF)
  • Switzerland (EWL)
  • Malaysia (EWM)
  • Turkey (TKF)

Let’s not forget about one of the hottest investments of the decade: Commodities. So many commodity ETFs have been showing up on trade screens over the past few years, it almost makes you wonder whether ETF buying of commodities will signal the last hoorah for the commodity boom. If the old investing adage that retail investors, sometimes known on Wall Street as the “dumb money,” are typically the last ones to buy in a booming market, then perhaps this is the end for commodities... or maybe not. Only time will tell. In the meantime, why not take a look at a popular Gold ETF (GLD) or one for Silver (SLV)? If you are interested in Agriculture, a brand new ETF, which debuted on January 5, 2007, is the PowerShares DB Agric (DBA).

And who can forget about perhaps the most hyped bull market of the past five years, namely energy. There are plenty of ways to trade the energy market using ETFs. Popular ones include the Oil Service Holders (OIH), the Energy Select Sector SPDR (XLE), the iShares Dow Jones US Energy (IYE), and the iShares S&P Global Energy (IXC). There is also the U.S. Oil Fund (USO) which debuted on April 10, 2006, making it the newest kid on the block among the energy ETFs previously mentioned. A more in depth analysis of the USO will be subsequently discussed.

If you are interested in investing in ETFs, please do not forget to do your homework on these to determine their suitability for your investment needs. Yahoo! Finance is a popular site with plenty of free information. You could also check out ishares.com and powershares.com, which provide scores of ETFs to could invest in. The two mutual fund giants, Vanguard and Fidelity, also offer a variety of Exchange Traded Funds. Among other things, be sure to check out the liquidity on these ETFs. Some trade very few shares each day. Also, do you homework on which stocks or commodities actually make up these ETFs. And, perhaps most importantly, compare the ETF’s percentage gain or loss to the sector, industry, country, commodity, etc. that it tracks. If the area that it tracks has outperformed the corresponding ETF over a certain period of time, that is a telling sign about the quality of the ETF you are investigating. Here is one such example:

As previously mentioned, there are a number of ETFs leveraged to energy, but the United States Oil Fund (USO) is unique in that it is the only one whose daily percentage change in price is designed to closely correlate with the spot price of WTI light sweet crude oil, more commonly known as the price of oil as reported in the press. As a result of this correlation, if WTI light sweet crude oil goes up 2% in one day, you will see a roughly equivalent rise in the price of the USO.

Since oil reached its high of roughly $77 in the July of 2006, both the price of crude oil futures and the price of the USO have retreated. What is notable, however, is that as of January 10, 2007, the price of the USO has retreated approximately 39% from its summer high, whereas light sweet crude oil futures are down roughly 29.9%. What caused this disparity? In one word: Contango.

Contango is when future months’ contract prices exceed the front month’s contract price of a commodity. The front month contract is the nearest upcoming month available to be traded. For example, currently, the front month light sweet crude oil contract on the New York Mercantile Exhcange (NYMEX) is the February 2007 contract. It closed today, January 10, at $54.02. The March 2007 contract closed today at $54.96. Looking out to July 2007, you will see the contract closed today at $58.17. This is significant because in a perfect market, the next month’s contract price would close at the same price as the front month’s contract price on expiration day (the day that the front month contract expires). However, this has not been happening with crude oil. Front month crude prices have been consistently closing higher than the front month contracts on expiration day. Sometimes, the spread between the two contracts has been as high $2-$3. What has then been happening is that once the future month contract becomes the current month contract, oil gaps higher the next day. Suddenly, it is worth more. However, this is not happening to the United States Oil Fund (USO). Therefore, crude oil gaps higher while the USO does not. Furthermore, when the NYMEX traders sell oil over the next few days to bring the price down to where it should be, the USO unjustly declines as well. This is where the disparity between the two is found.

One might think this is an easy problem to solve; simply price the USO higher the day after expiration of the light sweet crude oil front month contract. However, this will never occur because too many investors would be aware of the repricing that would occur and would buy the USO on expiration day to make free money once it gets repriced higher overnight. Therefore, it appears that under current conditions, the USO is doomed. In fact, if light sweet crude oil were to continue trading within a range, similar to the one of the past six months, it is conceivable to think that the USO would forever underperform the futures price of light sweet crude. Of course, it likely could never go to $0 because the fund would own crude oil contracts that would be worth something. However, if light sweet crude oil stays in a trading range, buying the USO as a long term investment may not be the smartest way to play the energy market.

In summary, ETFs are a rapidly growing, attractive investment vehicle that should be given consideration for any portfolio. But, just like any investment, due diligence is needed to determine which ETFs are suitable for each individual’s investment interests.