SMSF Investment StrategiesSharing Simple Strategies for Self Managed Super Funds

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Alternative Investments 2 – Exchange Traded Funds

In my earlier blog on April 30, I talked about using Exchange Traded Funds (ETFs) to gain exposure to gold and silver without the hassle of having to store the physical commodity. ETFs can be used to gain targeted exposure to a class of investments while maintaining diversification to manage individual company risk. For example, after the Lehman Brothers bankruptcy on 15 Sept 2008, all financial stock prices took a dive. My view was that not all financial companies are the same and unless our entire financial system collapses, the strong ones will buy up the weak ones and become even stronger when the dust settles in this global financial crisis. However, I wasn’t sure which ones would be the winners and which ones would be the losers. In late October 2008, prices began to stabilise so I looked at getting into some financial stocks. I considered buying direct shares in one of the stronger companies like Bank of America (BAC) which was holding up very well at the time, or buying XLF, a financial sector ETF which consisted of a basket of financial shares, including BAC. I decided to buy XLF because it gave me diversification while remaining focused on the financial sector. I was really glad I did that because due to a bad decision to purchase Merill Lynch, BAC shares fell 88% from 22.50 to a low of 2.50  in the following months (see chart below).

XLF also tumbled 60% from $15 to a low of $6 in March 2009 (see chart below) so my worst unrealised loss was 60% with XLF vs 88% if I had bought BAC. At the time of writing, financial stocks have recovered substantially and my XLF investment is still showing a 20% loss compared with a 55% loss for BAC. As a small investor with limited resources for research, I find ETFs an easy low cost means of getting exposure to specific areas of interest e.g. sectors, countries, bonds, currencies, commodities, etc while keeping risks manageable.

There are many other reasons why I like ETFs. Among the reasons are:

- they are low cost because they usually mirror an index so there is no need to have expensive fund managers to actively manage the funds.

- they can be bought on the stock exchange yourself without going through a financial advisor who would of course charge you fees for doing it for you.

- they are better than mutual funds for tax purposes because you can control when you pay capital gains or take capital loss. In mutual funds, when someone in the fund sells their units, any capital gains will be distributed to all members in the fund that year. With ETFs, you pay capital gains only when you sell your units.

ETFs are very popular in the US and they are hundreds of them available with new ones being added all the time. In Australia, they have yet to gain mainstream acceptance. ETFs are not actively promoted by financial planners and advisers because they do not make any commissions for recommending these products. I am only aware a handful of ETFs that traded on the ASX, and they are provided by:

1) Ishares, a leading global provider of ETFs which until recently was owned by Barclays Global Investors and

2) State Street Global Advisors (popularly know as SPDRs).

Vanguard, another leading global provider of ETFs has announced in March 2009 that they plan to launched ETF products in Australia.  Although the trading volumes are not very high in these ETFs,  the price is based on the price of the underlying stocks but a lack of liquidity can cause quite a wide spread in bid/ask price. Until ETF popularity picks up, I still prefer to buy ETFs on the US stock exchange. Popular ETFs like XLF and GLD mentioned before trade with bid/ask spreads of 5 cents or less! They are also optionable which allows you to sell options to increase your returns as discussed in my April 24 post.

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