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Hello and welcome to Financial Audio, an information series providing listeners with detailed and tactical guidance on today’s complicated financial world.  My name is Patrick and I’m your host.  You can find written versions of these podcasts at FinancialAudio.com and I encourage your candid feedback at the same location.  Today, we’ll be looking at a phenomenon that’s taken parts of the stock market industry by storm so let’s get started.

We’re talking about Exchange Traded Funds or ETFs for short.  Back in the forth chapter, we discussed the fact that at least 70% of the stock market’s volume is institutional and by “institutional”, we’re talking about large insurance funds, pension funds and mutual funds.  Well, there’s also another player in town and it’s the Exchange Traded Funds.  With all the money pouring into these ETFs these days, they’re accounting for more and more volume every day.  We’ll be looking at these in detail today but first, I think it makes sense to start with a definition.

An Exchange Traded Fund is essentially an open-ended fund that attempts to mimic a particular index, country, sector or grouping of stocks according to a predetermined set of rules.  So, let’s say we’re talking about an ETF that follows the largest 100 companies being traded on the NASDAQ stock exchange.  In fact, there IS such an ETF and it’s commonly referred to as the QQQ.  Actually, there are a bunch of ETFs that follow the NASDAQ 100 but the QQQ is the best known and the most heavily traded.

Anyway, people can invest money into the QQQ and their money will automatically be distributed over the NASDAQ 100 in proportion to their individual market capitalizations.  Well, that sounds a lot like a mutual fund, doesn’t it?  Indeed, it’s similar but there are a bunch of major differences.

For starters, mutual funds are managed by professional money managers and frequently have expense ratios in the 2% to 3% range.  These money managers try to beat regular market returns but the evidence shows the vast majority of mutual funds UNDER perform the market.  In other words, they get returns LOWER than the general market so an investor would get better returns investing in the general market than by selecting one mutual fund over another.  Sad but true.  Let me say it again.  The vast majority of mutual funds UNDER perform the market.  Now, there are a number of mutual funds that mimic a particular index just like an Exchange Traded Fund but the high expense ratio remains, eating into the funds’ returns.

Exchange Traded Funds have extremely low expense ratio because they’re not managed by professional money managers in the same way.  In fact, for most transactions, there’s nobody involved at all.  It’s just a computer.  So for the QQQ, the money that gets invested is passed along to actual stocks automatically.  No humans required.  Yes, ETFs are managed by somebody but the involvement is far lower.

These ETFs also rebalance automatically so if one company is doing well and the stock price is rising, that would mean its market capitalization is also growing which means it accounts for a larger proportion of the ETFs automatic distribution.  In other words, because the distribution of invested funds is based on market capitalization, the stocks that are doing well automatically get heavier weights as their values rise.  Likewise, when a company starts doing poorly, its market capitalization drops along with its stock price and it automatically gets a lower weighting within the portfolio.

This is no different from the way indexes work.  Capital allocation based on individual market capitalizations is common but it’s worth noting because it DOES benefit the investor.  In other words, if you took the returns of each company represented in a particular index and averaged them, you would get a return slightly LOWER than that of the index as a whole.  The reason for this is because of the accommodation that takes place based on changing market capitalizations.  Admittedly, the difference would be very small but that doesn’t change the fact.  No matter how small the difference is, it’s STILL a benefit.  And besides, it’s interesting and that’s why I mention it.

One of the biggest differences between mutual funds and ETFs is the fact that ETFs are traded on the stock market as if they were stocks themselves.  So the QQQ trades on the stock market and you can purchase one share or 100 shares or 1000 shares.  You can buy these shares any time you like and you can sell them any time you like as well.  As of this writing, the QQQ is trading around $45 per share but it’s traded as high as $120 in early 2000 and as low as $20 in late 2002 – and that demonstrates the magnitude of the dot-com bust, by the way.  Amazing.  $120 all the way down to $20.  That was an incredible correction.  We’re talking about the 100 largest companies on the NASDAQ losing an AVERAGE of 83% of their value in just 2½ years!  Anyway, the point is you can invest just $45 today and buy one share of the QQQ and that will give you a tiny piece of the top 100 companies trading on the NASDAQ.  On the other hand, most mutual funds usually require minimum investments of $1000, $2500 or even $5000.  Meanwhile, ETFs have absolutely NO fees either.

Again, the evidence is that most mutual funds (that don’t mimic an index) UNDER perform the market while ETFs follow the market exactly, meaning they OUT perform the vast majority of mutual funds.  And with some of these other advantages to boot, you can imagine the popularity ETFs have enjoyed in recent years.  And the beauty is they can be created according to any set of rules people are looking for.  Today, you can get ETFs for large companies, mid-sized companies and small companies.  You can get ETFs for growth stocks or value stocks (remember; growth stocks are those with high P/E ratios).  You can get ETFs for virtually any industry sector and you can get ETFs for different countries around the world.  In fact, you can even get ETFs that will automatically rotate in and out of different sectors according to which ones are doing well and which ones are doing poorly.

At the beginning, I said these ETFs are accounting for more and more volume in the stock markets these days so let’s look at exactly how much money is involved here.  As of this writing, the average daily volume for the QQQ is 120MM shares.  And with a current trading price of $45 per share, we’re talking about $5.4B being traded each day and that’s ONLY through the QQQ.  That means the QQQ re-balances $5.4B within the NASDAQ 100 every single day.  The total market capitalization of the QQQ is almost $18B.  If you just did the straight division, it would equate to $180MM worth of ownership in EACH of the top 100 companies on the NASDAQ.  And keep in mind, there are over 400 ETFs available in the market today.  Now, in fairness, the QQQ is one of the most heavily traded Exchange Traded Funds but you get the idea.  These ETFs control an enormous amount of money and it’s growing every day.

Let’s stop there for a moment, take a step back and discuss the concept of diversification.  When you have just one stock, you increase your risk dramatically.  The stock could jump up unexpectedly – that would be good news.  Or the company could have some bad news and see their stock tank in a single day.  As you spread your money around, you reduce the overall risk because some of your stocks will have good news while others have bad news.  Admittedly, you’ll temper the gains of a stock jumping up but you’ll also lessen the loss from a stock tanking unexpectedly.

Now, there are two types of risk.  There are risks associated with one particular stock and there are wider risks associated with the entire group the stock’s a part of.  For example, consider a local fishing industry.  The risk of each individual boat is that it may hit a rock, resulting in a hole in the hull and making the boat useless for the rest of the season.  Obviously, if this boat were a publicly traded company, the stock would fall through the floor.  The risk for the entire local industry is that, perhaps, over fishing in recent years dramatically reduced the number of remaining fish and all the boats can expect lower hauls than in years past.  In the stock market, this would negatively affect all stocks in that particular fishing industry.

When you buy many different stocks, you diversify away the individual risks but you can’t diversify away the industry or market risks.  The point is you can never eliminate risk all together but you CAN reduce it.  Mutual funds provide that benefit and so do ETFs but ETFs do it while generally providing better returns, lower buy-in requirements and far less fees.  That makes ETFs a great way to participate in a particular market segment without taking on unnecessary risks or investing enormous amounts of money.  It also allows you to participate without being locked in.  You can buy in or sell out on a moment’s notice.

Remember back to the chapter about BigCharts.com.  On that platform, there was an Industry tab that displays the top performing industry sectors.  Well, you could easily check that website and then select an ETF that represents that particular industry and invest your money, all within a minute or two.  Then, you could monitor the site on a weekly basis and rotate your money out when the leading industry starts slowing down, replacing it with whatever industry takes over.  That way, you benefit from diversification while keeping your money invested in the leading market sector at all times.

Now again, I just mentioned some of the newest ETFs are designed to do this automatically and I’m sure they’ll do a good job.  My point is; you can do this stuff yourself as well.  It’s good to understand exactly what’s going on and a simple ETF rotating between sectors is a great strategy, regardless of who executes the actual trades.

The business of ETFs has gone far beyond just countries, market capitalizations and industry sectors.  There are now ETFs that actually magnify the returns of the market.  This can easily be done by using financial options.  We’ll be discussing options in a later chapter but the point is you can now purchase ETFs that mimic 200% of the market’s movement, either up or down.  So if the market goes up by 1%, your investment would go up by 2%.  Likewise, if the market drops by a percent, you’ll lose 2.  If you remember the variables from the Money Central Deluxe Stock Screener, these ETFs automatically give you a BETA of 2.  They double the normal market volatility.

Using similar techniques, some ETFs actually reverse market movement.  So you can actually profit when the market goes DOWN.  Of course, people always have the option to sell SHORT and we’ll talk about that in a future chapter but there are certain types of accounts that don’t allow short selling.  Retirement accounts like 401Ks or IRAs, for example, do NOT allow short selling.  And while the intention is good, it stops investors from profiting while the market is dropping.  Using these new innovative ETFs, you can invest LONG – meaning you profit when the ETF goes up – but know it’s designed to go UP when the market’s going down.  Let me explain.

Consider an ETF that mimics the OPPOSITE of the market’s movement.  So if the market goes up by 1%, this ETF would go DOWN by 1%.  And if the market goes down, the ETF goes up.  Taking it further, you can buy some ETFs that mimic the opposite AND magnify the market’s movement so a 1% drop in the market would translate into a 2% gain with the ETF.  This provides some great ways to profit on both sides of the market, EVEN in your retirement accounts.

Let’s take a look at some specific examples.  Of course, we’ve already talked about the QQQ and that’s one of the most heavily traded Exchange Traded Funds available today.  But there are a couple providers that have entire menus of ETFs based on a wide variety of criteria and we’ll introduce two of those now.  Let’s start with iShares.com – if possible, get in front of a computer and go to iShares.com.  Again, it’s iShares.com.  You’ll see a menu on the left hand margin with headings including Market Cap, Style (like growth versus value), Sector or Industry, International, Specialty or Real Estate, Fixed Income and Commodities.  Each of these headings includes a variety of ETFs on any number of different criteria.  Look through them.  It’s fascinating.

Now, let’s go to ProShares.com.  Again, that’s ProShares.com.  Here’s another provider of ETFs but these guys have taken it to the next level.  These are the guys providing the magnified and market-reversing ETFs.  Once you get to the site, click on Products and you’ll see the day’s results for their major ETFs.  Next, click on Resources and scroll down to Product Literature.  Open the PDF labeled ProShares Product Guide to see the full list of their ETFs.  You’ll notice the first page has all their ETFs that do NOT reverse market returns and the second page shows all their ETFs that DO reverse market returns.  In both cases, the level of magnification is listed for each ETF.

Exchange Traded Funds are an incredible tool for refining your investment strategy, maintaining good returns and minimizing unnecessary risks.  Their popularity is growing quickly and we can expect more innovative options in the future.  In fact, I’ll bet some of these ETFs will soon be built on technically-based automated trading platforms and the competition will shift to the profit factor and percentage of correct trades.  We’ll talk more about that in the chapter on automated trading platforms.  In the meantime, visit iShares.com and ProShares.com and take a look around.  These are fascinating products and you can incorporate some of them in your investment strategy TODAY.

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Again, you can find written versions of these podcasts at FinancialAudio.com and I do offer workshops, seminars and keynote speeches as well as a variety of more advanced information products so please email me at Patrick [at] FinancialAudio.com for more information.  I’m also doing a series on innovative marketing and strategic business positioning.  That series is called Tactical Execution and you can find it on iTunes.

Stay tuned.  There’s a lot more to come.  In the meantime, think big, take action and invest strategically.  Bye for now.