ETFs – Why the Easiest Investment Isn’t Always the Best Investment

Here’s something that may interest you.

It’s a way to invest in shares without having to do all the hard work of researching individual companies.

We don’t recommend it for everyone. But if you want stock market exposure without taking big risks, here’s a simple way to go about it…

Have you ever heard of Exchange Traded Funds (ETFs) ? They are hugely popular in the U.S. and U.K.

An ETF is a basket of stocks that trades as a single share. In the old days (10 years ago) a fund manager would buy a whole bunch of popular shares, parcel them into a fund and then list the fund on the stock market. And that was it.

The fees were – and in many cases still are – very cheap. Simply because once they set up the ETF, the fund manager didn’t have to do anything. The price of the ETF shares would rise and fall according to the performance of the individual shares in the ETF.

But now, some ETFs are getting more and more complicated (and don’t often do what they’re designed to do). But since more are coming to Australia, it’s worth taking the time to look at whether they’re a good investment or not.

In a recent issue of Money Morning, I wrote about the BetaShares U.S. dollar ETF. It tracks the performance of the U.S. dollar against the Australian dollar. It’s a handy way to diversify your portfolio away from Aussie dollars.

But today I thought we’d look at something closer to what we do in Australian Small-Cap Investigator. That is, whether you can use ETFs to make small-cap gains…

Looking at ETFs
 

One benefit of an ETF – in theory – is that you can invest in one stock to give you exposure to a whole bunch of companies. So you get the benefits of index investing (passive investing, low cost) with the benefits of stock selection and active funds management (you get the best companies, not just the index).

Let’s show you an example. A U.S-based company has set up a fund called the IQ Australia Small-Cap ETF [NYSE: KROO].

But with any ETF, you have to see if the fund can actually do what it says. In this case, KROO tracks the performance of an index of small-cap stocks. But what’s in the index? Have a look below and see for yourself:

top holdings

 

Sector allocation

 

On a sector-by-sector basis, the fund actually looks diversified. Over 32% of the stocks are materials stocks (probably resources like coal and iron ore). There are a few consumer stocks (what I’ve called main street stocks in the past because they’re unassuming and you see them every day…yet they spin out cash dividends and good share price gains if you buy them when nobody wants them).

All up, there’s a bit of everything really, which seems okay.


But is It?

 

 

If you look at the top holdings, you’ll see some interesting things. For example, the single largest holding (as of early February) was UGL Ltd. UGL is a company with a $2 billion market cap that generates $5 billion in annual sales.

It manages assets for blue-chip clients, including engineering and industrial assets and facilities. In mid-January, it announced five new or renewed contracts worth $190 million dollars.

The second largest holding in KROO is Ansell. Ansell makes latex products, including rubber gloves and condoms. Ansell is a $2 billion company.

They may be good companies. But they aren’t what we would call small-cap stocks.

That’s why you should always look at the fact sheet and the prospectus for an ETF. It will tell you what the ETF invests in, how it invests (whether it uses leverage, for example) and how the ETF has done.

KROO contains many interesting and different companies. That is one of the great benefits of small-caps: you can invest in any kind of business. And the one thing all great small-cap investments have in common is they have the potential to grow quickly.

And even better, the share price can go up quickly as the business improves… whatever it does. Whether it’s condoms or railways… it doesn’t really matter!


Diversification Isn’t Always Safe

 

 

The trouble is, with an index, you get diversification but not necessarily safety. The purpose of diversification is to spread your risk and give you access to more winners. But if the fund selections are too diverse (and the management fees too high) the losers cancel out the winners, or worse.

We believe you can do MUCH MUCH better picking individual stocks. And rather than picking a lot of them (the KROO ETF must own at least 50 stocks if the top holdings are only about 2% of the total portfolio size), we believe you’re better off investing in just a handful.

The truth is, most portfolios have one or two stand out performers that drag the performance of the whole portfolio up. If you could, you’d only ever buy the stand out performers! But of course, you can never know in advance which they’ll be. So most investors buy many stocks, spread their risk, and hope for the best.

Our view is that you should try and figure out what the stand out performers have in common. That’s what we try to do in Australian Small Cap Investigator. You’re after exciting companies that are trying to do something great or new and make a mint as they do.

ETFs are a useful way to diversify a portfolio or to gain access to stocks or markets you can’t easily invest in. But you shouldn’t use them as your primary investment vehicle. For that, nothing beats hard work, research and picking individual stocks.

In our experience, that’s the only way you’ll consistently beat the market.

Cheers.

Kris.

Publisher’s Note: Kris Sayce will be appearing at After America: the Port Phillip Publishing Investment Symposium, March 14th-16th at Sydney’s Intercontinental Hotel.

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Port Phillip Publishing, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.


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