The ETF Book E-Book

Richard A. Ferri

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 534

Veröffentlichungsjahr: 2011

Beschreibung

Exchange-traded funds (ETFs) are revolutionizing the investment industry. From their introduction in 1993, ETFs have expanded exponentially over the past fifteen years. You, as an informed investor, need to know what makes ETFs unique, how they work, and which funds may help you achieve your financial goals. The updated edition provides the most current look at the ETF market, where the number of funds has doubled since the book first published in December 2007. A huge number of bonds funds, commodities funds, currency funds, leverage and short funds have been introduced. In addition, actively managed ETFs are here now, and some major mutual fund companies, like Fidelity and PIMCO, are getting into the market. Remarkably, the terminology in the ETP marketplace is also evolving at a rapid pace. The acronym ETP for exchange-traded product has become an industry standard. The term did not exist two years ago. Written by veteran financial professional and experienced author Richard Ferri, The ETF Book, Updated Edition gives you a broad and deep understanding of this important investment vehicle and provides you with the tools needed to successfully integrate exchange-traded funds into any portfolio. This detailed, yet clearly articulated guide contains the most up-to-date information on navigating the growing number of ETFs available in today's marketplace. Divided into four comprehensive parts, this guide addresses everything from ETF basics and in-depth fund analysis to the tax benefits of using ETFs. Included are a variety of portfolio management strategies using ETFs and examples of different model portfolios that you can easily adapt to your own investment endeavors. Whether you're just getting started or are a seasoned ETF investor, The ETF Book, Updated Edition will help enhance your understanding of this evolving field by: * Examining the fundamental differences between exchange-traded portfolios * Highlighting how to effectively implement a wide selection of ETFs?from * Exploring specific ETF strategies?from buy and hold to market timing and sector rotation * Introducing Index Strategy Boxes?a new way to understand index construction and how a fund is investing your money * And much more Each chapter of The ETF Book, Updated Edition offers concise coverage of various issues. It is filled with in-depth insights on different types of ETFs and practical advice on how to select and manage them. The appendixes are an added benefit, offering an ETF Resource List, which will point you to more places for information on these structures, and a detailed Glossary to help you with industry-specific definitions. The ETF Book, Updated Edition is an invaluable road map for developing a winning investment strategy. Armed with the knowledge found throughout these pages, you'll be prepared to build a solid portfolio of ETFs that will benefit you for years to come.

Leseprobe

Contents

Foreword

Acknowledgments

Introduction

Part I: ETF Basics

Chapter 1: ETFs from Evolution to Revolution

ETFs Are a Growth Industry

A Short History of Mutual Funds

The Future of ETFs

Summary

Chapter 2: The Nuts and Bolts of ETFs

Acts like a Fund, Trades like a Stock

Closed-End Fund Issues

ETFs to the Rescue

Summary

Chapter 3: Types of Exchange-Traded Portfolios

The Expanding Exchange-Traded Universe

Putting It All Together

Summary

Chapter 4: ETF Benefits and Drawbacks

The Positive Aspects of ETFs

The Negative Aspects of ETFs

Guide to ETF Characteristics

Summary

Chapter 5: Actively Managed ETFs

The First Filings

Not Quite Open-End Active

Advantages of Actively Managed ETFs

Disadvantages of Actively Managed ETFs

Summary

Part II: Indexes That ETFs Follow

Chapter 6: Benchmark Indexes and Strategy Indexes

A Definition of Benchmark Indexes

A Definition of Strategy Indexes

Characteristics of a Good Benchmark

Details of Benchmark Indexes

Details of Strategy Indexes

A Different View on Indexes

Summary

Chapter 7: Index Strategy Boxes

Indexes Follow Rules

Index Strategy Boxes

Benchmark Indexes and Strategy Indexes

Summary

Chapter 8: Index Security Selection

Security Selection Categorization

Passive Security Selection

Screened Security Selection

Quantitative Security Selection

When One Selection Method Does Not Fit

Summary

Chapter 9: Index Security Weighting

Capitalization Weighting

Fundamental Weighting

Fixed Weighting

Modified Security-Weighting Schemes and Style Biases

Summary

Part III: ETF Styles and Choices

Chapter 10: Broad U.S. Equity and Style ETFs

Broad Market Benchmarks and Style Components

Benchmark Index ETFs

U.S. Equity Strategy Index ETFs

Sample List of Broad U.S. Equity and Style ETFs

Chapter 11: Global Equity ETFs

Advantages of Investing Internationally

Disadvantages of Investing Internationally

Broad International and Global Market Benchmarks

International Strategy Indexes

Global and International ETFs List

Summary

Chapter 12: Industry Sector ETFs

The Evolution of Industry ETFs

Industry Sector Categorization

Industry Strategy Indexes

REIT ETFs

A Partial List of Industry ETFs

Summary

Chapter 13: Special Equity ETFs

Thematic Investing

Actively Managed Indexes

Leveraged and Short Beta ETFs

Hedging with ETFs

Special Equity ETFs List

Summary

Chapter 14: Fixed Income ETFs

Bond Market Structure

Treasury Indexes

Mortgages

Asset-Backed Securities

Investment-Grade Corporate Bonds

High-Yield Corporate Bonds

Composite Indexes

Barclays Aggregate Bond Index

Municipal Bond ETFs

International Fixed Income ETFs

Preferred Stock ETFs

Fixed Income ETF List

Summary

Chapter 15: Commodity and Currency ETFs

Commodities Basics

Commodity ETFs

Commodities Indexes

A Progression of New Funds

Disadvantages of Commodity ETFs

Currencies

The Future of Futures ETFs

Commodity and Currency Fund List

Summary

Part IV: Portfolio Management Using ETFs

Chapter 16: Portfolio Management Strategies

Passive Investing

Life Cycle Investing

Active Portfolio Strategies

Special Strategies and Uses

Tips for ETF Investors

Summary

Chapter 17: Passive ETF Portfolios

Buy, Hold, and Rebalance

Core and Explore

Realistic Returns from Passive Portfolios

The Forecast

Summary

Chapter 18: Life Cycle Investing

Life Cycle Models

ETF Portfolios for Each Stage

Summary

Chapter 19: Active Portfolio Management with ETFs

Nominal and Risk-Adjusted Returns

Top-Down Strategies

Momentum Investing

Technical Analysis

Prudence Is Recommended

Summary

Chapter 20: Special Portfolio Strategies

Unique Characteristics of ETFs

Using ETFs to Reduce Industry Risk

Pairs Trading and Market-Neutral Strategies

Currency Hedging and Speculation

Tax Loss Harvesting

Future ETF Strategies

Summary

Chapter 21: Operational Tips for ETF Investors

Selecting a Custodian

Trading ETF Shares

Asset Location Tips

Rebalancing ETFs

Hiring an Investment Manager

Summary

Appendix A: Index Strategy Box Abbreviation Guide

Appendix B: ETF Resource List

Glossary

Index

About the Author

Books by Richard A. Ferri

The ETF Book

All About Index Funds

All About Asset Allocation

Protecting Your Wealth in Good Times and Bad

Serious Money: Straight Talk About Investing for Retirement

Copyright © 2008, 2009 by Richard A. Ferri. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data

Ferri, Richard A.

The ETF book: all you need to know about exchange-traded funds / Richard A. Ferri; foreword by Don Phillips.

p. cm.

Includes indexes.

ISBN 978-0-470-53746-6 (cloth)

1. Exchange traded funds. I. Title.

HG6043.F47 2009

332.63’27–dc22

2009017153

The ETF Book is dedicated to all the brave men and women in the armed forces who protect our country, our freedoms, and our way of life. They give everything and ask for nothing except our unwavering support.

The author’s royalties from the sale of this book are donated to a nonprofit organization assisting wounded veterans and their families.

Semper Fi

Foreword

There’s no topic in personal finance today that’s hotter than exchange-traded funds (ETFs). Diehard believers in passive investing love the low costs and broad diversification available through ETFs. Traders and market timers love the ability to buy and sell on an intra-day basis, and they cherish the growing number of highly specialized offerings that allow them to execute far more sophisticated strategies than ever before. Even active managers are getting in on the scene, using ETFs to “equitize” their cash positions and imagining a future where actively managed ETFs will be widely available. Never before have so many investors embraced a financial concept so rapidly and for such a wide variety of reasons as they have with exchange-traded funds.

The ETF phenomenon is perhaps most revolutionary from the individual investor’s perspective. For years, there was a gulf between what was possible for institutional investors and what the little guy could do. Like many small investors, I recall reading about the global wanderings of legendary investor Jim Rogers, author of Investment Biker and other significant investment books. Rogers would observe global events and turn them into investment ideas, often shorting certain currencies, going long various commodities, and making bets on specific subsectors of a market, such as Japanese small companies. I was dazzled by his insight but was frustrated by my own inability to act upon such insights even if I could be as clever as Rogers in identifying them. Sure, I could buy shares in an international equity fund or a precious metals fund, but I couldn’t be sure that the fund’s manager was making the bets that I wanted. And even if I did identify a manager who seemed to have his portfolio aligned the way I wanted it to be, there was no guarantee that positioning would stay in place. Simply put, there was no way that I could do what Rogers did, even if I had the right ideas.

Exchange-traded funds have changed all that. Today the toolkit available to individual investors is bigger and better than ever before. Highly specialized precision investment instruments are now part of the small investors’ arsenal. If you want to bet on the fortunes of pharmaceutical stocks or regional banks, there’s an ETF for you. If you want to play the real estate market, there are multiple ETFs available for that purpose, investing in either domestic or international real estate. If you want to bet on companies that might find a cure for cancer or invest only in companies that don’t do business in Somalia, there’s an ETF for you. If you want to bet on companies known for innovation, ones that are leaders in their field, or ones that are followed by only a small number of analysts, there’s an ETF for you. And all of these bets can go in either direction, as ETFs can be bought long or sold short. There’s little to no limit to what an investor may do today; almost any choice is possible.

Of course, more choices don’t guarantee better results. Some highly respected investment commentators, most notably Vanguard founder Jack Bogle, have criticized the narrow focus of many ETFs and the overall push toward more frequent trading that some investors adopt when given greater opportunity to adjust their portfolios. Indeed, the basic concept of indexing is to buy and hold the entire market, something that seems at odds with the product proliferation and intraday trading of ETFs. So, while ETFs benefit from the goodwill created by the index movement, they can clearly be used for purposes that range far from the basic premise that underlies indexation. Bogle graphically captures the dual possibilities of ETFs when he likens them to a finely honed shotgun that can be used either for survival or for murder.

The reasons that ETFs have become so specialized so quickly are easy to understand. In the actively managed fund world, every shop can have its own broadly diversified large-cap stock fund, as the chance that it may outperform may make it an economically viable offering. In the ETF world, where passive strategies dominate, there’s less reason for each shop to have a broad-based equity index fund. Once a handful of these funds exist, there’s little reason for more. Accordingly, newer players in the market move quickly to fill more esoteric niches in order to be the first player in a new part of the market. The result has been a rush toward producing more narrowly defined funds that tend to have higher volatility than broadly diversified ones. Indeed, the volatility of the ETF market has moved systematically higher over the past decade, with the most volatile offerings, ones that leverage or short the market, coming in the past 12 months.

Call it the dark side of choice. With greater fragmentation comes greater volatility. Take a look at the quarterly leaders and laggards lists that many personal finance publications run. You’ll see that ETFs take up a disproportionate number of slots on lists that combine ETFs with open-end funds. Sadly, these funds that soar way to the top and then crash to the bottom are the very funds that investors are least likely to deploy successfully. We’ve done a lot of work recently at Morningstar concerning what we call investor returns. Simply put, investor returns take into account investors’ purchases and sales to determine collectively how much money funds actually make for their shareholders. What we’ve found is that highly specialized funds tempt investors to buy high and to sell low, producing bad performances. Investors fare far better with more broadly diversified offerings, such as the traditional balanced mutual fund or a total stock market index fund. Bogle’s warnings about the potential for misuse of ETFs should not be ignored. Power tools can help a skilled carpenter create beautiful furniture. They can also cause an amateur to lose a finger.

So what’s the individual investor to do? On one hand, there’s reason to rejoice that many of Wall Street’s artificial barriers are coming down. On the other hand, many of those barriers offered valuable protections that may be missed. I think that the only solution is to recognize that ETFs are here to stay and to plot a prudent path. And it always helps to have a reliable guide when exploring new terrain. There are few more able navigators than Richard Ferri. Rick is a fee-only investment adviser who knows the ins and outs of asset allocation, wealth protection, and index funds. He’s a great choice to help investors evaluate the growing number of ETF choices. In The ETF Book, Rick covers the nuts and bolts of ETFs, the nuances of index creation, and even strategies for putting into place a financial plan based on ETFs. He even goes so far as to suggest an innovative new means of classifying and thinking about these new vehicles. In short, he’s done the heavy lifting and the background research that investors need to go forth knowledgably into this exciting new world.

I think investors will benefit from this book. Its portfolio focus is refreshing amid the sea of get-rich-quick hype that too often distracts investors from their mission. Rick is a prudent and thoughtful investor who clearly has his readers’ best interests at heart. Whether you’re brand new to ETFs or you’re already a seasoned veteran, Rick is exactly the kind of informed guide you want by your side. Safe travels!

Don Phillips

Managing Director

Morningstar, Inc.

Acknowledgments

The ETF Book could not have been written without the support of a large number of people. I truly appreciate the advice, guidance, and inspiration from those mentioned here and those I may have accidentally left off the list. Several people contributed directly to the success of the book while others contributed indirectly through their published writings and informative personal conversations that I had the pleasure to engage in.

Special thanks goes to Don Phillips of Morningstar, who provided the wonderful foreword. In alphabetical order, I appreciate the help of Dr. David Blitzer of Standard & Poor’s, Robert Brokamp of the Motley Fool, Ron DeLegge of ETFguide.com, Srikrant Dash of Standard & Poor’s, Matt Hougan of Indexuniverse.com, Dodd Kittsley of Barclays Global Advisors, Ron Krisko of the Vanguard Group, Tom Lydon of Global Trends Investments, Christian Magoon of Claymore Securities, Brian Megibbon of Citigroup Global Markets, Richard Ranck of PowerShares, Tony Roache of State Street Global Advisors, Scott Salaske of Portfolio Solutions, Robert Tull of MacroMarkets, Jim Wiandt of indexuniverse.com, Brad Zigler, and of course, all the Bogleheads.

Introduction

Look up in the sky! . . . It’s a bird! . . . It’s a plane! . . . No, it’s Exchange-Traded Funds!

Exchange-traded funds are flying high. Better known by the acronym ETFs, each week new funds are launched on Wall Street exchanges and land in the portfolios of investors across the nation. While the hype surrounding an ETF launch may not compare to the glitz of an action-packed Superman sequel, some promoters of these investment vehicles make it sound as if their product could leap tall buildings in a single bound. A few ETF companies have even attempted to empower their funds with superpower-sounding names such as PowerShares, WisdomTree, ProFunds, and XShares.

Are PowerShares powerful? Are WisdomTree funds a wise investment choice? Do ProFunds perform like pros? Well, that remains to be seen. What we do know is that ETFs are an important evolution in the investment industry that may help you achieve financial success, and for that reason astute investors are learning all they can about them. The ETF Book gives you a broad and deep understanding of this revolutionary investment structure and provides the tools needed to become a more successful investor.

ETFs have many advantages and a few disadvantages over traditional open-end mutual funds. The advantages range from lower investment costs to increased trading flexibility. The disadvantages include a commission cost on each ETF trade and the arduous task of sorting out all the industry data and jargon (made easier by this book).

ETFs are an important step in an investment revolution that began in 1924 with the first open-end mutual fund offering. Since that time there have been many changes in the mutual fund industry that have been closely watched by a burgeoning regulatory environment.

At their core, ETFs are a simple idea. They represent a basket of securities that you can buy or sell over a stock exchange. However, under the hood, ETFs have a more complex operating structure that require a bit more study to understand and that makes investment analysis and selection more difficult than traditional with open-end mutual funds. Whether ETFs will work for you in a portfolio depends on your dedication to understanding this product and coming to an unbiased assessment of the benefits and drawbacks.

The one criticism that I have about the ETF industry is the unfounded right of superiority that a few ETF companies are claiming. Without mentioning names, some companies are trying to send a message to investors that their ETFs, which are based on complex strategies, will generate significantly higher returns than traditional index funds, which follow long-established benchmark indexes. In addition, a few newsletter writers are urging their readers to sell all their open-end mutual funds and buy only ETFs because they will offer far better returns. Both claims are baseless.

Claims of higher returns from ETFs over traditional open-end mutual funds are grossly exaggerated. There are some savings in cost that can occur over open-end funds, but those savings are not large enough to make a significant difference in returns. Barring any cost differential, there is no reason to expect a basket of stocks to achieve a higher return in an ETF structure than they would return in a traditional open-end mutual fund structure.

Some ETF companies claim they use superior indexing techniques. That is highly debatable. There are many different ways to design the indexes that ETFs follow, but no clearly superior strategy can guarantee consistently higher returns. Simply put, there is no Lake Wobegon ETF company where “the women are strong, the men are good looking, and all the ETFs deliver above-average returns.”

ETFs are not investments per se. They are an account structure. It is what is placed in the structure that matters. Many types of ETF structures have been approved by the Securities and Exchange Commission (SEC). Those structures are operational engines that investment companies use to create and manage many different types of funds. It is not the ETF structure that leads to a return; it is the investment strategy within the ETF that delivers the return.

The important story behind the ETF structure is their unique operations and how those processes can achieve lower overall investment costs, including lower taxes and increased trading efficiency. Those factors could result in increased returns, but that increase should not be overemphasized, and they should not be the sole reason to sell your open-end funds and buy ETFs.

Defining ETFs

Exchange-traded funds (ETFs) are baskets of securities that are traded, like individual stocks, through a brokerage firm on a stock exchange. Shares of ETFs are traded with other investors who are also going through brokerage firms to facilitate their transactions. All-day trading makes ETFs more flexible than their familiar sister open-end mutual funds, where investors must wait until the end of the day to buy or sell shares directly with a mutual fund company.

ETFs can be bought and sold throughout the trading day whenever the stock exchanges are open. Any way you can trade a stock, you can trade an ETF. Shares can also be sold short or bought on margin. That makes these investment vehicles useful for institutional investors and traders who often need to hedge equity positions quickly.

One difference between ETFs and traditional open-end mutual funds is that ETFs do not necessarily trade at their net asset value (NAV; the combined market value of the underlying security and cash holdings). Although the supply and demand for ETF shares is driven by the values of the underlying securities in the index they track, other factors can and do affect ETF market prices. The market price for ETF shares is determined by forces of supply and demand for those ETF shares, and the price occasionally gets off track from the underlying values in the fund. But not by much. ETFs have a mechanism that controls price discrepancy and stops discounts or premiums from becoming large or persistent.

The discrepancy between ETF prices and their underlying values creates a potential profit opportunity for a special set of investors. The market price of an ETF is kept close to its NAV by allowing a few large institutional investors called authorized participants (AP) to buy or redeem ETF shares in kind (using the underlying securities rather than cash). When a small price discrepancy occurs between an ETF and its underlying securities, APs conduct a risk-free arbitrage trade. The arbitrage trade allows APs to exchange individual securities for large blocks of ETF shares and vice versa. The arbitrage mechanism brings the market price of ETF shares in line with the fund’s true value and brings the AP a small profit. The arbitrage can happen very quickly and is effective in keeping ETF shares in line with the true value.

ETFs are organized as open-end mutual funds. However, the companies that issue ETF shares have agreed with the SEC that they will not advertise or market their products as open-end mutual funds or even as mutual funds in general. They are marketed only as exchange-traded funds and exchange-traded securities.

According to the SEC, mutual funds are issued and redeemed by a mutual fund company dealing directly with the public. ETF issuers do not deal directly with the public. They buy and sell only from APs. By regulation, the prospectuses and advertising materials for ETFs must prominently disclose that fact and state that individual ETF shareholders do not buy or sell shares directly with a fund company. When individual shareholders acquire shares on a stock exchange, they are purchasing part of a creation unit owned by an AP.

Sound complicated? Don’t worry. After reading this book you will be well versed in ETF operations. In fact, you will likely know much more about these unique investments than a large number of advisers who are in the financial services business.

Exchange-Traded Products

Several investment products discussed in these chapters are not exchange-traded funds by the strict definition of the term. But those investments do act like ETFs, trade like ETFs, and are often referred to as ETFs in the investment industry. There are many different exchange-traded products on the market today. The Wall Street Journal lists all types under the heading Exchange Traded Portfolios in its “Money & Investing” section. The terms exchange-traded products and exchange-traded portfolios better describe what is covered in The ETF Book.

One example of an investment product that is not a fund by definition is an innovative security from Barclays Bank called iPath Exchange-traded Notes (ETNs). These unique investments are not ETFs; rather ETNs are unsecured debt obligations of Barclays Bank that track the performance of certain market indexes.

Debt usually means interest is paid, but that is not the case with ETNs. These unique securities pay no interest and no dividends, and have no performance guarantees. ETNs track the total return of markets, and investors receive whatever the total return of the market is, minus fees. ETNs trade like ETFs on a stock exchange but are not taxed like ETFs. That is an important distinction that we will discuss in detail in Chapter 4.

There are other types of exchange-traded products that are not technically ETFs. Those securities are also covered in this book. However, for practical reasons, when there is no reason to distinguish these other exchange-traded products from ETFs, they are all referred to as ETFs.

Growth of the ETF Marketplace

The ETF marketplace is growing at a feverish pace, and that growth will likely continue for a number of years. ETF issuance has expanded exponentially every year since 2000. There were over 700 ETFs trading on the U.S. markets by 2008, with assets well over $ 500 billion in investor dollars. That is 20 percent of the value of traditional open-end mutual funds. By 2010, there could be close to 1,000 available ETFs on U.S. exchanges, with assets nearing $ 1 trillion. It is feasible that the number and asset level of ETFs could equal that of open-end mutual funds over the next 10 years, and that could be a conservative estimate.

ETFs have the potential to become the largest segment of the mutual fund marketplace by 2020. You, as an informed investor, should know what makes ETFs unique, how they work, where to get the information on new funds, and which funds may help you achieve your financial objectives. That is what The ETF Book is all about.

Overview of the Contents

The ETF Book is divided into four parts, with each part containing five to seven chapters. Each chapter is fairly concise for easy reading and comprehension. At the end of the book there is an ETF Resource List where you can find more information on exchange-traded products, a glossary to help you with definitions, and an index so you can quickly find the information you are looking for.

Part I: ETF Basics

The benefit of owning ETFs can be appreciated only after their internal workings are understood. It is the structure that makes them different.

Chapter 1 begins with the evolution of ETFs from their early beginnings to where the market is today. It is said that necessity is the mother of invention, and ETFs are no exception. Understanding how the ETF marketplace evolved and grew over the years is an important step in understanding the benefits they may bring to your portfolio.

Chapter 2 examines the nuts and bolts of managing ETFs, and those mechanics differ significantly from open-end mutual funds. The chapter offers an introduction into the rules-based index strategies that ETFs follow, the calculation of ETF market prices, the calculation of intraday values, the role of APs in the creation and redemption of ETF shares, individual investor trading in shares, and settlement differences between ETFs and other investment securities.

Chapter 3 examines the fundamental differences between different exchange traded portfolios. While all index-based ETFs follow rules, not all ETFs function in the same way. In fact, some investments that are commonly referred to as exchange-traded funds are not funds at all.

Chapter 4 explores the advantages and disadvantages of ETFs over the traditional open-end mutual fund. People commonly refer to open-end mutual funds as traditional because there are nearly 7,000 open-end funds on the market. It is a structure investors are familiar with. Included in the chapter is an overview of ETF tax benefits when shares are placed in a taxable investment account.

Chapter 5 examines the future of actively managed ETFs. An actively managed ETF does not follow a rules-based index. Rather, the securities are chosen by a portfolio manager or committee, using their discretion. The Securities and Exchange Commission now allows a limited form of actively managed ETFs, which will lead to an abundance of new issues.

Part II: Indexes that ETFs Follow

Most ETFs follow securities indexes. Studying the rules and methodology of index construction and maintenance is an important part of ETF analysis. The section differentiates between market indexes and custom indexes. It also introduces a novel method of categorizing ETFs by the type of indexes they follow. Index Strategy Boxes are an easy way to understand index construction and how a fund is investing your money.

Chapter 6 divides ETFs into two main types. The first type of index is a benchmark index. That is the classic method of replicating the performance of widely recognized stock and bond indexes. Benchmark indexes use passive security selection weight stocks using market capitalization. The second type is a strategy index. A strategy index differs from a benchmark index in that the index provider is actively involved in managing the security selection process or modifying the security weighting process, or both. Strategy indexes are compared to benchmark indexes.

Chapter 7 introduces the new and simple way to view index strategies using a tic-tac-toe box. Index Strategy Boxes have two dimensions. One axis of the box is security selection and the other is security weighting. How securities are selected for an index and how the securities are weighted in an index has a profound effect on the risk and return characteristics of the index.

Chapter 8 further examines the first dimension of Index Strategy Boxes, which is security selection. Index security selection is based primarily on one of three strategies: passive, screening, or quantitative. Choosing securities for index is obviously important. What is left out is also important. This chapter gives you in-depth coverage of security selection methods and their impact on performance.

Chapter 9 examines the second dimension of Index Strategy Boxes, which is security weighting. Security weighting is based on one of three strategies: capitalization, fundamental, and fixed. How securities are weighted in an index can have a profound effect on the risk and return characteristics of the index. There is a detailed discussion of the various methods and their impacts on returns.

Part III: ETF Styles and Choices

The financial markets are divided into many asset classes and many global regions. Part III divides the world into U.S. stocks, international stocks, bonds, and alternative asset classes. Examples of ETF strategies are provided in each category.

Chapter 10 summarizes the U.S. equity market, the largest component of the ETF marketplace. The chapter covers total market funds, growth and value funds, and those based on the size of companies. Chapter 10 also provides an overview of style and size methodologies used by various index providers.

Chapter 11 goes global by expanding the scope into international equity markets. Global equity ETF issuance is growing as more international indexes are created and U.S. stock exchanges form global alliances. Emerging country ETFs are expanding into parts of the world that were once very difficult to gain access to.

Chapter 12 looks at U.S. and global industry sectors, the fastest-growing part of the ETF equity marketplace. Industry sectors cover broad markets and micro markets, both in the United States and globally. Industry sectors are being sliced thinner and thinner, offering ETF investors access to niche markets that do not exist in the open-end fund universe.

Chapter 13 introduces the interesting field of special equity ETFs. These unique funds include theme investing, sector rotation strategies, leveraged ETFs, and short funds. The theme investment ETFs section covers a variety of areas, including clean energy, infectious disease, social responsibility, and corporate dynamics. Leveraged and short funds are used to market hedge risk and make leveraged market bets in one direction or another. They can be useful when trying to hedge an illiquid stock position.

Chapter 14 covers fixed income ETFs, including government bonds, corporate bonds, and preferred stocks. Fixed income ETF development was slow for several years. Fund providers have recently introduced several fixed income ETFs, ranging from high yield bonds to preferred stocks.

Chapter 15 explores the growing popularity of alternative asset class ETFs, including gold, oil, commodity indexes, and currencies. It is an interesting and often controversial area of investing. Academic research agrees that alternative investments help reduce portfolio risk, but the debate continues over the potential long-term return of these asset classes.

Part IV: Portfolio Management Using ETFs

Part IV offers advice on how you can develop an ETF portfolio and what you can reasonably expect to achieve from it. The section explores many strategies from buy-and-hold to market timing and sector rotation. Regardless of your beliefs, the key ingredients that are critical to the success of any portfolio management strategy is to have a belief, establish a plan based on that belief, implement the plan, and stick to it.

Chapter 16 is a broad overview of the various strategies. The major investment styles are the passive asset allocation strategies of buy-and-hold and life cycle investing, and the active strategies of market timing and sector rotation. Special strategies include hedging and building around illiquid stock positions.

Chapter 17 introduces a simple and effective portfolio management in strategic asset allocation using a buy-and-hold strategy. This prudent ETF diversification technique is favored by cost-conscious investors who wish to achieve the benefits of market returns without having to predict the markets. The concept of asset class correlation and portfolio rebalancing is introduced.

Chapter 18 provides tools and directions when developing a mix of ETFs based on our journey through life. A person who has just entered the workforce typically invests differently from one who is retiring from the workforce. Life cycle investing directs more weight to aggressive asset classes early in life and more weight to conservative asset classes later in life.

Chapter 19 is an introduction to the world of active portfolio investment strategies. Many different types of portfolio strategies are discussed, including fundamental methods and technical methods. The goal of active investing is to achieve greater returns than the markets outright or on a risk adjusted basis. A successful active strategy does not need to achieve higher returns than the markets if the strategy achieves substantially lower risks than the market.

Chapter 20 focuses special uses for ETFs in portfolio management. Those uses may include hedging a specific risk in a portfolio, such as a concentrated position in one industry. Pairs trading involves taking long and short positions in various market simultaneously in an attempt to capture shifts in the economic activity. A market-neutral strategy invests either a long or short position in an industry and invests the opposite way with a market index. Tax swapping is a conservative strategy for boosting after-tax returns.

Chapter 21 includes several cost-saving ideas for ETF investors. The chapter includes tips on opening accounts and trading that lower your overall cost. In addition, information is provided on professional portfolio management services available for hire.

Summary

The ETF Book is your guide to creating a winning portfolio strategy. It will get you to the next level of understanding, whether you are just getting started with ETFs or are a seasoned investor. Armed with the knowledge in this book, you will have the tools necessary to build the right portfolio that fits your needs.

PART I

ETF BASICS

CHAPTER 1

ETFs from Evolution to Revolution

Exchange-traded funds (ETFs) have emerged from their fledgling beginnings in 1993 to a full-blown revolution in the mutual fund industry. The number of ETF offerings increase by the hundreds each year. ETFs available for investment rose more than tenfold between December 2003 and December 2008, from 71 to 747, including a 221-fund increase in 2008, during a brutal bear market. It is not possible to predict when the growth will slow. New ways of using ETFs in portfolios as well as product innovation will ensure a robust new issue market going forward for many years. There are reasons to believe that the total number of ETFs will double or triple again before any slowdown occurs.