Richard A. Ferri - The ETF Book: All You Need to Know About Exchange-Traded Funds

Contents

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

332.6327dc22

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

Semper Fi

Foreword

Theres no topic in personal finance today thats 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 investors 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 couldnt be sure that the funds 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, theres 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 dont do business in Somalia, theres 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, theres an ETF for you. And all of these bets can go in either direction, as ETFs can be bought long or sold short. Theres little to no limit to what an investor may do today; almost any choice is possible.

Of course, more choices dont 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, theres less reason for each shop to have a broad-based equity index fund. Once a handful of these funds exist, theres 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.