Tips for Tactical Investing Using ETFs

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Exchange-traded funds can be excellent investment tools, but you need to know how to use them. ETFs have become plentiful, and there are often several different funds that offer similar strategies. If you are a trader this shouldn’t really matter that much, and your selection should be based on a fund’s liquidity so that you can buy and sell shares relatively easily.

However, if you are using investments in order to implement a longer-term strategy it can often be worthwhile to dig deep and to find ETFs with managers who gear their strategies toward long-term fundamental investors.

For instance, let’s say that you want broad exposure to large-cap American stocks. The best trading vehicle is probably the SPDR S&P 500 ETF (NYSEARCA:SPY). This fund is one of the most liquid, and it is also extremely inexpensive. But this isn’t necessarily the best investment vehicle.

Why? The primary reason has to do with the divergence between the strategies involved in index composition and value investing. The S&P 500 is an index that weights 500 companies in order of their market capitalizations – if the market values company A more than company B, then company A is weighted more heavily in the index. But this isn’t a good investment strategy. Maybe company B earns more money, or maybe the weighting differential in the S&P 500 doesn’t reflect the earnings differential.

The same can be said about revenues or dividends. To make the example clearer, suppose company A’s share price doubles for no apparent reason. Its weighting in the index will double, as well, but from an investment standpoint you are going to want to own less, not more, of company A.

In short, the S&P 500 and many other indexes reflect what the market is doing, but they don’t make for good investments. Therefore as an investor in ETFs, I would leave funds like SPY to the traders.

Instead, I want to look at funds that weight their holdings based on other metrics, such as earnings, sales, or dividends. Fortunately there are several funds that are geared toward this kind of thinking. In fact, there are two companies that offer such ETFs that I think investors need to take a look at.

The first is RevenueShares. A RevenueShares fund is going to weight its holdings by revenues, not by market capitalization. Even though this strategy is a little more expensive to implement than market-cap weighting, it has proven to be worthwhile. Take the RevenueShares Large Cap Fund (NYSEARCA:RWL). Since it first began trading, in February 2008, it has beaten the S&P 500 by 13 percent, or about 2 percent per year.

The outperformance is more pronounced if we look at small-cap stocks. Since the RevenueShares Small Cap Fund (NYSEARCA:RWJ) began trading, in February 2008, it has outperformed the iShares Russell 2000 ETF (NYSEARCA:IWM) by nearly 50 percent!

The second is WisdomTree, which offers a wide variety of ETFs – note that it is also publicly traded under the ticker symbol (NASDAQ:WETF). This company offers many different kinds of funds, but two strategies in particular include dividend-weighted funds and earnings-weighted funds. The former weights stocks based on the total amount of dividends that they pay out, which you can see on a company’s cash-flow statement, or which you can calculate by multiplying a company’s dividend per share by the total number of shares outstanding.

The latter weights stocks by their total income — the more money a company makes, the more of it the fund owns. This strategy hasn’t shown the outperformance that the RevenueShares strategies have. Nevertheless, these strategies have generated higher dividends, and they have started to outperform this year as higher-growth stocks and momentum stocks have begun to underperform. These funds also pay higher dividends than funds like the SPY or the IWM, and so they are better for retirees.

Ultimately, ETFs have changed the investment landscape for the better. However, there are pitfalls and new strategies that you need to understand in order to utilize them successfully. The funds I recommend here are certainly not among the most popular funds, but they are the ones you want to own if you are investing for the long run because they use fundamental analysis in order to make investment decisions.

In an earlier article, we talked about some basic tips on choosing ETFs to buy. Here’s a recap:

1. Look at expense ratios

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ETFs are funds. You are paying a company to compile several assets for you, and this costs money. Depending on the kind of fund, the cost can vary. For instance, if you are buying a managed ETF such as those offered by AdvisorShares, you aren’t just paying for transaction fees but for research as well — and this increases costs. On the other hand, if you just want a simple index fund you should expect costs to be very low.

For many asset classes you have several ETF options. If you come across two funds that offer essentially the same kind of exposure, one way to choose the best fund for you is to pick the one with the lowest expense ratio. The expense ratio is the fee that you pay the fund manager every year to maintain the portfolio. Every ETF’s website should list the expense ratio.

The only time that you should be willing to buy a fund with a higher expense ratio is if there are mitigating circumstances, which I discuss in the next two tips.

2. Volume and assets under management matter

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You typically want to own ETFs with larger amounts of trading volume, and with larger amounts of assets under management. In the latter case, larger funds are typically less expensive to manage on a dollar by dollar basis. Regarding the former point, you want to make sure you own ETFs that have a lot of trading volume because you want to be able to sell out of your ETF if you need to for whatever reason. For instance, if you are looking to buy gold through an ETF, I would stay away from the ETFs Gold Trust (SGOL), which trades just a few thousand shares every day. I would rather own the SPDR Gold Trust (GLD), which trades a few million shares every day. If you need to sell the latter fund, you should have no trouble doing so in a timely fashion, and you will be able to do so at a price that is very close to the funds’ net asset value.

3. Maximize your diversification

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One of the great things about ETFs is your ability to diversify your holdings through the purchase of a single trading vehicle. But you need to make sure that you are actually diversifying. For instance, consider the Powershares DB Agriculture Fund (DBA) versus the Rogers Agricultural Commodity ETF (RJA). Both funds are designed to give investors exposure to a variety of agricultural commodities. However, the former fund holds just a few commodities while the latter holds more than a dozen. It holds commodities such as oats and greasy wool that DBA doesn’t. If your goal is to get broad exposure to agricultural commodities, RJA is probably a better option.

Conclusion: Making sacrifices

Ultimately, you are going to be in a situation where you need to decide: Do I want more diversification or more liquidity? Or, do I want a lower expense ratio or more diversification?

Ultimately, there is no right or wrong answer to these questions. You need to decide what is important to you as an investor. Maybe it is worthwhile to pay an extra 0.2 percent per year in order to get exposure to 500 stocks instead of 50 stocks. Maybe it isn’t worthwhile. There isn’t an “apples to apples” comparison for every set of ETFs. However, a good rule of thumb is as follows: use the above three rules to eliminate extreme cases, and otherwise go with your personal preference. So for instance, don’t buy a fund with a 3 percent expense ratio even if it is liquid and highly diversified. But if you are choosing between paying 0.5 percent and 0.3 percent, but the 0.5 percent fund is much more diversified and liquid, it may be the better option. As another example, don’t buy an ETF with just $10 million under management and with just 5,000 shares traded in an average day, even if it is highly diversified and even if it has a low expense ratio. It may end up being too difficult to sell.

If you eliminate extreme cases, you will end up with a list of candidates for which making the “wrong” choice will have a negligible impact on your performance. Under these circumstances, you will be prepared to take advantage of the many benefits of ETFs.

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Disclosure: Ben Kramer-Miller has no positions in the funds mentioned in this article.