Insurance and Credit

It has been consistently demonstrated that your investment returns aren’t so much a function of what stocks your invested in, but what sectors/asset classes your invested in. In the dot com boom, it didn’t matter what dot com stock you invested in, if you were invested in dot com companies, you probably did alright. During the dot com bust, it wasn’t just a couple select companies that went down, it was just about all of them. Because of this tendency for similar stocks to move together, it is much more productive to be able to simply buy ” or short – a type of stock, then try and nail the exact right company. But how can you gain exposure to a sector without taking unnecessary risk based on the company?

The answer lies in a little tool known as the ETF. ETF stands for Exchange Traded fund. Think of it as a mutual fund that isn’t actively managed, focuses on a certain area, and can be traded like a stock without incurring extra penalties. Each ETF holds a number of companies, similar to a mutual fund, and its listed price is simply the overall value of the companies it holds.

Each ETF is designed to mimic an investment in a certain industry, region, or type of stock. Some examples of ETFs are the XLI, XLU, and EWC. These ETFs grant an investor exposure to the industrial sector of the S&P 500, the utilities sector of the S&P 500, and the entire Canadian stock market, respectively. Similarly, one who simply wanted to match the S&P 500 indexs returns could just invest in the SPY.

Yet if ETFs are so similar to mutual funds, why not just use a mutual fund. There really are a couple reasons to do so. First off, mutual funds have a history of underperforming the stock market as a whole after fees are included. This makes simple index investing, through an ETF representing a large basket of stocks, such as the SPY, an extremely effective way of matching the markets returns with nearly no cost. There are also slight tax advantages with ETFs compared to mutual funds. Mutual funds have to pay capital gains tax whenever they sell one of their holdings, and whenever they have a large wave of redemptions, they have to sell their positions to come up with the money. This leads to excess fees, some of which get passed on to the remaining investors.

Perhaps the biggest consideration is the simple convenience of owning ETFs when compared to mutual funds. They can be bought and sold (or shorted) any time during the trading day, using the same order types available to normal stocks. Free from redemption fees, the only deterrent from actively trading an ETF is belief in the efficient market hypothesis, and the standard commission costs from buying and selling stocks

Another important consideration is that most of the more liquid ETFs are optionable. This means that option-savvy investors can harness the power of stock options to change the risk-reward profile of their positions, and risk-conscious investors can use stratagems such as the covered call and protective put to protect their investment.

One thing to note is that not all ETFs are created equal. While some simply hold a basket of stocks and use those to keep the ETFs value near the benchmark, many use other, more exotic strategies, with various degrees of success. QLD for instance, aims to gain roughly twice the daily returns of the Nasdaq composite index, and is usually fairly consistent when doing this. Another similar instrument is the ETN, which is actually a debt based instrument. While ETNs also aims to gain returns based on a given benchmark, there price is also sensitive to changes in the debt rating of the issuer, and this should be considered when investing in them.

ETFs are a powerful tool for both the intelligent investor, and the active trader. Their ability to hone in and diversify within a given industry, or region of the world is invaluable when riding the larger megatrends that happen periodically in investment. Similarly, the ability to trade them just like a stock, using techniques such as shorting, options, and the various order types make them an invaluable asset for the active trader. For those believing the efficient market hypothesis, they even allow passive index investing at a cost far below that of a mutual fund.

There are 15 asset classes an investor might consider in 2009 for high yielding, secure retirement income strategies. But, with all the current discussion about credit risk today, many of our readers at AboutETFs.com have shifted more interest to US Government-backed bonds or high grade corporate bonds. Some investors even wonder if they should move all of their bond allocations into U.S. Government paper. Let us examine that idea a bit more.

First off, in terms of protecting principal, the safe bet is to stay with treasury notes, bonds and bills. The disadvantage with that notion, though, is the extraordinarily low yields. For example, T-bills are at one-fourth of a percent or even lower. Even taking into account fears about the volatility of the market, we do not see the cost benefit of such low yields. Are there options to earn more decent returns but still keep risk low?

Perhaps you should mix together the safety of US government paper with higher yielding instruments such as investment-grade corporate bonds and mortgage-backed bonds. Also, you could invest a small portion of your portfolio in non-investment grade corporates. This portfolio allocation will spread your risk over more asset classes.

To further mitigate the risk of default by an issuer on a specific bond, we recommend sticking with bond mutual funds (either open-end or closed-end funds) or examine the selections available in the growing world of exchange-traded funds (ETFs) that are based on indices. There are three bond-oriented ETFs that provide an excellent blend of Treasury, mortgage-backed and corporate bonds. They may provide you just the right blend for a high yield retirement strategy.

* (BND): Vanguard Total Bond Market-ETF

* (LAG): SPDR Barclays Capital Aggregate Bond Fund

* (AGG): iShares-Barclays Aggregate Bond Fund

The common thread for these three ETFs is the index they attempt to emulate: the Barclays Capital US Aggregate Bond Index. That index is divided into the following three categories:

* 25 percent is represented in investment-grade corporate bonds

* Treasury and Agency bonds (approximately 37 percent)

* 38 percent of the index is comprised of mortgage-backed securities

What about the maturities? Taken as a group, the maturity averages 6.8 years. Nearly 40 percent of the securities mature in less than one year. There are other factors to consider, though. How do these ETFs really compare?

The State Street Global Advisors (LAG) ETF, with a modest $10 million market cap and low trading volume of 31,000 shares daily, should probably be avoided. While the Vanguard (BND) product is an excellent choice, our final vote goes to Barclays (AGG): iShares Barclays Aggregate Bond Fund. AGG is king of the hill with a $9.7 billion market cap and average daily 800,000 shares in trading volume. What about performance?

All three of these ETFs followed the Barclays index, and all performed quite respectably in 2008. Through a portion of February, 2009, BND, LAG, and AGG dropped by 3.6 percent. As for yields, they are at 4.5 percent for BND, 3.8 percent for LAG and 4.6 percent for AGG.

What about corporate bonds? The only ETF that holds 100-percent investment-grade corporate bonds is the iShares iBoxx $ Investment-Grade Corporate Bond Fund (LQD). LQD follows the price and yield performance of the iBoxx $ Liquid Investment-Grade Index. The index measures the performance of 100 highly liquid, investment-grade, U.S. Dollar-denominated corporate bonds that offer maximum liquidity and represent the broader U.S. corporate bond market. The average duration of bonds held by LQD is 6.25 years, daily trading volume exceeds 800,000 shares and its market cap is $3.7 billion. It may be worth a close look.

To summarize, reduce risks in high-yield strategies by blending your portfolio. Consider investments via funds as opposed to single security investments. In addition, assess your risk tolerance if you want the higher yield in investment-grade corporate bond funds. Reader caution: the securities mentioned in this article may not be suitable for all investors. No solicitation, or offer, is being made to buy or sell securities by Chance Carson or his affiliate companies Carson & Associates and Alpine Strategies nor any of its personnel. There are substantial risks of losing principal when buying or selling any securities. Readers are advised to review all the terms disclosed on the Privacy and Terms page of AboutETFs, or to consult with a professional advisor before acting on any opinions, which are subject to change, in this article.