Sector Investing - A Better Way
By Dr. Steve Sjuggerud Chairman, Investment U ( 07/18/05 )

In his current business bestseller The Bull Hunter, my good friend Dan Denning calls ETFs "Precision-Guided Investments." Dan raves about the benefits of ETFs in his book... "Imagine a single security that allows you to buy an entire sector or industry or even country - in just one stock. ETFs are a cross between individual stocks and index mutual funds, and they offer the best of both worlds..."

I agree with Dan, but I've been frustrated with some of the opportunities available in ETFs... until now... Three weeks ago, a handful of "PowerShares" sector ETFs were introduced. These things are fairly revolutionary in the ETF market, and I'm excited about them. If Dan liked ETFs before, then he'll really like PowerShares.

Let me explain... Better Than ETFs? I Think So... The traditional ETF (or exchange-traded fund) is, as Dan described, a single investment that allows you to hold an entire sector (like the energy sector, for example) in just one stock. ETFs are like a mutual fund, in that they hold a basket of stocks with a similar theme (energy stocks, for example). And they're generally most like index funds, in the sense that they just hold a fixed portfolio of companies in that theme. Lastly, and importantly, ETFs generally hold the stocks in proportion to the size each stock makes up in its sector. To me, this is where the problem comes in...

Exxon and Chevron, for example, make up nearly half of the iShares Energy Sector ETF. So are you really holding a basket of stocks representative of the energy sector? NO... It just so happens that Exxon and Chevron are so huge, based on their market value, they're the industry giants. So if you buy the iShares Energy Sector ETF, you're not getting diversification in energy stocks... you're really just buying Exxon and Chevron.

If I want a basket of 30 or so energy stocks, I want all 30 of them to contribute to the performance of my portfolio. However, in the case of the iShares Energy Sector ETF, if Exxon and Chevron lose half their value, I'm bound to lose a lot of money no matter how the other 28 stocks perform.

Why Some ETFs Are a Real Scam To me, the whole point of ETFs is to get broad exposure to a sector (like 30 stocks) in just one buy... all with low fees, easy trading (just like a stock) and tax benefits. While the low fees, easy trading, and tax benefits are definitely there, the broad diversification promised by ETFs is a bit of a scam in some cases...

Take the semiconductor ETF with the symbol SMH - Intel and Texas Instruments make up nearly half of this ETF. Like the Energy ETF above, by buying SMH you're not buying a basket of semiconductor stocks. You're really just buying Intel and Texas Instruments, as their performance is going to make up most of the performance of this ETF. As far as diversification goes with this ETF, it's a sham.

The worst offender might be the ETF with the symbol BBH. BBH is a biotech ETF where two-thirds of the ETF is made up of just two stocks - Genentech and Amgen. That's terrible... When you buy BBH, you're not getting a diversified portfolio of biotechs. You're really just buying these two stocks.

The "promise" of ETFs is: diversified exposure to an entire sector in just one stock. I don't know how these ETFs above went so wrong. But a relatively new ETF manager, PowerShares, seems to have gotten it right... Broad Exposure, Dropping the Losers, and Other Advantages It seems to me that PowerShares actually started out by asking, "What would the customer want?"

As the customer, I want broad exposure to a sector (maybe 30 stocks). Don't mess with it too much, please. But if you must mess with it, please kick out the "dogs" every once in a while, and don't just passively sit by and watch them go to zero.

And please don't load up on overpriced stocks simply because the market value of these stocks has gone up. I don't want the fund to buy more and more of what's already become super-expensive.

PowerShares fulfill both of these objectives... Each PowerShares sector ETF actually contains 30 stocks. And most importantly to me, no stock can make up more than 5% of the portfolio. So the biotech PowerShares, for example, couldn't possibly have two stocks make up two-thirds of the assets. Simple stuff. But great stuff.

Thankfully, the dogs can also be kicked out... stocks that appear attractive (based on quantitative measures) can be let in... and the super-expensive stocks will still never make it to more than 5% of the portfolio. That's because instead of holding a fixed portfolio, the PowerShares portfolio changes quarterly based on dynamic underlying indexes, called "Intellidexes."

The Bottom Line on PowerShares Let me get to my bottom line here... PowerShares allow me to invest in sectors the way I want... where all 30 stocks in the fund actually affect the performance. If I want to buy biotech, I don't want to own Amgen and Genentech. I want to own the 28 other stocks that have bigger upside potential than the two giants. I don't want to own BBH... I want the biotech PowerShares.

Also, the fact that the PowerShares portfolio changes quarterly is actually attractive to me... it's a way to kick the dogs out of a portfolio early on, instead of waiting for some stuffed-shirt committee to finally (and arbitrarily) decide to kick a dog out.

My friend Dan, if you like ETFs, I think you'll love PowerShares. And so should anyone else looking for truly broad exposure to a sector. Check 'em out at http://www.powershares.com.