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Unequal Weighting, Unequal Returns

This is why I have been advising clients to invest in the Rydex S&P 500 equal-weight ETF (RSP) which weights each company in the index equally. In 2003 the equal weight S&P 500 ETF beat the S&P index by 11%, in 2004 it beat the index by 5% and year-to-date it is up slightly while the S&P index is down.

In my book, 'The New Global Advisor', I ask readers a provocative question. For those that prefer broader exposure including some small cap companies, I have discovered a new family of ETFs called Powershares.

The new and innovative Powershares family of ETFs essentially creates its own indexes based on rules-based quantitative analysis that they refer to as 'intelligent indexes.' This seems to me to be more useful than blindly following market cap weighted indexes.

Is your financial consultant missing a critical piece to the ETF?

Exchange-traded funds (ETFs) are great investment tools but most have a flaw that investors and advisors usually miss. Let’s take a look under the hood and introduce some new and innovative ETF products.

Essentially, ETFs are nothing more than an index fund that trades like a stock. whereas of their simplicity, flexibility, low cost and tax efficiency they are growing fast. Last year the Barclays iShares family of ETFs brought in more new money than the Fidelity mutual fund machine.

Diversification

Unfortunately, many investors and advisors are formation portfolios of ETFs without looking inside the box and seeing where the money is going. One of the monarch goals of a portfolio is diversification and many ETFs are not very diversified. This is since the companies in the ETF are weighted by size – specifically by the market value of its outstanding stock. This can result in an unwise concentration of risk and uneven performance.

The index fund community’s preoccupation with market cap weighting may have a strong theoretical burden but to me it is contrary to twopenny sense. To be blunt, I pay very little honour to it while casting global portfolios for clients.

Most investors would yes that just as long as a work site is bigger doesn’t mean that it is a alter investment. Let’s look at the most well known index – the S&P 500 index. Many investors think that investing in the S&P 500 means that their money is topical divided equally needle 500 companies. This is far from the truth. seeing the companies are weighted by size, 22% of your investment is going to the ten largest companies in the index and 60% of your investment is going to the largest 50 companies in the index.

Unequal Weighting, Unequal Returns

This is why I have been guidance clients to invest in the Rydex S&P 500 equal-weight ETF (RSP) which weights each cadre in the index equally. In 2003 the equal weight S&P 500 ETF beat the S&P index by 11%, in 2004 it beat the index by 5% and year-to-date it is up slightly while the S&P index is down.

In my book, “The New Global Advisor”, I ask readers a provocative question. If you wanted exposure to the dynamic biotechnology industry, would you prefer to primarily invest in a few large well know biotech companies or would you prefer to spread your investment over thirty biotech companies? If you’re the former, you might invest in the iShares Nasdaq Biotechnology ETF (IBB) whereby 25% of your investment would go to three companies. For those that prefer broader exposure including some small cap companies, I have discovered a new family of ETFs named Powershares.

The new and innovative Powershares family of ETFs essentially creates its own indexes based on rules-based quantitative critical review that they refer to as “intelligent indexes.” This seems to me to be more useful than blindly following market cap weighted indexes. There are two Powershares that I particularly like at this point.

Two I Like

The first is the biotech Powershare (PBE) that contains 30 biotech companies. If its holdings were weighted by market cap, two companies would think of for more than 60% of its holdings. Instead your exposure is spread 30 different companies with no clique numbering for more than 5% of the total. 30% of your exposure is to large cap companies, 26% is to mid-cap companies and 43% is to small cap companies.

The biotech Powershare is an short position so don’t get passed away. I think it is a smart play on the tremendous opportunities for ranking extension in the biotech industry which is showing some momentum considering trading sideways since early 2004. The hourly fee is only 0.60%.

The other Powershare that I like is the International Dividend Achievers Powershare (PID) that contains 42 ADRs traded on U.S. exchanges. I am usually not a big fan of ADRs since they usually trade at a premium to the underlying security but they do offer some take in tow to investors since they meet U.S. reporting requirements and can be easily purchased on U.S. exchanges. The ADRs in this Powershare have to pass a stiff test: five fiscal years in a row of increased dividends. en plus the top holdings are no more than 5% of the total index and so you get great diversification.

A foster Way to Get Global Diversification

One problem with the most widely used international index, the MSCI Europe, Asia & Far East Index (EAFE) is its concentration in Japan and the United Kingdom which description for about 50% of the index’s total value. Meanwhile exposure to promising countries such as Ireland and Hong Kong are less than 2%. Last year, this Powershares index beat the MSCI EAFE index by 7% and companies in the ETF averaged a 29% return on equity. The index is re-balanced quarterly and has an commonplace book fee of 0.50%. Right now 67% of the companies in the index are large cap, 20% are mid-cap and 13% are small cap companies.

Getting the right embodiment of ETFs takes some time and effort. Remember that all ETFs are not equal so want carefully.

My latest net-net article over at GuruFocus includes my clearest explanation of what to look for in net-nets – and more importantly – what it takes to make money investing in net-nets:

If the balance sheet is very liquid and insider ownership is very high – there’s a good chance something will happen. I have no idea what. And I have no idea when. But someday, something will happen to increase the return on those assets…Sometimes it’s as simple as returning the assets to shareholders, using net cash to make a management buyout super cheap, or using net cash to buy a totally different business…When you buy a net-net you are not buying future earnings. You are buying future assets. What I’m talking about here is asset conversion. At some point, you are expecting today’s assets will be converted into something you can profit from. Something a control investor will pay for. Or something the market will reward. 

It’s very hard to imagine these events ahead of time. But you can still bet on them:

That’s the uncertainty in net-nets. Most of the best net-nets have this certain/uncertain duality. It is certain the stock is selling for less than it’s worth. It is uncertain how the stock will ever sell for what it’s worth.

Remember what Ben Graham told the U.S. Senate:

The Chairman: When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about – by advertising or what happens?

Mr. Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it one way or another.

Talk to Geoff about Faith in Net-Nets

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