Achieving Diversification with Exchange Traded Funds
This entry was posted on 7/9/2006 6:32 PM and is filed under Diversification,ETFs.
As mentioned in last week’s posting, achieving diversification is a key part of the investment process. Investment types do not all go up or down together. During some periods stocks may do well, while bonds or real estate may do better in other periods. The extent to which types of investments move together is correlation. If investments always move up and down in sync, they are said to be highly correlated. If they move in opposite directions, they are negatively correlated. Diversification involved selecting investments which are NOT highly correlated with each other. This helps to dampen the volatility of the overall portfolio and helps investors sleep at night. Expanding your investment horizon to include investments which are not highly correlated can be accomplished using stocks and bonds from different international markets or through mutual funds. Until recently it was not so easy to included other investments such as currencies and commodities which have historically had a low correlation with stocks and bonds. Including these types of investments improves diversification since stock an bond prices may suffer in an inflationary environment, but commodity investments may do wll in that same environment.
This has changed with the proliferation of exchange traded funds in recent years. An exchange traded fund (ETF) is a mutual fund that trades throughout the day like a stock. ETFs have been available for many years in various international sectors (for example a Japan ETF) and types of investments (growth stocks, value, stocks. short term bonds, long term bonds, etc.). Recently new ETFs have become available which invest in gold, silver, currencies and baskets of commodities. It is now easy to achieve even greater diversification by investing in these types of assets. An commodity ETF representing a basket of six commodities (light sweet crude oil, heating oil, gold, aluminum, corn and wheat) became available in early 2006. More recently, two exchange traded notes (ETNs) have become available representing an even broader basket of commodities (over 20 commodities). ETNs are a little different than ETFs. ETNs are notes (like a loan) backed by the commodities, so it is essential that they are issued by a reputable firm to minimize credit risk. The two recently issued ETNs are issued by a prominent financial firm which is also a large issuer of ETFs.
In addition to diversification, ETFs can be used in other investment strategies such as hedging a portfolio. For example, if you own stocks in oil and gas companies but feel that oil and gas prices may fall you could take a short position on a commodity ETF concentrated in oil and gas. If you are concerned about the falling dollar, you can purchase a currency ETF on foreign currencies (there are now several available). These currency ETFs also earn interest which can more than offset underlying expenses and provide income in addition to the currency exposure. Stock options are available on some ETFs so that options strategies such as covered calls can be implemented.
As with any investment, investments in individual ETFs must be considered carefully. While diversification is desirable, some commodities are at record high prices and it may be wise to wait for a suitable entry price.