Finding the Right ETF

By Matthew Hougan

Let me be clear: I was not arguing in my last blog that the Benjamin Graham ETN is the best total market ETF/ETN on the market today.

Far from it. As I've written before, celebrity branding makes me very nervous. The Ben Graham ETN is not a true total market fund. It takes huge risks and bets against a true market portfolio, with a non-transparent methodology that any investor would question.

But the Ben Graham ETN is almost beside the point. The point is that ETFs give investors the means to express their precise views on the market.

My point would have better been made by examining all the ETFs in a given sector. Take, for example, the returns of the various healthcare ETFs in January.

Healthcare ETFs Sorted By January Returns
Fund Name	Ticker	ER	Assets	YTD	2008	Mkt Cap	P/E
iShares DJ US Medical Devices	IHI	0.48	247.8	3.40	-36.79	4,312	16.2
First Trust Healthcare Alphadex	FXH	0.70	12.5	2.38	-29.50	7,169	13.0
PowerShares Bio and Genomics	PBE	0.63	157.2	0.44	-26.75	2,388	17.5
Rydex S&P EqualWgt HealthCare	RYH	0.20	35.1	0.06	-26.50	10,766	12.8
iShares Health Providers	IHF	0.48	87.5	-0.39	-43.46	5,897	10.4
iShares NASD Biotech	IBB	0.48	1452.6	-0.45	-12.28	5,851	21.1
Healthcare Select Sector SPDR	XLV	0.21	1906.4	-1.21	-23.31	40,461	14.1
SPDR Biotech	XBI	0.35	493.3	-1.59	-8.63	4,124	27.3
iShares DJ Health Care	IYH	0.48	861.2	-1.62	-22.90	32,979	14.6
Vanguard Health Care	VHT	0.25	562.5	-1.71	-23.32	27,596	17.3
First Trust AMEX Biotech	FBT	0.60	57.9	-1.93	-18.24	4,062	21.7
PowerShares Dynamic Health	PTH	0.71	72.5	-2.55	-34.83	2,967	12.9
SPDR Pharmaceuticals	XPH	0.35	48.4	-2.82	-9.02	6,478	11.2
iShares DJ Pharmaceuticals	IHE	0.48	117.8	-3.29	-14.92	12,321	13.1
PowerShares Dyn Health Services	PTJ	0.70	16.3	-3.44	-42.99	4,489	10.4
PShares FTSE RAFI Health	PRFH	0.75	11.5	-4.25	-24.41	43,772	13.4
PowerShares Pharma	PJP	0.63	138.2	-4.84	-10.86	10,861	14.5

The swing on YTD results is 8.24%, ranging from the iShares DJ US Medical Devices ETF (IHI), which was up 3.40%, to the PowerShares Pharma ETF (PJP), which was down 4.84%.

If you look at the gradation of returns by industry segment, you can break it down more or less into industry categories:

• Medical Devices
• Biotech
• Broad-based Healthcare
• Pharmaceuticals
• Healthcare Services

I'm Monday morning quarterbacking here, but as a former biotech analyst, it's easy to explain these returns.

If you examine which parts of the healthcare sector are most exposed to both the current economic downturn and general cost pressures, it would break out the same. Both biotech drugs and medical devices are cost-insensitive: they are generally fixed-price products with limited or no generic competition, and somewhat limited replacement alternatives within their space (particularly on the biotech side). Pharmaceuticals, on the other, are facing enormous generic competition with the ramp-up of programs like the $4 generics Wal-Mart (WMT) plan. Health care services, to round out the group, is more exposed to employment trends and broader cost-cutting measures at the corporate level.

That's not to say that these returns will follow a similar pattern in the future. But you could make an argument for one or another piece of the healthcare sector depending on your view of the economy.

Even once you make a sector or industry choice, how you drill down into individual funds makes an enormous difference. Biotech ETFs, for instance, had returns in January ranging from 0.44% to -1.93%. The reason is that various biotech ETFs tackle different parts of the market: some focus on large established biopharmaceutical companies, and others focus on smaller, more nimble genomics plays.

The point is that investors have important choices to make with ETFs. They can buy full market exposure with a few funds and be done with it. They can make broad size/style tilts and be satisfied. Or they can drill down to very specific industries and make specific allocations. Even within each of those levels, they can make specific ETF choices that have a major impact on returns.

About The Ben Graham ETNs

As an aside, let me answer the question Jim posed in his last blog about why the Ben Graham ETN is structured as an ETN. The first and primary reason is that it is an actively managed product. There may be some quantitative metric behind it, but it is as active as it wants to be. Since you can't run an actively managed ETF very easily right now, putting it in an ETN wrapper was the only solution for getting it launched.

The next logical question might be: why would an investor buy an actively managed equity ETN and take on the related counterparty risk, when they could just buy an actively managed mutual fund? It's a good question, and I'm not sure an investor should.

But ETNs do have a major advantage for taxable investors, which is that it should not pay out any capital gains distributions. Cap gains distributions cost actively managed funds 1-2% per year. Is a 1-2% increase in after-tax returns each year worth the counterparty risk that accompanies an ETN? Maybe, maybe not: but it's a legitimate calculus to consider.

Comments

[RationalThi...:]

Is Mary Shapiro looking to shut down SKF and SDS?

NYT: "In the meantime, Ms. Schapiro has outlined an ambitious agenda for the coming weeks. She says she will work quickly to adopt rules to minimize the conflicts of interest at credit-rating agencies that many experts say contributed to the current crisis. She is exploring whether to impose restrictions on short-selling, a type of trade in which an investor profits on stock declines. One idea she is considering is the revival of the uptick rule, a regulation that prohibited short-selling while a stock is declining."

Given that they seeking to match daily inverse leveraged returns (not a hedge nor an investment), it's going to be a hard case for ProShares to make to remain active...

Feb 23 12:12 AM