- ETFs have investment advantages.
- ETFs have investment disadvantages.
- A portfolio of its top holdings is better than the ETF itself.
Exchange-traded funds are another form of investment for investors to choose from. An investment firm would search for stocks that share some kind of criteria. They could be in the same sector or have the same market value. They would bundle them up into the same fund for investors to buy and get exposure to many different stocks
ETFs have some advantages over investing in specific stocks. They are good for investors that don't have a lot of time to research their own investments. The investment firms that created these have already done the research. So instead of having to choose, an investor can just buy an ETF and get exposure to many stocks at once. ETFs can also limit risk. Single stocks fluctuate on their own news. ETFs are invested in a lot of different stocks and one bad piece of information about a single company may not decrease the price of the ETF.
There are some limitations to an ETF as well. ETFs could limit your upside. If one of the stocks reported higher earnings that specific stock could increase in price. However, when it's in the ETF that same stock may not have enough weight to make a difference in the price. Also, since ETFs are invested in a lot of stocks some stocks are going to perform badly.
This is where my research comes in. I want to find something like an ETF but that would perform better. I believe that instead of buying an ETF an investor would be better off creating their own ETF/portfolio by only buying the top holdings of that ETF. That would give you the stocks that the investment firm liked while also staying away from the bad stocks.
I am going to test out my theory using ETFs and stocks that are focused on the Aerospace and Defense sector. There are two main ETFs. The first one is from PowerShares (NYSEARCA:PPA) and the other one is from iShares (NYSEARCA:ITA). PPA has 52 holdings and ITA has 37, but they have the same 4 of the top 5 holdings. These are: Boeing (NYSE:BA), United Technologies (NYSE:UTX), General Dynamics (NYSE:GD), and Lockheed Martin (NYSE:LMT).
My research starts from 10/31/2005 and goes to 7/21/2014. That is when PPA started, and ITA started the following May. I believe that the last 8 years is probably a good representation of data as we have had different economies. We had a recession and a growth period. As you can see from the Yahoo graph below, all 6 investments seem to go in tandem with each other. They all went down during the recession and they have all been climbing since then.
Yahoo Finance charts
Earlier in the article, I mentioned about how ETFs could limit the downside risk and upside reward as well. You can see this come true in the graph. You can see the 4 stocks crisscross below the two ETFs on the downward slope and also on the upward climb.
To get a clearer picture of how well these investments did over this period I have created a table using the historical prices and dividends during this time. This data was found on Yahoo Finance. For illustration purposes, I will just own 1 share of each investment and the dividends won't be reinvested. When calculating the return of the stock portfolio I will add a $5 transaction cost per share. That's an extra $15 of transactions costs because of the extra three stocks I will be buying.
Beg. Price 10/31/05
End Price 7/21/14
Amount of Dividends
4 stock portfolio
$234.26 total cost
$523.26 Total value
The results are pretty much what I expected. If an investor had limited resources, didn't have time to invest, and was adverse to risk, choosing one of the ETFs would have been a good decision. An investor would have doubled their money over eight years. For people who love risk, an investor would have had a 75% chance of beating both ETFs if they just wanted to invest in one of the stocks. UTX, GD and LMT beat both ETFs. LMT was very good. Boeing was kind of a laggard in the group. However, for my article I was trying to see if there was a difference between investing in an ETF or just a portfolio of its top holdings. The portfolio's return was 146% which beat PPA by 21% and ITA by 27%. I think doing this kind of investing wouldn't take much more effort than buying an ETF. The investment companies who created the ETFs have already done most of the work when they chose their top holdings. The investor gets the best of both worlds. They get stocks that an investment firm favors while avoiding the bad stocks that are in the ETF as well.