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, Random Roger (123 clicks)
Portfolio strategy, ETF investing, foreign companies
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One of the benefits of ETFs, even narrow ones, is that they help investors avoid single stock risk. While stock picking does not have to be unsolvable, black box work, many investors, including professionals, would rather not pick stocks. Broad based funds allow for capturing asset class diversification and narrow based funds, depending on how they are used, can replicate many attributes of a portfolio consisting of individual stocks up to a point which is a democratizing force I've mentioned before.

What if an ETF is riskier than holding individual stocks? Is this even possible? I believe it is and no the context is not the structure of a fund like a derivatives based product.

Someone looking to build a portfolio comprised of narrow based funds would, I think, need to make some sort of decision about the financial sector. If you look at most of the financial sector ETFs, they all seem to be heaviest in some lousy companies. I continue to believe that banks (the ones that are most likely to be heavy in these funds) in the US, Europe, Japan and China stink. How could someone who agrees with that buy Financial Select Sector SPDR ETF (XLF) or SPDR S&P International Financial Sector ETF (IPF) (as examples)? Obviously some folks think these banks are good investments right here and maybe they'll be right, but I think that is a long way off.

Other ETF alternatives in the sector include narrower bank funds which might work for some people, there are a couple of capital markets funds but they have investment banks in them, PowerShares has a small cap fund. One other place to look would be country funds that are heavy in financials. For example, iShares Singapore (EWS) has 44% in financials and there are many other funds with financial weightings in the same ballpark. Whether this type of exposure counts as a proxy is really up to the end user.

So, anyone wanting at least some financial exposure, but thinking the ETFs are too flawed to own, will need to consider individual stocks. Our firm has some accounts that size-wise are ideally suited to one or two holdings per sector with the vast majority being ETFs, but for the financial sector I can't really find an ETF I'm comfortable with (iShares Emerging Market Financial (EMFN) has 30% in China and the EG Shares Financial GEMS ETF (FGEM) has 37% in China).

This creates the possibility that individual stocks must be considered as a proxy for financial related ETFs--so to speak.

That I might be negatively disposed to financial ETFs really shouldn't mean much to you but if you are someone who uses ETFs, it should underscore the idea that no single wrapper can be ideal for every segment that might be built into a diversified equity portfolio. I would hope that anyone using ETFs would take the time to look under the hood and make a decision or two about what is there. In that context it is possible that for a given fund you will not like what you see and if that is possible then it is also possible that all the funds in a space will be unattractive.

This creates the need for a willingness to consider some individual stocks in a portfolio that is large enough to go narrower than SPDR S&P 500 Trust ETF (SPY), iShares MSCI EAFE Index ETF (EFA), iShares Russell 2000 Index ETF (IWM).

Source: Diversification: Individual Stocks as a Proxy for Financial Sector ETFs