Prudent Use of Sub-sector ETFs In a Diversified Portfolio

Roger Nusbaum submits: Tom Coyne (below) isolates some potential problems with sub-sector ETF. The article starts with a couple of positives, which I don't think are all that compelling, before getting to the negatives.

The first negative cited is that the funds "may also tempt more investors to become active traders, in the belief that they can earn higher risk adjusted returns than those on a broad-based index fund."

Is this a flaw of the product or the people that trade the product? I'd say this is a flaw of human nature to over-trade an account.

The next negative point is about risk adjusted returns of some of the sub-sector ETFs. I think the point of this part of the article is that if you take twice as much risk to get an additional 10%, it probably is not worth doing. That is a fair point.

The way I read the article I felt it was talking about the sub-sector ETFs as standalone investments. This is not how I would advise anyone to look at sub-sector ETFs or any other holding you would consider for your portfolio.

A diversified portfolio should blend together different volatilities, sectors, countries, cap sizes and a few other things. The various stocks, ETFs, CEFs and even OEFs out there can allow anyone to manage how much volatility they take on.

If you want your portfolio to have a beta of 0.75 (compared to the market's beta of 1.00) you can select weightings in different products to create that effect. That does not mean that a few of the components can't be very volatile.

For example a volatility-adverse investor might, after doing some research, be favorably disposed to Sandisk. Sandisk is a hot potato of a stock that makes flash memory. This is the type of stock that could double in a year or cut in half. This volatility-adverse investor can control the impact on his account with how much he buys. A 4% weight would increase volatility of the portfolio a whole lot more than a 1% weight.

If the stock doubles, it would add 1% to the overall portfolio. A savvy investor that can find two stocks a year that can double is achieving a lot of his eventual return with just two stocks and 2% of his portfolio. If this investor is not so savvy and he picks two hot potatoes that cut in half, he would lose 1% overall. That would be too bad but does not create reckless volatility for a portfolio.

Sandisk is just an example -- focus more on the concept not the example. Certain sub-sector ETFs can be used the same way. A networking stock ETF is unlikely to double in a year but 30%-40% is not impossible.

Comments

[AlphaProfit]

One typically tends to perceive sub-sector or industry group ETFs as 'risky' if they are evaluated as standalone investments. As you correctly state, a diversified portfolio should blend together different volatilities and sectors. At AlphaProfit, we take the approach of using sector and industry group funds as building blocks for model portfolios.
Sam Subramanian

2006 Nov 13 03:20 PM