ETFs Are More Than Just Investment Themes

Jun.28.12 | About: SPDR S&P (SPY)

Our earlier article Comparing the Incomparable may have set the stage for considering the essential role of comparison in making value judgments. But it probably could have done a better job of explaining why ETFs can be, and need to be, compared with one another. So here goes.

Most investors simply regard ETFs as a many-advantaged substitute for mutual funds.

The mutual fund industry has for decades encouraged investors to judge desirability on what individual funds have provided as returns in the past. Their approach to collecting capital from investors, upon which to charge "management" fees, has been to create more funds than there are stocks, and intensely publicize those that by chance have recently been at the top of the history rankings.

Plenty of writing exists that describes how few of those results persist into the future. Still, that judgment pattern may tend to continue with ETFs. Inertia is one of life's more powerful forces.

The other mutual-fund induced influence on ETFs is what almost the entire investment industry has preached for my more-than-a-half-century in it: "To be an intelligent, conservative investor, you should invest for the long term."

That self-serving advice is deeply rooted in the economics of the investment management business: Getting new clients is far more expensive than getting more capital from existing ones. Losing clients or having them reduce their capital under your control (and fee computations) is the greatest business risk.

A long-term investor may be persuaded in bad periods to avoid selling out and removing cash - which needs no management - or quitting the firm's guidance altogether. And any time a change in holdings is made, there is always the possibility of initial adverse price experiences that may raise questions as to the manager's judgment and capabilities.

Because there inevitably will be bad periods, buy-and-hold is the order of the day. And the year. And next year. And . . .

Now, if the investor in ETFs has a strong constitution he or she may be well suited to riding through bad periods in SPY or QQQ or any other broad-market index-tracking ETF. That is an asset-class portfolio management decision based on ample evidence that trying to make short-term timing decisions about the overall equity market is usually not a rewarding expenditure of effort and anxiety. We agree about markets, but specific issues may differ.

Which brings us to the question of why there are more than 1400 other ETFs beyond the three dozen or so of a broad-market index-tracking nature?

Part of the answer lies in the defensive actions of the seriously-threatened mutual fund industry, following their well-practiced obfuscation guidelines. If you are not familiar with Ron Rowland's regular deathwatch reviews of the ETF scene here in Seeking Alpha, it is a very useful perspective maintainer.

The other important part of the answer is that most ETFs are approached as diversified thematic investments. The investor wants to participate in the notion of emerging country stocks, or in financial industry stocks, or in government bonds, or in precious metals, or. . . you name it.

In the investment letter we write for, Block Traders' ETF Monitor, now in its tenth year of publication, we cover over 200 of the most widely-held and actively-traded ETFs, arbitrarily grouped into ten such themes.

ETFs are, because of their marketability, like stocks apt to go through periods of over- and under-enthusiasm by investors. Few ETFs regularly are priced strictly on the market values of their holdings, save those based on specific commodity (gold, silver) exchange quotes.

Just as investors regularly discriminate between the values represented at the moment by Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) or between Exxon (NYSE:XOM) and Chevron (NYSE:CVX), they need to discern the varied potentials among similar ETFs.

Even long-term investors should want to get a good start on a new or additional holding. Differences of more than a couple of years' trendline growth are always worthwhile. And when they occur and recur in just a few months' holding periods they are very constructive.

Since the significant (double-digit percentage) mis-pricing opportunities that frequently arise are the product of investor perceptions rather than the holding-by-holding quotes on each of SPY's 500, or even the ten largest holdings of XLF, what is needed is a sense of where the ETF's future price is headed.

Our best candidates for judges of those future prices are the market-makers at the major investment banking firms who help their big investment fund clients adjust huge portfolios to capitalize on what those clients see coming.

As we have outlined before, that activity usually involves the transaction facilitators putting their firm's capital at risk in providing the market liquidity to get trades completed. The risks anticipated are nearly always offset by price insurance, whose costs tell the extent of the dangers - and opportunities - contemplated.

Our proprietary means of determining those anticipations have been in operation for over a decade, both on stocks and ETFs. We regularly appraise the subsequent market actions of the over 2,000 daily forecasts being implied. So we have a sense of the odds of gain and the scope of actual drawdown risk exposure for each, at their varying balances of upside to downside prospects. An example using AAPL is illustrated in our previous article entitled Behavioral Analysis Forecast of Coming Facebook Prices.

This is perspective information that we have used in the past in managing pension fund portfolios for Fortune 100 companies and in running hedge fund investments. It is present in our investment letters, and we are in the process of setting it up for individual investor access on our website.

When things are ready, we will let you know. In the meantime, and afterwards, we will continue to share perspectives, hopefully of value, with you through Seeking Alpha.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.