From the December 2006 issue of Wealth Manager Web • Subscribe!

Scalpel or Hammer?

Indeed, the long-awaited (not to mention oft-predicted) shift to large-cap stocks appears to be taking hold. The Dow Jones Industrial Average, home to many megacap stocks, rose nearly 5 percent in the third quarter, the index's best third-quarter performance since 1995. The S&P 500 turned in a solid third-quarter performance as well, also rising about 5 percent. And for the first nine months of 2006, the Dow and S&P 500 jumped 9 percent and 7 percent respectively, outperforming the S&P SmallCap 600 (up 6 percent) and the S&P MidCap 400 (up 2 percent).

This move in large caps feels like it has legs. After all, small-cap stocks absolutely obliterated large-cap stocks over the last five years--the S&P SmallCap 600 had an annual return of 15 percent over the last five years versus a 7 percent annual return in the S&P 500--so perhaps the time has come for large-cap stocks to lead the way. That means aggressively dumping clients' small-cap holdings and plowing huge amounts of money into large caps, right?

Perhaps. But remember that market watchers were constantly predicting a rebirth of large-cap stocks throughout that five-year run of small caps--a rebirth that never materialized. And an argument could be made that the recent love affair with large caps isn't the beginning of a lasting romance, but merely a one-night stand that could send investors rebounding to small caps should economic growth going forward exceed Wall Street's expectations.

The bottom line is that as an advisor, you walk that thin line between trying to add value and trying not to screw up in the process. And while being right on a huge bet on large-cap stocks gets you a pat on the back from clients, being wrong gets you fired.

That's why some advisors avoid incorporating market, interest-rate or style-box bets into client portfolios. In their minds, the downside outweighs the upside.

Increasingly, however, investors will demand such value-added from advisors. After all, if you are an advisor who uses mutual funds or exchange traded funds to construct client portfolios, you can't show you add value by being a great stock picker. You'd better be able to show you add value with "macro" bets.

The good news is that there's a great tool at your disposal--exchange-traded funds--for incorporating market, interest-rate, or style-box bets into a portfolio. ETFs are fee- friendly, so you can make style or sector shifts with very little drag from transaction fees. And perhaps even more important, ETFs allow advisors to calibrate macro bets. Indeed, ETFs can be used as sledgehammers or scalpels on portfolios, depending on how much or how little you want to tilt them in a particular direction.

Let's say you want to boost exposure to stocks with the largest market cap, but only marginally and without exposing the portfolio to the 'large-cap" style box. One way would be to focus on large-cap ETFs that are a bit more concentrated in large-cap stocks. For example, the Spider S&P 500 (SPY) exchange traded fund has an average market cap of $49 billion. Now, if you want to ramp up the bet on large-cap stocks even more, you might consider selling the Spider and buying the Dow Diamond (DIA) ETF, which has an average market cap of $102 billion. And if you want to supercharge the market-cap bet even more, you might consider the Rydex Russell Top 50 (XLG). This ETF focuses on the 50 largest stocks in the market and sports an average market cap of $142 billion.

You've just seen the beauty of ETFs in terms of calibrating a size bet. Each of the aforementioned ETFs--Spider, Diamond, and Rydex Russell Top 50--fall in the large-cap style box, but their average market cap is significantly different. Thus, advisors have the ability to maintain consistency across size boxes--which may be necessary for client allocation mandates and/or investment objectives--yet still be left with several ways to bet on a shift toward larger-cap stocks.

Some of you may argue that you can do the same calibrating of "macro" bets using open-end mutual funds, but that's not true. One reason that you can fine-tune portfolios more precisely with ETFs is their transparency. Remember that all ETFs are based on an underlying index which is continuously updated. Thus, you have a high degree of confidence that an ETF holds what you think it holds, which is crucial when trying to finesse client portfolios in a certain direction. You don't have that same assurance with mutual funds.

The table on page 66 lists several large-cap ETFs, each with very different characteristics when it comes to average market-cap, sector exposures and dividend yield. These differences--created partly by how the ETF weights its components--generate a number of ways for advisors to tilt portfolios. As the table shows, there are traditional market-cap- weighted ETFs, price-weighted ETFs, equal-weighted ETFs, and "fundamentally weighted" ETFs which weight their components based on certain fundamental metrics.

For example, WisdomTree--one of the newer players in the ETF world-- weights all its ETFs based on dividends. What WisdomTree provides is yet another way to make a bet--this time, a strategy bet on dividends-- without altering your client's size-box exposure.

Let's say you want to maintain the same exposure to large-cap stocks in a portfolio, but you want to make a modest bet that dividends will be more highly prized by investors. You could switch out of a market-cap-weighted large-cap ETF and buy WisdomTree's LargeCap Dividend (DLN). The WisdomTree lineup also allows a dividend tilt to small caps (WisdomTree SmallCap Dividend) as well as midcaps (the WisdomTree MidCap Dividend). You can even tilt international exposure toward dividend payers via WisdomTree's many international ETFs.

Understanding how ETFs are weighted can come in handy when making other macro bets, such as sector bets. True, with the many sector ETFs in the marketplace, one simple strategy is to bolt on to a portfolio a few sector ETFs that focus on favorite groups. However, a more incremental way to achieve sector tilt might be to look at the sector weightings among ETFs in the same size box. Perhaps you have a feeling that tech is going to remain weak, energy is due for a rebound, and financials will remain strong. However, you don't want to make a big tactical bet by buying financial and energy sector ETFs. And you are concerned about maintaining size consistency in the portfolio's overall allocation. Interestingly, when you look at four large-cap ETFs in the table below-- the Diamond, Spider, Rydex Equal Weight S&P and WisdomTree LargeCap Dividend--you see four fairly different exposures in these three areas:

Here we have four large-cap ETFs with four different weighting schemes: price weighted (Diamonds), market-cap weighted (Spiders), equal weighted (Rydex Equal Weight), and dividend weighted (WisdomTree LargeCap). Which ETF would be most appropriate given our expected sector scenario above? You could argue that the WisdomTree is the best fit with its mix of large-cap stocks (its average market cap is $73 billion) and sector tilts toward energy and financials and away from tech.

Two additional bets that are easily and cheaply made with ETFs are style bets--growth versus value and interest-rate bets. There are a host of ETFs that slice broad market indices into growth and value tranches. For example, let's say you think large-cap growth stocks will outperform large-cap value stocks over the next 12 months. To tilt toward large-cap growth one strategy would be to sell a portion of your Spider and invest the proceeds in the iShares S&P 500 Growth (IVW) ETF. In terms of interest-rate bets, your choices are more limited. Still, iShares offers three ETFs that slice fixed-income maturities into three ranges: iShares Lehman 1-3 Year Treasury Bond (SHY), iShares Lehman 7-10 Year Treasury (IEF), and iShares Lehman 20+ Year Treasury Bond (TLT). Thus, if you believe rates are headed lower but are wary of making a big rate bet, you could gradually shift out of the SHY and extend maturities a little (with the IEF) or a lot (with the TLT), depending on your confidence level, client needs, etc.

One final macro bet worth discussing is that most dangerous of all--the market-direction bet. While advisors owe it to their clients to have an idea of where the market is heading, this is not a call for aggressive market timing. Fortunately, ETFs exist that provide an easy, cheap--and, perhaps most importantly--tax-friendly way to adjust market exposure at the margin. Let's say you have a bad feeling about the broad market, but you don't necessarily want to sell holdings for tax reasons. And your client would go ballistic if you dabbled in puts or shorted individual stocks. One option might be to bolt onto a client portfolio an ETF that reduces your market exposure without forcing you to sell securities. ProShares recently came out with a quartet of ETFs--ProShares Short S&P500 (SH), ProShares Short Dow30 (DOG), ProShares Short QQQ (PSQ), and ProShares Short Mid-Cap 400 (MYY)--that provide downside protection versus a particular index. These are "scalpel" ETFs rather than "sledgehammers," but when you want to scale back market exposure, these ETFs can tweak portfolios without major disruptions to holdings or allocations.

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (HarperBusiness). David Wright, CFA, provided research assistance for this article.

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