February 11, 2011

Lydon Likes Small Cap, Industrial Metal ETFs: ETF Leader Interview

Suggests predictions of ETF industry shakeout are overblown

There’s no denying ETFs are an innovative and effective product, which accounts for the sector’s explosive growth over the past 10 years among both advisors on behalf of their clients and individual investors alike. But this explosive growth and resulting inventory too often creates confusion for you and your clients. In the first of a series of interviews with the leaders in the ETF industry, we asked Tom Lydon, president of Global Trends Investmentsand editor and proprietor of ETFtrends.com, to explain where we are in the product’s lifecycle, and where good deals can be found.

AdvisorOne: In 2009, The Wall Street Journal’s Personal Finance columnist Jason Zweig said a major ETF shakeout would occur due to overcapacity and because ETFs with less than $50 million in assets are not self-sustaining. Has this shakeout occurred?

Tom Lydon: It’s not really about liquidity or asset size; it’s more about the underlying index and how often it is traded. “Real estate” in the space tends to fill up rather quickly, so new entrants and those late to the game have to find a way to differentiate themselves. For instance,T. Rowe Price was one company that was relatively late in entering the space. Rather than offering hot, new products, they instead relied on their performance and brand name as competent managers.

Although there have been a fair amount of closures in recent years, it’s far from a shakeout. In an increasingly competitive industry that demands more and more originality from its products and a bigger marketing push from providers, closures aren’t going to be unusual because not everything can catch on with investors. Investors ultimately will decide what works and what doesn’t. Providers who close low-asset funds are acting responsibly and maintaining their product lineups so that the highest-quality ones remain on the market.

AdvisorOne: What ETFs should advisors consider now? What looks appealing?

Tom Lydon: In fixed income, advisors should look at SPDR Barclays Capital High Yield Junk (JNK) and iShares iBoxx High-Yield Corporate Bond Fund (HYG). Now is a great time for corporations: liquidity is returning to the markets, default rates are dropping, they’re sitting on nearly $2 trillion in cash and fourth-quarter earnings are coming in strong. An improving environment coupled with yields that remain handsome (JNK boasts a 7.48% yield; HYG has a 7.72% yield) make high-yield corporate debt an appealing destination if you don’t mind the risks.

Also, ProShares UltraShort 20+ Year Treasury (TBT) should be considered. The economy is improving, joblessness is coming down

 

and economic reports show progress, and investors are returning to the markets.This recovery means the Fed will raise rates at some point; when that happens, long-term bond prices may fall while yields rise. TBT is designed to gain two times when the Treasury prices fall.

In Small caps, Schwab U.S. Small Cap (SCHA) makes sense. Small caps historically outperform large caps in recoveries due to the fact that they’re more nimble and quicker to react to changing economic conditions. In the last six months, small-caps are up about 28%; large-caps are up about 21%.

Lastly, industrial metals and SPDR S&P Metals & Mining (XME) look promising. XME holds a mix of industrial metal miners and producers−copper, steel, etc. Industrial metals are poised to benefit as the economy recovers, thanks to their large role in building skyscrapers, machinery and more. Both domestic and emerging market demand should help lift prices in the coming year.

AdvisorOne: How should advisors evaluate ETFs?

Tom Lydon: First, on their expenses; ETFs are cheaper than mutual funds, on average. It would be folly to assume that all ETFs are cheap, so always check the expense ratio to ensure you’re getting the best deal.

Also, look for a small premium or discount. Sometimes the price of an ETF is driven higher than the value of its holdings; that is, it’s selling for a premium. Similarly, the share price of an ETF can be pushed below the value of the stocks it owns. Then, it’s selling at a discount. As an investor, you want the premium or discount to be small—an indication that the ETF is being traded efficiently.

In the active tradingcategory, if shares of the ETF you own are changing hands frequently, you have a better chance of getting the best price when you want to buy or sell. You also want to make sure your ETF will survive a slower market and not close up shop.

Also, ask yourself about its overall fit. The ETF needs to fit with your existing holdings and complement them. If you already have copper mining exposure, then you probably don’t need that Chile ETF. If you’re holding an oil futures fund, perhaps you’ll want to skip the oil producers ETF. That is, unless you do want that exposure. It’s up to you.

Lastly, if your client is a risk-averse investor, leveraged and inverse ETFs may not be best for them. Perhaps they want a lot of risk, in which case, conservative Treasury bond ETFs may not be giving them the excitement they crave.

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