Another Drawback of Exchange Traded Funds (ETFs)

Despite the title of this post I’m sure that most people that have read my stuff know that I am a huge fan of ETFs. They allow people willing to spend the time to build very sophisticated portfolios that by and large avoid single stock risk. The broader funds allow for simple and cheap beta for people who for whatever reason do not build portfolios with narrower funds in the capacity I write about.

All that noted there are drawbacks to the product, every product has drawbacks. One written about previously is that it can be more difficult to capture a good dividend yield. Some of the “dividend” ETFs are (were?) heavy in financials and quite a few of the WisdomTree funds have very lumpy dividends.

Look at the dividend stream for the WisdomTree Intl Energy ETF (NYSE:DKA) which most clients own. First of all the 7% you might see at ETFconnect is wrong because just this year WisdomTree switched to quarterly payouts from annual. So the “7%” is picking up the one annual payout for 2008 plus the two quarterly payouts thus far for 2009. The dividend paid in March of this year was $0.09 and the June div was $0.43. There can be two reasons for the lumpy dividends. One is that many foreign companies pay dividends once or twice per year instead of four times. Another issue for WisdomTree has been that share creations or redemptions have impacted the payouts in the past and this could be an issue at anytime in the future.

Anecdotally it seems like less of an issue now than it used to be but grain of salt that one.

This brings us to the other drawback implied in the title of the post. Yesterday after the close, as I usually do, I looked at how the various stocks and ETFs I own for clients did and I noticed an odd quirk. I should note that I have a quote-widget on my desktop where I have programmed in the SPX, all the big SPX sectors (proxied with an ETF) and a couple of other things which hopefully allows me to have a sense of what is going on during a given session.

The healthcare ETF I follow for this purpose is the iShares Dow Jones US Healthcare ETF (NYSE:IYH) which is a domestic sector fund. That fund was down 0.14% which not surprisingly was better than the SPX’ 0.81% decline. The quirk I noticed is that three of the five stocks I own in the sector were up on the day smoothing it out better than the ETF would have.

To be crystal clear one day means absolutely nothing, one day is a quirk and anyone with a diversified portfolio of 30-50 stocks had names that were up yesterday. But it does raise an interesting issue. In just owning one ETF to capture the sector there is no chance of adding value over a more reasonable period of time by picking a stock. There is also no chance of lagging by picking a stock either.

In using an ETF for a sector you are giving up the chance to outperform at the sector level. This potentially becomes a smaller issue the narrower ETFs become. For many people this opportunity cost is probably small consideration but it is a drawback. For example one health name I have owned for years now, and disclosed many times before, is Teva Pharmaceutical (NASDAQ:TEVA). This is far from an obscure name. It has outperformed IYH dramatically for 5yr, 2yr, 1yr and YTD according to the chart on Yahoo Finance but has lagged for the last six months and I did not look at any shorter time periods.

Picking a big theme like generics and picking one of the largest stocks in a market (Israel) is a long way from uncovering a hidden gem or adroitly picking a stock. I realize not everyone will or should pick stocks but that does not mean you should not fully understand the drawbacks of the products and strategies you use.

About Roger Nusbaum 169 Articles

Roger Nusbaum is an Arizona-based financial advisor who builds and manages client portfolios using a mix of individual stocks and ETFs. Roger writes a popular blog, which focuses on risk management, foreign stocks, exchange traded funds, options etc.

Roger has been recognized by many in the investment management industry for his expertise in portfolio management. Roger has been regularly interviewed by the financial press, trade journals, and television news shows. He has also had numerous technical articles published and has been quoted in a number of professional trade journals, newspapers, and consumer finance magazines. He appears frequently on CNBC Asia as a market commentator.

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