4 Simple Rules to ETF Profits

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By Steve Christ

Thursday, April 10th, 2008

It’s spring here in Baltimore and the only thing that is coming up faster than the dandelions is exchange-traded funds.

In fact, as we discussed last week, 2008 may well go down as the year of the exchange-traded fund (ETF).

ETF investments have become the tool of choice lately for those looking for an easy way to diversify their portfolios without buying into a mutual fund.

In fact, the demand for ETF’s has become so great that the number of ETFs in the United States has grown by 48% in the last year. To date, there are now 703 of the funds sold by 30 companies.

That’s a big contrast to only a year ago when 18 companies offered shares in 452 funds.

And there are more exchange-traded funds on the way nearly every day.

In fact, with the Securities and Exchange Commission (SEC) proposing future rule changes governing the creation of ETFs, there could easily be over 1000 of the exchange-traded funds in the near future.

The good news for investors of all stripes is that ETFs make asset allocation relatively easy. That’s because instead of having to focus on individual stocks, ETF investors are able to focus instead on the many different asset classes the individual ETF’s represent.

That’s important because repeated studies by unbiased university researchers have shown that about 95% of a big money managers’ performance, for better or worse, can be explained by their selection of asset classes, not by their selection of individual stocks.

So all you need to do to build a winning portfolio is pick asset classes in markets that will outperform. And while that’s easier said than done, the careful selection of ETFs can cast a much wider net.

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ETFs and Broad Market Trends

Take for instance the commodities ETFs that I recommended to Wealth Daily readers in January.

They were broad market plays on the falling U.S. dollar and the supply and demand imbalances that had helped to send the prices of commodities higher.

And if you have been to either the grocery store or the gas station lately you know exactly what I mean.

Those picks allowed investors to easily be exposed to the commodities boom without the trouble of picking the winners among the individual stocks and assets that they represented.

Those commodities ETFs were:

• PowerShares DB Oil (AMEX: DBO )- An index composed of futures contracts on Light Sweet Crude Oil (WTI). It is intended to reflect the performance of crude oil.

• PowerShares DB Commodity Idx Trking Fund (AMEX:DBC) - An index composed of light, sweet crude oil, heating oil, aluminum, gold, corn and wheat.

• PowerShares DB Energy (AMEX:DBE ) — An index composed of futures contracts on some of the most heavily traded energy commodities in the world—Light Sweet Crude Oil (WTI), Heating Oil, Brent Crude Oil, RBOB gasoline and Natural Gas.

The outcome was that with only three investments, these ETF’s allowed their buyers to be diversified into a whole range of assets with money-making results. Buyers of these particular ETF’s have gained an average 15% on them in the last three months.

But the best thing about ETFs is their variety. By adding both bond and stock ETFs to those commodity plays, any investor can build a diversified portfolio across all asset classes.

Of course, how you allocate them depends on your own individual situation.

4 Rules for Successful EFT Investments

The key to successful ETF investments, however, isn’t as easy as just merely loading them up on to your tray. Like stocks, the good ETFs swim along with the bad.

A little common sense, however, goes along way. Here’s what you need to consider before placing your bet.

• Know What You are Buying — A no brainer right? Well obviously not for everyone. The important thing to understand is exactly what your ETF is supposed to track. Moreover, if your ETF holds many different assets, it’s important to know the break down of each of them by percentage. Taken together, that information will give you a better idea of how your fund may perform—especially in a down market.

• Don’t Chase Price, Chase Performance -ETFs may be diversified, but that doesn’t mean that they are not susceptible to momentum price swings. Remember that they trade like stocks and can become wildly over valued in the short run. So use each fund’s Net Asset Value (NAV) as guide to what the fund should cost.

• Avoid the Newer Funds -ETF providers tend to develop new funds in the hottest markets. That means these funds have greater risks associated with them since they lag the trend itself. Moreover, because these new funds are largely untested, the have no track record to base a solid buy on.

• Longs: Avoid the Urge to Trade — In general, ETFs are like mutual funds. That means that they are, in essence, long term bets on broader market trends. So avoid the urge to trade them. As long your original thesis is correct, holding them only makes sense.

Of course, with new exchange-traded funds coming on line all of the time now there are simply too many to list, kind of like those dandelions in my yard —but a lot more fun.

That’s a trend that is well worth looking into.

Your profit-hungry analyst,

Steve Christ, Chief Investment Analyst

The Wealth Advisory

PS. My subscribers already know all about successful ETF investing. The Wealth Advisory portfolio recently cashed in on two of them. We sold FXP for a 27% gain. and covered a short position in CAF for another 32% gain. Not bad for a bear market.

In fact, since the downturn began, our portfolio is 11-2, with an average gain of 15% in a little over three months.

By the way. winning stock picks are just a part of what our subscribers receive by signing up. Its bigger purpose is to help investors learn how to think for themselves-and build wealth along the way.

In short, it is a serious education for the serious investor.

That alone is worth the price of $49 for the year.

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