Way back in 2020, I compared the individual stock holdings of two sector ETFs (exchange-traded funds).
As my team and I prepared the piece for publication, my editor commented: “Can we add more info? Why should our readers care about ETFs?”
She was right, and I obliged. (We call that the curse of knowledge: When know-it-all authors assume that their readers have the background to understand everything they write.)
But it got me thinking … and a bit fired up.
Why should our readers care?! About ETFs?!
Are you kidding me?!
Don’t get me started on ETFs…
They might not sound as exciting as individual stocks, but smart investors should care about ETFs for several reasons.
The Only Free Lunch in Finance
For one, ETFs allow everyday retail investors like you and me own a diversified basket of stocks.
Instead of betting the farm on just one stock, say, in the technology sector … you can position yourself for a bullish trend in the sector without having to guess which one company will outperform the rest or which company’s stock will tank on one lousy earnings report.
Diversification has been called “the only free lunch in finance.”
In simple terms, you can earn an equal or higher return when you diversify compared to when you don’t … and you can suffer far less volatility and drawdowns when you diversify too.
That significant risk-reduction feature of diversification is what makes it a “free lunch,” particularly since you don’t have to give up superior returns when you do it right.
Of course, diversification is an age-old piece of wisdom even outside the stock-market arena.
My whip-smart grandmother grew up on a family farm in Kanawha County, West Virginia. One Thanksgiving, we were talking with her about the farm and how they’d weathered multiple economic downturns over the years.
I remember asking her what she credited their survival to…
She didn’t hesitate. With a half-chewed bite of turkey leg in her mouth, she said: “We were diversified.”
Back to stock market investing, ETFs give us an easy way to own a diversified basket of stocks … and that decreases our risk of taking a catastrophic loss on any single stock.
In turn, that gives ETF investors a far greater chance at weathering a downturn compared to someone who’s bet the farm on one company.
Ultra-Wealthy Hedge Fund Strategies
The diversification benefit ETFs afford alone should be enough to keep your interest in them.
Beyond that though, the latest innovations in ETFs now give regular retail investors access to strategies and exposures historically reserved for ultra-wealthy hedge fund clients.
Almost three years ago, I pitched to an audience of several hundred investors 15 ETFs that I thought were good buys “for 2020 and beyond.”
Of those funds, 10 could be considered “bullish” stock market ETFs. They gave access to specific stock market factors and strategies — things that, again, have been limited to hedge funds in the past.
And five of the ETFs were considered “hedges,” which I expected to perform well during an economic or market downturn … though I was clear with the audience that I couldn’t forecast precisely when that downturn would come or what would cause it.
Long story short, that simple “ETF portfolio” I recommended in mid-October of 2019 killed the S&P 500 through the end of 2020!
Not only did it lose far less than the S&P 500 through 2020’s coronavirus crash … it was still beating the market even after months of recovery.
And that’s because the ETFs I recommended gave investors access to strategies you simply can’t get when you plunk down your money on a single stock, or even in an S&P 500 fund, such as the uber-popular SPDR S&P 500 ETF (NYSE: SPY).
The Value of ETFs
To list just a few, the ETFs I pitched to that audience gave them exposure to:
- Gold (the world’s oldest crisis hedge).
- A portfolio of put options. (Note: Put options soar higher when stocks stumble.)
- A long-volatility vehicle. (Volatility also soars higher when stocks tumble.)
- A sector-rotation strategy that invests in U.S. stock sectors that are both valued on the cheaper side compared to other sectors and trending higher.
- A momentum strategy applied to stocks in the health care sector.
- A fund of low-volatility stocks, which tend to fall less in down markets.
- A fund that uses options to allow participation in the S&P 500’s profits in rising markets, while also limiting, or “capping,” the S&P 500’s losses in down markets.
And that’s just to name a few…
In reality, it took me a full hour to pitch this “all-weather” ETF portfolio to the audience in October 2019. I had just a few minutes for each fund!
So I can’t cover each one of them and the unique value they provide in today’s issue.
For now, I hope you can begin to see some of the benefits that come with keeping an open mind about ETFs.
It’s true that stock-picking can be a thought-provoking and lucrative endeavor — and we certainly do a great deal of that in my premium Green Zone Fortunes stock research service.
But if you’re looking past ETFs because you think that they’re too boring or “slow” to be worth it … I hope you’ll think again!
To good profits,
Adam O’Dell
Chief Investment Strategist
Story updated on September 1, 2022.