What are iShares and Exchange Traded Funds?

After a 36% rise of the Dow Jones Industrials, a 40% rise of the broader S&P 500 and a 55% rise of the NASDAQ, investors decided to take a breather.  The first stocks to succumb to selling pressure were last year’s market leaders; technology and biotechnology companies comprising the majority of the NASDAQ index.  It reached a peak on January 29th suffering three periods of 6% declines each since then.  The index is currently off just under 10% from its high.   The Dow reached a 52-week high on February 19 at 10,753, but has fallen 5.6% since then.  The S&P 500 was last to succumb, peaking on March 5th and falling 4.4% from that level. 

Market experts have warned of a correction for several weeks, saying a decline was needed to bring valuations more in line with reduced earnings expectations.  The correction appears upon us.  In a very short time investors have gone from rather extreme optimism to pessimism about the market and corporate earnings growth.  A number of factors amplify concerns; from the terrorist bombings in Madrid, to the negative tenor of the presidential election rhetoric, to the continued mixed signals from the economy.  But while a market correction was expected and somewhat overdue, most agree that it will be relatively short-lived and mild.

Investors remain understandably prickly following the bursting of the largest bubble in history and the subsequent corporate scandals.  CEO’s under new SEC regulations are less sanguine about their future than they used to be and tend to report only the bad news during the interim quarter.  The good news is typically held until the quarterly earnings are reported.  While overall market volatility has declined, individual stock volatility continues.  Extraordinary stock price movement generally accompanies quarterly earnings announcements, but also comes unexpectedly when an analyst changes his or her opinion or the company announces a material disappointment of some kind.  The stocks can move rather substantially downward and underperform their peers longer than was typical before.

Our response to this problem has been the increased use of exchange-traded funds (ETFs) such as “iShares.”  These shares represent funds which are not managed in the traditional sense.  Those who offer them, such as iShares and Standard & Poors Spiders, build portfolios to mimic a particular index or economic sector.  The extent of their management is to mirror the pertinent index’s performance.  Therefore, management fees are very low in comparison with those mutual funds whose objective it is to beat particular averages.

ETFs are increasing in availability and popularity among investors for at least two primary reasons; they provide instant exposure to an economic sector, index, or country and they dramatically reduce volatility risk through diversification.  A third and important advantage is that they can offer steadier price appreciation than their individual components.

During the early market rally of 2003 we noted that while the indexes marched relentlessly on, the stock leadership within them changed just as steadily.  The same thing happens within ETF portfolios.  Look below at the comparison of the iShares NASDAQ Biotechnology index (IBB) to its two leading components Amgen and Biogen.  Over the past year the IBB index racked up a 47% return while Amgen and Biogen achieved only 9% and 20% returns, respectively.

We believe the biotechnology industry will be incredibly important in the advance of medical research in the coming years.  But this industry is highly fragmented and comprised of numerous small, high-risk companies with high individual stock volatility.  Exchange traded funds facilitate exposure to this promising industry, while reducing its risk through diversification.

Another example of improved performance can be found with a comparison of Microsoft to the Goldman Sachs Software Index on the next page.

Microsoft appreciated only 9% over the past year, while the Software Index iShares IGV rose almost 51%.

Yesterday Procter & Gamble had a great day as they reported an excellent quarter’s results.  The stock rose by as much as 5% on the day’s news.  The corresponding ETF, the SPDR S&P Consumer Staple Index actually fell a half percent on the day.  But look longer term.

As you can see, the black line representing the ETF has performed nearly identically to P&G as of yesterday, but with more consistency.  WalMart is included for an even more vivid example of how the index smoothes volatility.  One does not think of WalMart as being particularly volatile, indeed its price has not changed much since October of 1999.  But at various times during the past year, WalMart has outperformed its industry by 12% and underperformed it by a similar 12%.  Over the past five years the Consumer Staples index has delivered a total return of 16.8% compared to WalMart’s .5%.

Our long-term strategy remains the same, but our tactics have changed in response to today’s realities new opportunities.  With a combination of top-performing individual stocks and exchange traded funds we believe we can deliver better than benchmark returns with lower volatility over the long run.