become too emo-tionally involved in their decisions and thus not make the best decisionswhen under pressure. By trading too often, costs increase and profits de-cline. Surely the expectation is that professionals can do better. After all,that’s why they’re paid those high salaries, isn’t it?
You might ask, “How is it possible that the pros are no better than pub-lic investors?” Aren’t we constantly being bombarded with advertisementsboasting  how  one  fund  after  another  has  an  outstanding  track  record?Those funds advertising their performance provide data showing how wellthey have done over a specified period of time. Don’t let those ads fool you.A normal distribution of results means there always are going to be somefunds that earn bragging rights. Funds that have performed well in recenttimes  take  advantage  of  that  fact  and  promote  themselves  to  public  in-vestors as the solution to all their investment woes.
This leads to the obvious question: If a fund outperforms the market,does that mean its managers are making great investment decisions, anddoes it mean that you should invest your money in these funds and expectfuture results to resemble those of the recent past? Alas, when mutual fundmanagers  tell  us  in  their  disclaimer  that  future  results  cannot  be  deter-mined by past performance, they are telling the truth. A two-year study wasmade of 294 diversified mutual funds (funds investing in a wide variety ofstocks,  i.e.  not sector  funds)  that  placed  advertisements  in  Barron’s orMoney  Magazine boasting  of  their  market  beating  recent  performance.8The study found that recent past performance bears little relationship to fu-ture performance. In fact, on average, the performance of the funds thatplaced those ads was significantly lower than that of the market averages.The authors concluded the following:
• The funds performed well in the year before the ads appeared, averag-
ing 1.8 percentage points better than the S&P 500.
• Comparing the inflow of capital to control groups, it was determinedthat  the  ads  were  effective,  increasing  capital  inflows  by  20  percentover expectations.
4339_PART2.qxd  11/17/04  1:02 PM  Page 35
Traditional Mutual Funds
35
• The performance of these funds in the year following their boasting ofresults was quite poor, with the funds averaging (an almost unbeliev-able) 7.9 percentage points worse than the S&P 500 over the next year.• When mutual funds tell consumers that past performance is no guar-
antee of future performance, they are telling the truth.
WHAT ABOUT THE ADVICE OF MARKET GURUS?
There are a great many stock market advisory newsletters available for thepublic  investor.  Are  they  worth  the  price?  Do  the  gurus  who  sell  thesenewsletters have the ability to make money for their subscribers? Statisti-cal studies tell us that some must perform well and others must performpoorly. A statement by business tycoon Alfred Cowles III9 provides the an-swer: “Market advice for a fee is a paradox. Anybody who really knew justwouldn’t share his knowledge. Why should he? In five years he could be therichest man in the world. Why pass the word on?”10
THE VERDICT, PART II. SHOULD YOUHIRE PROFESSIONAL MONEY MANAGERS?
No.  They  are  unable  to  deliver  market-beating  performance  and  theycharge a fee to manage your money.
I believe the most serious problem with mutual funds is their under-performance. Much could be forgiven if the managers were able to provideoutstanding  investment  results  for  their  clients.  Many  investors  don’tbother to read the reports issued by management and don’t follow the re-sults of their investments closely. They remain unaware that their funds un-derperform the market. Many pay scant attention when selecting mutualfunds to buy in the first place. Jim Rogers, well-known author, investor, andglobal traveler, recently commented on this situation in an interview in SFOMagazine: “People send their life savings off to some investment managerthey know nothing about. The idea of just blindly putting money into a mu-tual fund is madness.”11
When they were making piles of money, especially during the soaringmarket  of  the  1990s,  most  investors  never  gave  a  thought  to  the  perfor-mance of their funds, and it was easy for the managers to get away withunderperformance.
4339_PART2.qxd  11/17/04  1:02 PM  Page 36
36
CREATE YOUR OWN HEDGE FUND
Those  few  investors  who  were  aware  that  funds  earned  less  than  themarket averages probably didn’t know what they could do about the situa-tion. But when the market turned sour early in the new millennium, investorshad to suffer the indignity of paying excessive management fees in additionto suffering real losses in the value of their holdings. Some investors mightshrug their shoulders when learning of management improprieties, but whenthis behavior is coupled with poor performance, it’s reasonable for public in-vestors to seek other venues for their savings.
Investors are savvy enough to understand the ramifications of reportsdemonstrating the poor performance (and perhaps poor ethics) of mutualfund  managers  and  realize  that  investing  in  mutual  funds  is  not  the  no-brainer decision it once was considered to be. But most investors are un-aware of the viable alternative to mutual funds. The mutual fund industryspends  enormous  amounts  of  money  to  see  that  the  public  remains  un-aware of the options. There is a sizable sales force, earning big commis-sions,  selling  those  funds  to  the  public,  and  it’s  not  in  their  interests  toeducate investors. Thus, customers continue to plow billions of dollars intotraditional mutual funds.
As  of  July  2003,  more  than  91  million  Americans  (53  percent  of  allhouseholds) owned shares of mutual funds, according to the InvestmentCompany Institute. The vast majority of actively managed funds do not per-form well enough to earn back their fees and loads. As a result,
• Investors pay fees to managers for underperformance.• The mutual fund business thrives.• Investors retain their ownership of mutual fund shares for lack of a bet-
ter choice.
MUTUAL FUND FEES
Up to this point we have seen that mutual funds underperform the aver-ages, charge a management fee for that underperformance, and advertisegreat  results  when  they  achieve  them.  Is  there  anything  else  the  publicought  to  know  about  the  mutual  fund  industry?  Yes.  Actively  managedfunds are expensive to operate. They make many transactions in their at-tempt to beat the market, driving up trading expenses, and the sharehold-ers  pay  those  expenses.  They  hire  large  research  teams  to  back  up  theirinvestment decisions, and again, the shareholders pick up the tab. Somefunds charge a sales commission (load) to buy (and/or sometimes to sell)their shares. All in all, for a public investor, owning shares of a mutual fundis an expensive undertaking.
4339_PART2.qxd  11/17/04  1:02 PM  Page 37
Traditional Mutual Funds
37
TABLE 5.1 How Mutual Fund Management Fees Consume Your Account
$10,000 Growing at 11.0 % per Year, but Reduced by Management Fees of 1.25% or 0.25% per Year
Years
NoFee
51015202530
$ 16,851$ 28,394$ 47,846$ 80,623$135,855$228,923
Fee1.25%
$ 15,923$ 25,354$ 40,371$ 64,282$102,356$162,981
$ Lostto Fees
$928$ 3,040$ 7,475$16,341$33,499$65,942
Fee0.25%
$ 16,662$ 27,761$ 46,255$ 77,068$128,408$213,950
$ Lostto Fees
189$$633$ 1,591$ 3,555$ 7,446$14,973
According to the Investment Company Institute, the average manage-ment fee for a fund was 1.25 percent per year in 2002.12 Let’s do a little arith-metic. Over the past 30 years, the S&P 500 index has grown at an annualcompounded  rate  of  approximately  11  percent.  Assuming  your  fund  ex-actly matched that average, and assuming it charged 1.25 percent per yearto manage those funds, would that really have made a significant differencein  the  value  of  your  account  today?  Yes,  it  would.  Table 5.1  shows  howmuch less you would have today for a variety of holding periods, assumingyou began with an investment of $10,000.
Note that after 30 years, the account that paid annual fees of 1.25 per-cent is almost $66,000 lower than the equivalent account that paid no fees.And many funds charge even higher annual fees. For comparison, the tableincludes a hypothetical account paying an annual fee of only one-quarter ofone percent. After 30 years, this account is only $15,000 lower than the ac-count  with  no  fees.  If  you  manage  your  own  portfolio,  you  can  save  allthose fees. The methods taught in this book will enable you to manage yourinvestments easily, and your chances of outperforming the market will beincreased significantly.
If the information available concerning mutual fund management up-
sets you, it should. But take heart; a satisfactory alternative is available.
If  yours  is  among  those  mutual  fund-owning  families,  and  if  none  ofthese reasons for withdrawing your money from mutual fund managers isenough for you, then this book should get you to reconsider. By using ex-change traded funds to reduce investment expenses and stock options tohedge your investments, your chances of outperforming the market will besignificantly increased.
4339_PART2.qxd  11/17/04  1:02 PM  Page 38
C H A P T E R   6
ExchangeTraded Funds
In  an  attempt  to  increase  their  revenues,  the  stock  and  options  ex-
changes are always on the lookout for new financial products to intro-duce  to  the  investing  public.  But  finding  an  investment  vehicle  thatattracts a strong following is not an easy task. Many such offerings fall bythe  wayside,  and  eventually  the  exchanges  must  delist  them.  One  of  theamazing new product success stories is the exchange traded fund (ETF).State Street Global Advisors and the American Stock Exchange (Amex) in-troduced the first ETF to an American audience in January 1993 when Stan-dard & Poor’s depositary receipts (symbol SPDR) were listed for trading onthe American Stock Exchange, and the rest is history. Today the Amex re-mains the leading exchange for ETFs.
Beginning with that single entry, ETFs have exploded in popularity. Inthe first decade of their existence (through year end 2002), ETFs attractedmore  than  $102  billion  of  investor  capital,  according  to  the  InvestmentCompany Institute, and experts forecast continued rapid growth as morepublic and institutional investors become aware of the availability (and ad-vantages) of investing in these products. By June 2004 the total invested indomestic ETFs increased to more than $178 billion. That’s good news asETFs provide an opportunity for investors everywhere to compile a portfo-lio  that  meets  the  demands  of  modern  portfolio  theory  (MPT)  regardingasset allocation, diversification, and passive investing.
Exchange traded funds have become so popular with the investing pub-lic that several constantly rank at the top of the most actively traded list.The  most  actively  traded  ETFs  are  QQQ  (nicknamed  qubes),  SPDR  (spi-
38
4339_PART2.qxd  11/17/04  1:02 PM  Page 39
Exchange Traded Funds
39
ders), and DIA (diamonds); they mimic the performance of the Nasdaq 100,S&P 500, and the Dow Jones Industrial Average (DJIA) respectively.
I consider these ETFs to be the modern mutual fund, although they arenot exactly like mutual funds. Each ETF is a collection of stocks that tradesas a package, giving shareowners a proportionate investment in each of thestocks in the collection. In this respect, they are exactly like a traditionalmutual fund. Technically, the first ETF, SPDR, is a type of investment vehi-cle  called  a  unit  investment  trust  (UIT).  This  novel  investment  vehiclerapidly gained acceptance in the marketplace and paved the way for accep-tance of similar products. These unit trusts own a fixed portfolio of stocks.The roster of stocks in the portfolio is changed only when one company isdropped from the index and is replaced by another. In this respect, SPDR issimilar to an index mutual fund. But, unlike an index fund, UITs must ex-actly replicate the index whose performance it is attempting to mimic, andsampling is not allowed. Sampling consists of compiling a portfolio that con-tains most, but not all, of the stocks in an index. (The goal of sampling is toachieve a very high correlation with the actual index using as few stocks aspossible.) Details of the workings of UITs are presented later in this chapter.ETFs are available to track many of the popular broad-based indexes,such as the Dow Jones Industrial (DIA) and Transportation (IYT) averages,the Nasdaq 100 (QQQ), or the Wilshire 5000 (VTI). In addition, holding com-pany  depositary  receipts  (HOLDRs)  and  sector  spiders  are  two  populargroups of ETFs that invest in specific sectors of the market. They are secu-rities that represent an investment in companies in a specific industry, sec-tor,  or  group.  These,  as  well  as  other  ETFs  with  slightly  differentcharacteristics, are described in greater detail below.
A SIMPLE ROAD TO A WELL-DIVERSIFIED PORTFOLIO
By buying shares of a broad-based ETF, investors essentially own the mar-ket.  This  accomplishes  a  major  goal  for  investors:  diversification.  Ofcourse,  owning  shares  of  a  mutual  fund  accomplishes  the  same  goal,  sonext let’s compare ETFs with their cousins, traditional mutual funds. Youwill see why investing in ETFs is a viable alternative and how ETFs can beused as the centerpiece of your overall investment strategy. Following theprecepts of MPT, our investment goals are to increase profit potential whilereducing risk.
Owning ETFs is not without market risk. In that respect, ETFs are nodifferent from traditional mutual funds. But the strategy recommended inthis book is intended for investors who want to own stocks and who want
4339_PART2.qxd  11/17/04  1:02 PM  Page 40
40
CREATE YOUR OWN HEDGE FUND
to invest money in the stock markets of the world. If owning stocks is con-sistent with your investment philosophy, but if you prefer to do so with re-duced risk, then you have come to the right place. If owning stocks is notfor you, then this strategy is not for you. Except for the most risk-adverseinvestors, every asset allocation plan that follows the teachings of MPT rec-ommends owning stocks as the heart of an investment plan.
HOW ETFS DIFFER FROM TRADITIONAL MUTUAL FUNDS
You buy shares of traditional open-ended mutual funds by sending moneyto  the  management  company  that  operates  the  fund,  or  to  a  salesperson(usually your broker) acting on behalf of the fund. You pay the net assetvalue of the fund, as calculated from the day’s closing prices.1 If the fundcarries a sales charge (load), then the purchase is made after the load is de-ducted.2 If you buy a no-load fund, 100 percent of your investment is usedto purchase shares. The fund’s managers take your money (along with thatof  other  investors)  and  decide  to  keep  the  money  in  cash,  use  it  to  payshareholders who are redeeming shares, or use it to invest in the market.
Since the price of the shares is determined once per day, at the close ofbusiness, if your buy or sell order (or telephoned instruction) arrives dur-ing  the  trading  day,  you  get  that  day’s  closing  price  (net  asset  value,  orNAV). If it arrives after the close, you buy or sell your shares at the follow-ing day’s NAV. This is a disadvantage if you want to buy or sell shares at thecurrent market price. You must wait to the end of the day to learn the priceat which you buy or sell shares.
It’s much simpler to trade ETFs, as they trade on an exchange, just likestocks.  They  can  be  bought  or  sold  any  time  the  markets  are  open.  In-vestors benefit by being able to choose when to place a trade, rather thanbeing forced to accept the day’s closing price as the entry or exit point.
Thus, advantage number one for ETFs is the ability to trade any timeduring market hours. As you will see, this is necessary because it allowsyou to make your ETF investment and immediately use options to hedgethat investment.
Because  the  managers  of  traditional,  actively  managed  mutual  funds  areconstantly buying and selling shares in their attempt to beat the market,they often realize profits and losses. Profits are passed along to the share-holders in the form of capital gains distributions. Whether you accept thosegains  in  cash  or  reinvest  the  gains  to  buy  additional  shares,  you,  the  in-vestor, are obligated to pay capital gains taxes on those distributions. You
4339_PART2.qxd  11/17/04  1:02 PM  Page 41
Exchange Traded Funds
41
may receive such a capital gains distribution, and with it an income tax lia-bility,  even  during  periods  when  the  fund’s  NAV  is  declining  (the  fund’sshareholders  are  losing  money).3 As  a  shareholder,  you  have  no  say  inwhether you receive those capital gains. If you receive them, you must paythe taxes.
ETFs are much more tax efficient. Because ETFs seldom change thecomposition of stocks in the portfolio, they seldom have capital gains todistribute. That’s a great benefit to you, the shareholder, as your tax liabil-ity is determined by when you buy and sell your shares. In other words, in-vestors  who  trade  ETFs  can  arrange  the  timing  of  their  capital  gainsliability. That is advantage number two.
If you are a mutual fund shareholder interested in following your invest-ments closely and want to know which stocks are contained in your port-folio,  you  are  out  of  luck.  Funds  are  required  to  publish  their  currentholdings only two or four times per year. At other times, you cannot learnthe makeup of the fund’s portfolio.
ETFs, however, are transparent (advantage number three). Investorsalways know exactly which stocks are owned, since the list of stocks in theETF portfolio is almost exactly the same as the components of the index. Infact, if the ETF is a UIT, the portfolio is exactly the same. Information de-scribing the composition of the specific indexes is readily available online.(See, for example, www.amex.com.)
Mutual  funds  allow  investors  to  invest  money  and  buy  more  shares  anytime  as  long  as  a  reasonable  minimum  investment  (often  $250)  is  made.Similarly, withdrawals are allowed at any time. In some cases, an additionalfee (back-end load) is charged if shares are sold before a minimum holdingperiod.
A fourth advantage in buying ETFs is that there is no minimum invest-ment. In fact, except for HOLDRs, which require a minimum purchase of100 shares, you can buy as little as one share. When buying shares of anETF, the investor pays a brokerage commission, just as when buying stock.For the investor who has several thousand dollars (or more) to invest, thecost of commissions to purchase ETFs becomes insignificant (especiallywhen  using  a  deep-discount  broker),  when  compared  with  the  front-endsales load of traditional mutual funds. No-load funds are another matter, asthey can be purchased with zero sales charge and no commission. How-ever, these no-load funds cannot be combined with the options strategy dis-cussed in the following chapters.
For  small  investors  who  make  periodic  investments  (perhaps  $50  or$100 every month), buying ETFs is not efficient, as the broker’s commis-sion may be higher than the sales load.4
4339_PART2.qxd  11/17/04  1:02 PM  Page 42
42
CREATE YOUR OWN HEDGE FUND
As noted, managers of traditional mutual funds charge a management fee,regardless of performance. Individual managers may even earn a bonus iftheir performance is considered to be superior—but they pay no penalty fora very poor performance. Actively managed mutual funds generate huge ex-penses in the form of commissions and research costs. ETF managers sel-dom  trade,  thereby  saving  their  shareholders  those  expenses.  Lowermanagement fees are advantage number five for ETFs.5
The discussion that follows assumes you are capable (alone or in con-sultation with a financial professional) of selecting a mix of ETFs that is suit-able for you. For some investors, owning shares of one broad-based indexETF may be sufficient diversification. Other investors will be more comfort-able with additional diversification. It’s your decision. Chapter 13 presentsexamples of how to create a portfolio by buying shares of various ETFs.
DIVERSIFICATION CHOICES WHENBUYING EXCHANGE TRADED FUNDS
Investors  can  choose  to  own  shares  of  ETFs  that  own  shares  in  varioustypes of companies.
Different-Size Companies
• ETFs specializing in the shares of large, midsize, or small companies.
Businesses Located Worldwide
(Some foreign-based ETFs are not available for ownership by Americans.)6
• Single-country ETFs own shares of companies located in one specific
country.
• Continent-specific ETFs invest in shares of companies located in Eu-
rope or Asia.
Specific Industries
• Both sector spiders and HOLDRs invest only in shares of companiesdoing business in a specific industry, such as semiconductor, retail, orbiotechnology.
Specific Indexes
• ETFs  track  the  performance  of  the  following  specific  indexes  from
around the world:• Broad-based indexes, such as the Nasdaq 100 index, the S&P Mid-
Cap 400 index, or the Russell 2000.
4339_PART2.qxd  11/17/04  1:02 PM  Page 43
Exchange Traded Funds
43
• Narrower indexes, such as the Dow Jones Industrial average or the
Dow Jones Transportation average.
• Indexes based on foreign stocks that trade in the USA. Baskets ofListed Depository Receipts (BLDRs) own only ADRs (American De-positary  Receipts—essentially  foreign  stocks  that  trade  on  Ameri-can stock exchanges).
• Foreign indexes, such as the MSCI EAFE or the S&P 100 Global index.7
• Growth or value components of various indexes
• Several  broad-based  indexes  have  been  subdivided  into  “growth”and “value” sectors. That division is based on the price-to-book ratioof the individual stocks.8
DIFFERENT TYPES OF EXCHANGETRADED FUNDS
From a technical point of view, there are three different legal structures forETFs. They are:
1. Unit investment trusts2. Open-ended mutual funds3. Grantor trusts
Unit Investment Trusts
Investors who buy shares of a UIT are not buying shares of a mutual fund.As far as investors are concerned, the results of the investment are essen-tially identical with owning a fund, but for those interested in the details,this is the real-world situation (using QQQ as an example):
Unit investment trusts are investment companies that put together acollection of stocks and sell fractional interests to public investors. In thisrespect, they are identical with open-end mutual funds. One such unit in-vestment  trust,  named  the  Nasdaq  100  Trust,  Series  1,  issues  securitiescalled Nasdaq 100 Index Tracking Stock. When you buy or sell QQQ shares,in reality you are trading the tracking stock that represents ownership inthe  portfolio  of  stocks  held  by  the  trust.  That  portfolio  consists  of  theproper number of shares of each of the common stocks in the Nasdaq 100index and is intended to mimic, before expenses, the price and yield per-formance of that index.
The Nasdaq 100 index does not represent an equal number of shares ofeach  of  the  100  companies,  but  instead  is  capitalization  weighted.9 (Thecompanies  with  the  greatest  market  value  have  the  most  weight  in  the
4339_PART2.qxd  11/17/04  1:02 PM  Page 44
44
CREATE YOUR OWN HEDGE FUND
index.) Thus, as stock prices change, their proportionate representation inthe index undergoes subtle changes. To maintain the correspondence be-tween  the  securities  held  by  the  trust  and  the  stocks  in  the  index,  occa-sionally the securities are adjusted to conform to periodic changes in therelative weights of stocks in the index.SPDR, the first ETF, is a UIT.This type of trust is not allowed to sample the index it is attempting tomimic, but must own each of the entities of the index in its exact propor-tion. But even this requirement has an exception. No fund is allowed to in-vest more than 25 percent of its assets in the stock of any one company. Ifthe weighting of any one company within an index is above this threshold,a  fund  statistically  optimizes  its  holdings  to  reflect  the  weighting  of  theindex while still adhering to the diversification rule.
UITs are not allowed to reinvest cash dividends. Instead, they depositany  income  in  a  non–interest-bearing  account  and  distribute  those  divi-dends (after first deducting the expenses of operating the ETF) periodicallyto shareholders. This is the major difference between UITs and open-endedmutual funds. For some UITs, the dividends are less than the fund’s oper-ating expenses, and no dividends are available to pay to shareholders.
Table 6.1 lists ETFs in this category.10
BLDRs Nasdaq sponsors BLDRs, the acronym for baskets of listed de-positary  receipts.  Each  BLDR  represents  ownership  of  shares  of  ADRs(American Depositary Receipts, equivalent to shares of foreign companiesthat trade in the United States) in one of the Bank of New York’s ADR in-dexes. BLDRs operate as UITs.
Table 6.2 lists the four BLDRs.
PowerShares PowerShares  are  unique  ETFs  because  they  seek  toreplicate the performance (before expenses) of a managed group of stocks,specifically the Dynamic OTC Intellidex index and the Dynamic Market In-tellidex index. These are different from all the other ETFs discussed so farbecause the group of stocks owned by the ETF is managed. Those man-agement decisions are made on a quantitative, objective basis. That means
TABLE 6.1 Unit Investment Trusts ETFs
Unit Investment Trusts
DIAMONDsMidCap SPDRsNasdaq 100 Index Tracking StockSPDRs
Symbol
DIAMDYQQQSPY
4339_PART2.qxd  11/17/04  1:02 PM  Page 45
Exchange Traded Funds
45
TABLE 6.2 BLDRs
Exchange Traded Fund
Symbol
Type
BLDRs Emerging Markets 50 ADR Index FundBLDRs Developed Markets 100 ADR Index FundBLDRs Asia 50 ADR Index FundBLDRs Europe 100 ADR Index Fund
ADREADRDADRAADRU
InternationalInternationalInternational, RegionalInternational, Regional
Source: www.bldrsfunds.com
there are no investment managers imposing their biases on the stock se-lection process. There are no costly research departments. This manage-ment  process  is  less  costly  than  those  of  traditional  mutual  funds,  andexpenses are capped at 0.60 percent per year—less than traditional mutualfunds but at the high end of ETF management fees.
These  ETFs  operate  as  UITs  and  represent  one  of  the  newer  entries
into the ETF marketplace.
Table 6.3  lists  the  two  PowerShares  ETFs.  The  American  Stock  Ex-change recently announced that six new PowerShares have been approved,but a launch date has not been set. Table 6.3 lists these six new products aswell.
Open-Ended Mutual Funds
Most ETFs operate as open-ended mutual funds.
iShares iShares  are  very  similar  to  UITs,  but  they  are  not  exactly thesame.  The  differences  are  subtle  and  of  no  concern  to  most  investors.
TABLE 6.3 PowerShares
Ex