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The Independent Investor: Exchange-Traded Funds Catch On

Bill Schmick

Exchange-traded funds (ETFs) assets have recently surpassed the $1 trillion mark as investors continue to discover these securities are a welcome alternative to both stocks and mutual funds. Adding $122 billion to this growing class of funds in 2010, investors and experts alike believe ETFs will continue to grow as markets become highly correlated in the years ahead.

Readers are aware that I have written a number of columns on ETFs over the years. But for those new to the concept, I'll quote Wikinvest's definition of an ETF:

An exchange-traded fund (ETF) is an investment product — similar to a mutual fund — that trades on a stock exchange. Most ETFs track major stock indices or industry sub-sectors, which allows investors to get exposure to either the entire market or specific sectors with a single purchase. Unlike a mutual fund, an ETF's holdings — the investments it makes — are always known (its components are simply the weighted components of the index it tracks). While mutual funds often aim to 'beat' the market or the sector they track, ETFs usually aim only to track the market and match its performance, good or bad. As a result, ETFs often charge lower fees than mutual funds, and are known as inexpensive ways for investors to invest in the market as a whole or specific subsectors. ETFs also have lower-expense ratios because they are not actively managed. In most cases, this results in lower management fees and lower turnover costs.

Now given that they are cheaper, trade all day, (unlike mutual funds that trade once a day after the market close), and outperform mutual funds the majority of the time, why haven't they driven mutual funds out of business?

The answer is two-fold: commitment and self-control.

Some investors believe that they can outperform the market if they pick the right mutual fund manager. There are fund managers out there who consistently do that although the numbers are less than 25 percent of all mutual funds.

Although ETFs will generate the same returns as their underlying index, many investors are guilty of buying and selling ETFs at the wrong time. Emotions sometimes get in the way of objective investing. ETFs, given that they trade all day like stocks, are far easier to dump (or chase) when the markets suddenly turn against you while mutual funds charge a penalties for such short term trading. And unlike ETFs, they can only be purchased once a day after the stock market closes.

Nonetheless, experts expect the demand for ETFs will continue to grow. Financial giants such as Charles Schwab and TD Ameritrade have begun to offer their own ETFs and are offering investors incentives to switch their buying to their house brand by offering commission-free trades and undercutting competitors in the expense ratios area.

The recent proliferation of exchange-traded notes or ETNs that invest in commodities such as gold bullion, sugar, platinum and a host of other commodities have also attracted the interest of investors. Many of us have found a cheap, viable approach to investing (or speculating) in a field long closed to all but the best-heeled professionals. But buyers beware, ETNs are taxed differently then ETFs (even in tax–deferred accounts such as IRAs).

Nonetheless, ETNs have been so successful in attracting new money that there have been several articles criticizing ETNs for artificially inflating the price of commodities such as oil, and causing spikes in consumer stables like gasoline.

Finally, the fact that most stock markets have become highly correlated makes buying individual stocks or even mutual funds less efficient. If everything is going up together an ETF enables the investor to buy into sectors, countries, regions or even world indexes quickly. They allow the little guy to truly become a global investor, although how one performs requires that same old self-control and commitment that has been around for centuries. The more things change, the more they stay the same.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

Tags: ETF, mutual funds      

The Independent Investor: Hi Yo Silver

Bill Schmick

Gold is at record highs this year but silver is barely back to where it was 30 years ago. As the spin doctors out do each other in bumping up their price targets for the "other" metal, I am going to stick to my guns. Silver is just $6 an ounce short of my price target.

Back in 2008 when silver hit $20 an ounce and gold topped $1,000 for the first time, I recommended investors take profits. That turned out to be sage advice since both metals dropped precipitously. Silver fell to almost $9 an ounce. I promptly recommended purchasing it again. Once the price returned to $20 an ounce, I suggested that silver could reach $36-$37 before pulling back again. This week silver topped $30 an ounce before falling 5 percent.

There are several explanations for why silver has had such a great run this year. Silver's largest end-users are the electrical and electronic sectors. Both are now emerging from recession and industrial demand for the physical metal is rising. Jewelry demand for silver has also picked up. The price of gold has soared, making silver a less expensive alternative for shoppers.

The creation of silver exchange-traded funds (ETFs) has opened up a new source of demand for bullion as well. Up until 2006, investors interested in purchasing silver were required to buy and store bullion through a bullion desk, or go to a jeweler or trade in the futures market. The advent of silver ETFs greatly expanded the silver market and offers investors a low-cost, liquid way of investing. As more and more investors purchase these silver ETFs, the funds must buy up additional quantities of silver or silver stocks, sending prices up even further.

Silver does offer some protection against potential inflation as a physical and transferrable store of value. It is the same argument that is behind the price increases we have experienced for all commodities from gold to pork bellies.

Gold and silver pros often keep an eye on the price ratio between the two metals. Up until 2008, it typically required 55 ounces of silver to buy one ounce of gold. Today that ratio is roughly 47 ounces. Silver has been outperforming gold all year but historically, (over 10 years) when that ratio hits 40, silver starts to underperform gold.

Like gold, silver can be purchased in a variety of forms. Some investors buy coins, others actually buy and store 100-ounce silver bars. These physical silver options trade at a premium to the silver price and storage costs eat into profits. One can also buy silver stocks, precious metals mutual funds and/or exchange traded funds that offer investors the option of stocks, futures or bullion without the storage fees or premiums.

There is also the junk silver market: U.S. quarters, dimes and half-dollars minted before 1965. These coins have no collectable value since they are worn, scratched, chipped and otherwise damaged. This wear and tear has reduced their silver content. On average, they now contain only 71.5 ounces of silver down from the 90 percent when first minted.  These old coins are sold in bags of either $100 or $1,000 face value and tend to outperform silver bullion.

Now you have a better idea of why silver is where it is. But remember, the most important lesson in investing in silver or any other commodity is to know when to sell. My price target remains $36-$37 an ounce. If I were a cautious investor, I would not wait until that price range is reached. Remember, too, that commodity prices can drop sharply and in a blink of an eye. A 10 to 20 percent drop in a week is entirely within reason, especially after a big run-up so buyers beware.

That doesn't mean that the bull market in silver is over but it could mean a sharp decline followed by a period of consolidation.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

Tags: metals, silver, ETF      
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