Wednesday, August 13, 2008

Don't "Over-Diversify" with ETF's

I'm a big fan of using ETF's (exchange traded funds) as a part of a successful portfolio. But its easy to fall into a false sense of security with many of these funds. Also, people tend to "over-diversify" with these funds. My theory for ETF's is use them as a tool for investing in areas where its hard to otherwise. I use ETF's to short various indexes or sectors. I'd also use an ETF to buy into an asset class with few US listed stocks (for example wind power companies).

But if you've identified a trend to want to capitalize on (say agriculture stocks for example), do your homework. Identify the best companies in that space, and if there are available stocks, which in this case there are, don't handcuff yourself by buying an ETF. For example, buying Mosaic(MOS) or Potash(POT) would give you much better returns than buying an ETF (MOO).

The problem with ETF's is they use a wide variety of stocks to offset risk. But often times, that means your fund is holding stocks of large, diversified companies. These companies may have some businesses in the space you're looking at, but may be at risk in other areas. I think of GE in a situation like this. You'd like to own it for their wind turbine business, or their infrastructure/aerospace business, but you have to buy their finance business as well.

So the big take-away here is use ETF's when there aren't good investment opportunities in a sector or trend you like. Don't use them when there are better alternatives.

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