Blue chip stocks
A "blue chip" is the nickname for a high-quality stock that is
thought to be safe, in excellent financial shape and firmly entrenched as a
leader in its field. These kinds of stocks have been called "blue
chips" for decades. the phrase blue chip comes from poker where the
highest and most valuable playing chip is blue. It is an interesting reference
in that the game of poker and the stock market both involve some elements of
skill, luck and risk. Blue chips belong to companies renowned for the quality
and wide acceptance of their products and services, and for their ability to
make money and pay dividends in both good and bad years. Blue chips generally
pay dividends and are favorably regarded by investors especially by investors
with a conservative risk tolerance.
A few examples of blue chips are Wal-Mart, Coca-Cola, Gillette, Berkshire
Hathaway and Exxon-Mobile. Blue chip stocks are sometimes referred to as
bellwether issues. Despite their reputation as boring, stogy and perhaps even
a little outdated, blue chip stocks have long reigned supreme in the portfolio
of retirees, non-profit foundations and conservative individuals. These
companies often reside at the core of American business and boast pasts as
colorful as any novel. Yet the prosaic-ness attributed to them is certainly
not deserved; there is nothing more exciting than making a profit and that is
certainly what blue chips are all about. Information about blue chip stocks is
usually found on the Dow Jones Industrial Index.
EXCHANGE-TRADED FUNDS
Exchange-traded funds (ETFs)
are like index mutual funds that behave like stocks. They trade all day on
recognized stock exchanges such as the American Stock Exchange, and some trade
during extended hours. These funds are not actively managed; they are like
index funds that are passive. They replicate an index, such as the S&P 500
index or a growth stock index, without trying to outperform that index.
The trustee updates the holdings every few seconds to keep the net asset value
of the ETF in line with the market. This is a lot of updating, so you obtain
better tracking results with a smaller index like the Nasdaq-100 than you do
with a large one such as the ONEQ that tracks every Nasdaq stock. As with any
trust, there is a custodian who holds the securities that the trustee buys.
There is a lot of free education about ETFs on the Internet now that the
public has joined hedge funds in trading these instruments. Nuveen Investments
has a web site, ETFConnect, at www.etfconnect.com; and, as usual, Yahoo.com
has extensive information on this popular new trading vehicle.
Exchange-traded funds are important to us for two reasons. First, they provide
a way for our model portfolio to invest in two potentially lucrative assets:
the Nasdaq Composite index and gold bullion. There is no Nasdaq index fund and
there is no convenient way to trade gold. Exchange-traded funds are the only
way to put these two investments into a real portfolio. Second, they expand
our options for sector investing. Both functions are equally important to our
model portfolio.
Before we examine the details of ETFs, however, let us inject a little Wall
Street wit.
Nicknames for some of the first ETFs reflect this industry’s penchant for
dry humor. The first ETF appeared in 1993 with the objective of replicating
the total return of the S&P 500 index. The name of the trust is Standard
& Poor’s Depositary Receipts (SPDR). Its stock symbol is SPY, and it
quickly earned the nickname “spider.” Newspaper advertisements for this
fund, or trust, featured a spider building a web of financial security. It is
the same with the first ETF for the Dow Jones Industrial Average. The symbol
is DIA; the nickname is “diamonds,” and the advertisements include
gemstones. Vanguard, which started the indexing trend with their family of
mutual funds, created a group of ETFs called Vanguard Index Participation
Equity Receipts (VIPERs). The Nasdaq-100 ETF has the symbol QQQQ and the
nickname “cubes.” Wall Street loves nicknames.
EQUITY ETFS
Standard & Poor’s
Depositary Receipts offer a convenient way to implement the trading decisions
generated by our model portfolio. Each SPDR owns all 500 of the stocks in the
S&P 500 index in their market capitalization weight. We can trade the SPDR
all day and into extended hours; we can buy and sell options on it; and we can
leverage it in the futures market. There is a price for all this flexibility;
your broker will still charge a commission when you buy any ETF. If you are
charged about $30 and you are investing less than $30,000, you are better off
in an index fund directly from Vanguard. Larger investments, obviously,
benefit from economies of scale in trading commissions.
Vanguard does not, however, offer a mutual fund that replicates the 3,000
stocks in the Nasdaq Composite index. This index is one of the investments
that gave us outstanding returns in our model portfolio, but until 2003 there
was no way to buy that index. The only way to capture all of the Nasdaq stocks
in one trade is to buy the Fidelity Nasdaq index fund called the ONEQ. Its
management fee of about one-half of 1 percent causes it to underperform its
benchmark a little, but we finally have a way to invest in the Nasdaq
Composite index.
Other equity ETFs track a myriad of sector indexes that help us with our
sector rotation investing and our selection of individual stocks.
Index ETFs are true index funds as opposed to the sector mutual funds. Those
sector funds may hold only 80 percent of their assets in their sector, but
ETF’s have as much money as possible invested as a mirror image of their
index. Because exchange-traded funds are truly passive, many of them have
lower fees and better tracking results than traditional sector mutual funds.
The new exchange-traded funds offer hundreds of ways to track indexes in all
of our asset classes. They also include the four styles: large and small
capitalization and value or growth stocks. Then, of course, there are ETFs
offering indexes of blended styles.
FIXED-INCOME ETFS
Fixed-income ETFs fall into two
categories: international and domestic. Barclays Bank is the trustee for a
family of foreign fixed-income ETFs that allows investors to choose among
several points along the yield curve. Like a traditional bond mutual fund, an
ETF will never mature; so investors are just choosing whether they want
short-, intermediate-, or long-term investments. In effect, they are buying
perpetual bonds of a particular duration. Goldman Sachs acts as trustee for an
ETF that mirrors its corporate bond index, and Lehman Brothers is the trustee
for several U.S. government security funds. These funds may be one of an
investor’s better opportunities to get institutional prices for bonds.
REAL ESTATE ETFS
The fund selector on Yahoo.com identified four real estate investment trust
ETFs. Each one tracks an index for different parts of the domestic REIT
market. The oldest one is the iShares Dow Jones U.S. Real Estate ETF that came
out in 2000 when the yield curve inverted. The fund went from $55 per share at
inception to $123 per share four and a half years later and earned an average
annual return of 20 percent. As you know, the stock market lost 20 percent
during those four years. Whoever made that new product decision at Dow Jones
probably uses the same yield curve analysis that you and I do.
GOLD BULLION ETFS
Gold ETFs are one of the few
ways that people can invest in gold bullion near a price that is usually
available only on an exchange. These ETFs buy gold bullion and store it in a
vault. This is very different from gold mutual funds that own shares in mining
companies but do not own the gold itself.
The two investments behave quite differently during a crisis. Mining companies
trade like any other stock when investors panic and sell equities
indiscriminately. At a time like this, gold stocks decline along with all the
others. The physical commodity of gold, however, often provides a safe haven
during uncertain times and makes money when stocks crash.
The first gold bullion ETF appeared in November 2004 and attracted a
phenomenal $1.3 billion in assets during the first two months. This gold ETF,
StreetTracks Gold Shares, uses the symbol GLD. Unlike most ETFs, it trades on
the New York rather than the American Stock Exchange.
Yahoo.com shows two performance numbers for each ETF: that of the ETF itself
and that of the index it replicates. Investors can see how well their fund is
doing its job of tracking its benchmark, and StreetTracks Gold Shares appears
to lag the performance of gold by about one-half of 1 percent. This
discrepancy is probably due to the cost of storing the gold. Owning an ETF may
be the cheapest way to buy and store gold because economies of scale allow the
trust to buy gold near the price on a major exchange, such as the COMEX in New
York, and spread the storage costs among so many investors.
Now that we have investment vehicles that represent gold on the COMEX and the
Nasdaq Composite index, we can use them in our model portfolio instead of cash
and the S&P 500 index. For the sake of simplicity, however, we will use
our usual trade dates rather than buying gold when the 10-year, three-month
yield spread exceeds 10 percent. We will start after 1973 when the price of
gold was allowed to fluctuate (see Table 1).
All of our returns look better with our new starting date; even the S&P
500 index improves a couple of percentage points compared to previous graphs.
The more aggressive equity investment, the Nasdaq index, provides one-third
more return even without active management; including dividends on the larger
index would have closed this gap a little. As Figure 1 shows, trading two
aggressive instruments, Nasdaq and gold, more than doubled the return of the
unmanaged S&P 500 index.
The dollar amounts of the three portfolios are vastly different because of the
impact of annual compounding at different rates (see Figure 2).
The returns might have been even stronger if we had used foreign currencies.
FOREIGN CURRENCY ETFS
Foreign currency ETFs are similar to international equity index funds except
that they may own stocks in a global index. There are many global indexes, and
the term includes the United States. If your objective is to own nothing but
foreign currencies, make sure that your ETF does not include U.S. investments.
The web site ETFConnect is one of the few that allow you to search their
databases by investment objective, and a search for global investments found
37 funds matching that description.
The difficulty with mutual funds and ETFs is that convenient products like
these usually become available a little late in the investment cycle.
Cutting-edge investors often have to do their own homework and invest directly
in stocks in order to get in at the beginning of each new cycle.
Investing directly in stocks provides the opportunity for greater returns than
investing in an index fund. Of course, the risks are greater as well, but our
market timing model should allow you to focus on the right sector. Once you
become familiar with the business and the companies in a sector, you are in a
good position to buy a strong security. Sector investing provides the
background you need as well as a list of companies from which to select your
investment.
SUMMARY
There is a wide variety of new funds that provide inexpensive diversification
with a minimum of homework. Exchange-traded funds add to our flexibility for
trading throughout the day, and some of them take advantage of extended
trading hours. Many of them have lower fees than sector mutual funds that may
impose a sales charge or marketing expense. Unlike mutual funds, however, ETFs
incur a brokerage fee as if they were a stock.
These funds are important to us because they complete the tools we need to
implement our model portfolio. Up to now we have been able to invest in all
asset classes except for gold bullion and most equities except for the Nasdaq
Composite. Two of these new funds fill those gaps. One fund, StreetTracks Gold
Shares with the symbol GLD, gives us a chance to own gold bullion near the
price it trades on the COMEX division of the New York Mercantile Exchange.
Another ETF, the ONEQ, allows us to own all 3,000 stocks in the Nasdaq.
The rest of the exchange-traded funds offer hundreds of ways to invest in
industry sectors and styles with low portfolio management fees. They open a
window on a segment of the business world and supply us with a list of
companies to study in depth. Once we have mastered an industry, we are ready
to choose one of the stocks on this list to buy.