Which are better?

When I say “the market”, normally I use the S&P 500 Index as a benchmark. Sure, there are other indexes I can use, ranging from the Dow Jones Industrial Average to a basket full of regional and global indexes, but most pros use the S&P 500 as the market proxy. The truth is that it is notoriously difficult to beat the market and do so consistently.

“But what about Apple?” protests one recent client, who has owned this darling of Wall Street for several years. “It has beaten the market hands down every year.”

True enough, Apple, along with a number of other individual stocks, have done better than the market for a year or two or even three, but they have not done so consistently year after year. And even though Apple has done better than the market, I have yet to see any equity portfolio with just that one investment. Normally, Apple is just one of many investments in the portfolio. When all these returns are combined, the gains of an Apple are offset by losses in other stocks.

The risk in holding individual stocks is twofold. One, if you hold comparatively few stocks and one or more blows up, your portfolio will suffer dramatically. If, on the other hand, you have a large stock portfolio it becomes difficult to follow and your performance will tend to mimic the market.

Investing in mutual funds is less risky than owning individual stocks because your risk is spread out among many more stocks; but unfortunately, in most cases, performance also declines. Statistically, the pros that manage mutual funds fail to beat the market over 80% of the time. If you also add the fees that these mutual funds charge investors each year their performance is even worse.

Now, just like stocks, there are mutual funds that have a fabulous track record, either because the fund manager is especially gifted, lucky or both. Think Peter Lynch, the fabled manager of Fidelity’s Magellan Fund, or Bruce Berkowitz, recently named the fund manager of the decade. But finding the next Peter Lynch is as difficult as finding the next stock market double. In the meantime, the risk of picking wrong can be monumental.

Ken Hebner, a well-known index fund manager, argues that by buying a diversified portfolio of index funds, that incorporate emerging markets, international markets as well as the U.S. market, will provide you the best results with lower risks than a portfolio of stocks. I would take that a step further.

My experience indicates that by including certain sector index funds in your portfolio (while excluding others) you could generate even greater gains than the market. For example, during the first quarter of this year, the materials, energy and small cap sectors lead the market higher. Those investors that were over weighted in these areas beat the market with much less risk than if they had held individual stocks in those sectors. In addition, the expense ratios for index funds are much cheaper than mutual funds.

Bottom line, index funds offer far less risk than stocks, outperform mutual funds 80% of the time and are cheaper, easier and trade as frequently as stocks. What’s not to like?

Paul, 46, manages his $12 million fund from his colonial farmstead nestled beside one of the many roads of rural Columbia County. It hasn’t been easy for Paul but in May of this year he will have a five-year track record which will be the envy of many fund managers. His fund is already gaining attention.

For those who aren’t familiar with Exchange Traded Funds (ETFs) please see my column “Exchange Traded Funds have Come of Age. In brief, an ETF is an index fund that invests in a set number of stocks, bonds, currencies or commodities that mimic whatever index they target. Once established, they don’t change so an investor who buys a share receives approximately the same return as the underlying index. These securities have been around since 1993 and have been my investment of choice for more than 16 years.

Over the last few years a handful of managers around the country have created what are called Funds of Funds. These are mutual funds which invest in a portfolio of ETFs but their results have been spotty at best–except for ETFOX.

Over the last 14 months it has ranked in the top one percent of 1,800 large -cap growth funds measured by performance (the top 4% on a three -year basis). It is the only ETF fund that is rated highly (5 stars) by Morningstar, the premier mutual fund rating house, as well as by Lipper Fund Services where it is rated a Lipper Leader for Total Return and Preservation of assets.

Frank has a disciplined approach to investing and uses a combination of Modern Portfolio Theory principals and fundamental analysis in selecting from a universe of almost 200 exchange traded funds. Last year, although he was down, he still beat the benchmark S& P500 index by over 11% and by 3.5% over the last three years, and that’s after management fees.

So why did Frank decide on ETF investing rather than managing mutual funds or stocks? He explains that ETFs are cheaper with expense ratios less than half those of mutual funds. They also offer certain tax advantages for taxable portfolios. There’s another reason as well.

“By using ETFs I am taking security specific risk out of the equation. Investors will not be wiped out if a component of one of the ETFs suffers a loss.”

Frank uses a two prong approach to picking the best ETFs for his portfolio. He analyzes the risk versus return of each exchange traded fund and then uses good old common sense to decide if the numbers still make sense. If they do, he adds the ETF to his portfolio, but it’s no buy and hold strategy.

He monitors each investment constantly comparing it against both short and long term benchmarks and has no compunction in selling one of his funds, especially in this volatile market environment, if the investment goes the wrong way. He also uses inverse ETFs (funds that move up when the markets move down) to protect his portfolio when market conditions demand it.

The fund’s main theme is U.S. large cap-growth ETFs. However, between 20-25% of the fund is reserved for “opportunity areas”. In the first half of last year for example, Frank bought the Brazil Country Fund (EWZ) and a gold ETF (GLD) while in the second half he replaced those investments with two U.S. Treasury bond funds, clearly an astute move given the market’s performance. He admits that there were very few places to hide late last year, thus the bond investments. He also stayed away from the financial sector, picking defensive sectors like healthcare instead.

This year he has moved into biotechnology, high yield and corporate bonds, as well as some more aggressive investments but is still wary of the markets. You can see more by accessing his website at www.etfmutualfund.com.

So what kind of investor should consider adding this fund to their portfolio? Anyone who is seeking capital appreciation with longer than a one-year time horizon, since historically the fund has returned above-market returns while taking only 75% of the market’s risk. But buyers beware since the expense ratio is 2.22%, high for a fund management company, but given the performance of Frank’s fund it appears well worth the marginal expense.

Exchange traded funds are index funds, which mean they invest in a set number of stocks, bonds, currencies or commodities that mimic whatever index they have targeted. If their underlying index goes up so does the fund and vice versa (for those unfamiliar with ETFs, please re-read my March column “Exchange Traded Funds have Come of Age” for further background on these securities).

An inverse ETF does the opposite; it goes up when the markets and sectors go down. Inverse or “short’ ETFs are available on various worldwide indexes including all the major ones here at home like the S&P 500, the Dow and NASDAQ. You can also hedge yourself with various sector and style funds. They are liquid, trade just like stocks and do not require large investments in order to hedge a portfolio.

Granted, you can accomplish this same purpose by the more traditional method of selling shares of stock short but that involves borrowing money and stock from your broker, establishing a margin account (similar to a loan), paying an interest charge for the privilege and receiving margin calls when the stocks you sold start to go up in price. Sound complicated, it is and successful short selling requires a great deal of chutzpah, skill and experience.

There are also put options and futures but they require you to open both future and options trading accounts. Besides, most brokerage firms will not allow investors to engage in such transactions unless they can furnish convincing proof that you the investor have the understanding and skill to engage in trading these instruments and understand the risks involved. With inverse securities you simply buy shares of an ETF when you are nervous about the markets or on a particular industry and sell your position when you think the coast is clear.

Let’s say you have a number of stocks and mutual funds in your $100,000 portfolio. You have spent a good deal of time and effort in putting these investments together. Along comes a year like 2008. All the sub-prime, credit and inflation problems have descended upon the market and battered your portfolio to the point that you just don’t want to take any more losses. But you hate to sell because you just know that the stocks you own will win out in the years ahead.

You could buy a few hundred shares of an inverse ETF, for example the Proshares Short S& P 500 (symbol: SH) for $67/share. Sure enough in the days ahead the S&P 500 declines by 5% while your investment in SH rises to $70.35/share. So what you might lose on your stock investments you gain on your short ETF. You can buy as many or as few as you like depending upon how much of your portfolio you want to hedge.

There are several families of funds that offer inverse ETFs such as Proshares, Powershares, Market Vector and more. Just Google the subject and explore the websites. You will discover that there are also leveraged inverse ETFs which double your inverse returns. These funds can accomplish this by using derivatives, futures and options. That means you can hedge your portfolios with just half the securities that you would need on a one-to-one ratio. That’s called leverage.

But let me give you a heads up on buying and selling inverse ETFs–don’t speculate. You can loose your blouse (or shirt) in this market if you start betting on market swings. There are some inverse ETFs that can move up or down 10% a day or more especially in several volatile markets like financials, oil, gold and currencies. Here you will be competing with the big boys, the hot money and they make a living picking off individual investors. Use these securities with the sole purpose of protecting your investments in stressful times.