Exchange traded funds (ETFs) play an essential role in investment analysis. ETFs are an easy to use investment tool that allows traders to enter positions based on broad market factors rather than complicated financial statement analysis. Because an investment in a particular company requires a great deal of research to determine why one particular corporation is more fundamentally stable than another, many individuals do not have either the time or financial knowledge to determine the strength of a corporate balance sheet.
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Simple to Understand
This is not to say that an ETF investment does not require a certain level of financial acumen, it simply allows broader positions based on general economic outlooks. The type of analysis is very different from selecting a single company to invest in. While research analysts are often justified in claims regarding the intrinsic value of a share not yet recognized by the market, such claims require a substantial amount of time to perform the required due diligence. On the other hand, purchasing an ETF is based on broad macro economic factors which can be assessed more so through intuition and general knowledge rather than financial statement analysis.
Allow for General Forecasts
For example, if an investor believes that the recession is over and has a long term positive outlook for the market, positions in such funds as the Financial Select Sector SPRDR (NYSE:XLF) or the Industrial Select Sector SPDR (NYSE:XLI) can be entered into. The financial sector and the industrial sector tend to move in the same direction as the economy. Rather than going through the quarterly releases of the 79 companies which make up the XLF fund to determine their individual exposure to European banks or other risk variables, an ETF provides the necessary diversification to mitigate such unsystematic risk.
Investing in What You Know
Likewise, an investor who is employed in the energy industry building pipelines may understand the fundamentals of the broad oil and gas market, but may lack the necessary expertise to determine which company is trading at inflated production and EBITDA multiples. Exchange traded funds such as United States Natural Gas (NYSE:UNG) or the Energy Select Sector SPDR (NYSE:XLE) would allow one to invest in either the natural gas or general energy market respectively. XLE has 39 holdings which range from integrated oil giants such as Exxon Mobile to energy service corporations such as Schlumberger.
On of the pitfalls of portfolio management is that investors fail to fully diversify their holdings, not because they don't know the benefits of diversification, but because time constraints do not allow the vast sea of stocks to be properly analyzed. Furthermore, many international companies do not produce their financial statements in English, making research practically impossible for those who do not understand the presentation language. The iShares MSCI EAFE Index (NYSE:EFA) and iShares MSCI Emerging Markets Index (NYSE:EEM) ETFs which focus on emerging markets hold 924 and 622 securities respectively. Going through all of the holdings individually is almost impossible.
Because ETFs trade like stocks, there is a certain level of comfort for those who are not active derivate traders. The iPath S&P VIX Short Term Futures ETN (NYSE:VXX), for example, allows one to speculate on volatility without derivate investments.
If time permits, stock picking can offer greater returns - if done right - although with much greater risk. An ETF focused strategy may not be ideal for institutional investors, but there is a lot of upside in ETFs for everyday investors. (To take full advantage of these vehicles, you need to know how they can fulfill certain strategies. To learn more, see How To Use ETFs In Your Portfolio.)
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