Are ETF's Right for Long Term Investors?

James is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Exchange Traded Funds (ETF's) are an investment tool often used to play broader macro economic trends.  For those new to the concept, allow me to explain.  ETF's are a basket of stocks with a specific investing goal that trade like a single stock.  Some focus on industries like technology or health care.  Others may focus on entire countries like Germany, South Africa, and Brazil.  Because they are traded on exchanges just like stocks they have the same liquidity and accessibility as your average stock.  Here I will examine some of the more popular ETF's trending right now to determine if they are worthy of finding a home in your long term portfolio.

Recently, three major ETF's have increasingly found their way into the news based on speculation that the Chinese market could be set to resume growth.  We'll use these as a jumping off point for the examination of ETF's. 

iSHares MSCI Brazil Index ETF (NYSEMKT: EWZ) is an all-Brazilian grouping with a heavy emphasis on raw materials, consumer, and financial stocks.  In recent years EWZ has taken quite a beating due to the lagging Brazilian economy brought about by decreasing demand from China.  The two stocks have traded very closely together over the past few years.  That is until recently, when China began showing signs of life again.

Looking at the main China ETF, the iShares FTSE/Xinhua China 25 Index (NYSEMKT: FXI), we can see this correlation played out graphically (Figure 1) if we put both together.

Figure 1:

<img src="/media/images/user_14634/fxi-ewz-three-year_large.png" />

In the past these stocks traded in lock step.  However, the recent speculation that China may be having a bit of a soft landing, as opposed to the widely predicted hard landing, and even beginning a sort of recovery has sent the FXI up in recent months.

Another economy heavily reliant on exports to the Chinese markets is Australia.  The Australian index is best represented by the ETF iShares MSCI Australia Index Fund (NYSEMKT: EWA), which is overweight in raw materials and financials.

Looking at the graphical relationship between China and Australia (Figure 2), we can see a similar relationship play out.

Figure 2:

<img src="/media/images/user_14634/fxi-ewa-3-year-chart_large.png" />

However, we notice something different here.  Australia doesn't appear to be lagging China, but instead appears to be leading the way.  This is because over recent years China has been increasing trading exposure with Australia, while Brazil has been lagging in that regard, which is why it hasn't quite responded to the upside in the same manner.

For the sake of comparison I've broken down some relevant facts into a table (Figure 3) for ease.

Figure 3:

<table> <tbody> <tr> <td>Valuation</td> <td>FXI (China)</td> <td>EWZ (Brazil)</td> <td>EWA (Australia)</td> </tr> <tr> <td>P/E</td> <td>N/A</td> <td>N/A</td> <td>N/A</td> </tr> <tr> <td>Yield</td> <td>2.36%</td> <td>2.60%</td> <td>5.15%</td> </tr> <tr> <td>Earnings/Share</td> <td>-9.36</td> <td>-3.75</td> <td>-1.07</td> </tr> <tr> <td>Five Year Return</td> <td>-20%</td> <td>-26.00</td> <td>0.00%</td> </tr> </tbody> </table>

It doesn't take a genius to notice that these are some less than impressive numbers.  Especially when you consider that our own S&P 500 is up 14% over that same five year period.  The only positive on this whole group would come from Australia by using a Dividend Re-Investment Plan (DRIP) over that time which would result in positive returns.

But the upturn recently that China saw looks attractive on the chart, right?  Well, in actuality it was only a 12.8% gain since the bottom in July.  Over that time if you invested in select individual companies with exposure to China you could have seen much larger gains.  Even our own S&P 500 was up 10% since November, producing almost the same result in just half the time.

Which begs the question; why would I invest in these ETF's for the long term?  The short answer is that I wouldn't.

I am not a fan for a variety of reasons, and the first is transparency.  Because many of the stocks in these funds are traded on foreign markets they exist under different accounting rules, regulations, and enforcement. Another would be the fact that fees charged by these funds eat away at their overall returns over time.  Finally, actively managed funds are lagging the market, resulting in under-performance.

What these ETF's are good for is short term trades, momentum trades, or macro-economic swing trades.  Notice the underlying theme is "trades."  These are not long term tools.  While I am aware many are billed as long term investments, I personally object to this notion.  Aside from the reasons above, the fact is that short-term traders themselves have zeroed in on these instruments as trading vehicles and not investment tools.

Conclusion:  You still have to do your homework since the discipline of stock picking will never die.  ETF's have been sold to the public as a "buy and hold forever" instrument when in fact they have become trading vehicles.  I would advise against using them for long term investments and continue to focus on developing value investing methodology.



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