Resource World Magazine

26 www.resourceworld.com A U G U S T / S E P T E M B E R 2 0 1 9 In the 1939 movie The Wizard of Oz, Dorothy wanders through the fantasy land of Oz chanting "Lions and Tigers and Bears, Oh My!" In the brave new world of ETFs she might say instead "Diamonds and Spiders and Qubes, Oh My!" What are these things? They are the informal terms for ETFs that track the Dow Jones Industrial Index, the S&P 500 Index and the NASDAQ 100 index, respectively. In this article, we will explore the emerging world of Exchange Traded Funds (ETFs), the reasons ETFs are growing in popularity, and new trends in the sector with special attention to ETFs that may be of interest to resource investors. First of all, why were ETFs created, and what advantages do they provide com - pared to mutual funds? Modern financial thinking has pro- posed that stock markets are efficient, factoring in all available information. It suggests that there are two kinds of risk in the market, Alpha, which is company- specific risk, and Beta which is the risk of the overall market. Investors buying indi - vidual stocks are taking both kinds of risk, assuming they have superior insight and harvest the rewards of both kinds of risk. However, because markets are believed to be efficient by modern financial theory, there is no way to beat the market by doing extra research, and suggests the extra Alpha risk is just gambling. ETFs were created to track the overall market and harvest the reward of the overall mar - ket, (Beta) without exposure to specific company risk (Alpha) by being diversified, and doing so at minimum cost. Mutual funds have been in existence much longer than ETFs and do provide diversification but are managed by portfo - lio managers who are allocating money to the market in different proportions than the way the market is composed. For this work they charge management fees. By investing in a mutual fund rather than an ETF, one is betting the portfolio manager can consistently outperform the index of the market by more than the management fee charged by the fund. Since mutual funds typically charge about 2% per annually, and ETFs less than 1% generally (except for very specialized ETFs), and in some cases less than 0.2% (for very broad based funds), this is a much-debated bet. If you believe portfolio managers cannot be relied upon to outper - form the market, then ETFs are for you. The amount of money flowing into ETFs has grown by leaps and bounds, and now challenges mutual funds as an asset class. As ETFs become increasingly accepted by investors, the financial industry has come up with new ways of using these tools. Originally, ETFs were meant to hold a representative slice of the specific mar - ket they were tracking based on the market value of the companies. So, for example, the Qubes ETF [QQQ-NASDAQ] would contain 10% Apple Computer if the NASDAQ Index had 10% of its value based on Apple Computer. So what happens when an individual company becomes such a large part of an Index that Alpha raises its ugly head? The industry answered by capping the ETF to no more than 20% in any one stock to preserve the benefit of risk diversification. And so capped ETFs were created. A second innovation was the concept of ETFs based on specific industries, indus - try sectors, or commodities. The financial Diamonds, spiders and qubes, Oh My! A RESOURCE WORLD PRIMER ON ETFS by Alf Stewart INVESTMENT

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