ETFs for Poets

When ETFs emerged in the 1990s as the cool new investment vehicle, their calling card was lower cost, tradability, diversification, tax efficiency and transparency.

At that time there were just a few SPDR and Barclays ETFs with simple and easy-to-understand strategies.

But today's tally of thousands of ETFs totaling more than a trillion dollars in assets make ETF investing considerably more complex and confusing.

The experts attending next week's InsideETFs conference — the largest annual gathering on the topic — will doubtless examine exchange-traded products in all their dazzling intricacy.

But just as English majors are wont to fulfill their college science requirements through "Physics for Poets" type courses, ThinkAdvisor reached out to veteran indexing expert Ron Surz to provide a comprehensible yet sophisticated understanding of ETF portfolio construction.

A prolific writer, Surz first published his poets thesis in 2002 but the dozen years that have passed have not invalidated his essential analysis.

The San Clemente, Calif.-based principal of Target-Date Solutions, which advises on portfolio strategies, Surz' first ETF strategy for poets is what he calls the Longfellow, because it has a long-only focus and does not involve any short sales.

The ideas is to forgo the broadly diversified index ETFs, such as an S&P 500 fund, in favor of sector ETFs in order to extract higher tax-adjusted investment returns.

How so? Losing sector ETFs can be sold to offset gains elsewhere in the investor's portfolio (this is called tax-loss harvesting). On the flip side, winning sector ETFs can be sold to offset losses in the investor's portfolio.

While Longfellow aids in optimizing ETFs' tax advantages, Surz's Thoreau strategy enhances their diversification benefits. How so? Because ETFs now cover virtually every conceivable investment niche, an investor can add exposure to areas missing from his portfolio — to make sure he is "thoroughly" covered. Surz hastens to point out that an investor can use ETFs to neutralize an overexposure to a style or sector by shorting an ETF that matches the concentrated position.

Beyond tax efficiency and diversification comes ETFs' outstanding tradability, something that hedge fund managers have long availed themselves of by, say, buying puts on SPY (SPDR's broad S&P 500 fund) in order to hedge against broad market losses.

So, for more advanced investors who think they can identify the best investment managers, Surz suggests buying those managers' funds while shorting their corresponding ETFs. The investor still derives the tax management benefits identified above, but can now precisely capture the alpha that the best managers generate. Surz calls this the Hogg portfolio, for Scottish poet James Hogg, because it feeds on all the available information.

Any of the above three ideas can of course be applied via international ETFs in a portfolio Surz calls Shelley, since international investments are overseas (except for Canada and Mexico) and shells proliferate in the sea.

For your final exam, Surz will have you remember this simple poem he composed:

Longfellow: diversification — take a vacation;

Thoreau: completeness, A for neatness

Hogg: alpha capture, total rapture

Shelley: international, very rational

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