ETFs- The Best of Both Worlds

Since my first days of investing, I’ve had dozens of people (friends, family, colleagues, acquaintances, etc.) as me a simple question, ‘How do I invest my money?’ It’s a simple question, but an extremely loaded one. Investing is not something I think anyone should take lightly. Some people open up a trading account and invest in whatever comes to mind. Others participate in structured investment programs like 401K’s and employee stock purchase plans with little to no understanding in what they’re investing in. Both strategies, although sometimes successful, can cause major problems down the road. As I try to tell everyone, investing is something that should be taken seriously and requires time and understanding. This is your hard earned money (or at least somebody’s hard earned money), throwing it investments that are not fully understood is a dangerous proposition. Now this post isn’t meant to be an instruction manual on how to invest. Actually, that series of posts is on its way. Instead I wanted to talk about a specific tool that I recommend all relatively new investors utilize.

The ETF Concept

ETF’s (short for ‘Exchange Traded Funds’) is an investment tool that any average investor can buy into as an alternative to stocks or mutual funds. They are basically a collection of some asset like stocks, commodities, or

Bonds, broken up into little pieces and sold to investors. You might realize that this sounds somewhat like a mutual fund, and you’d be right. But there are some very important differences between ETF’s and mutual funds which make ETF’s an attractive option. Let’s go ahead and list some advantages and disadvantages:

Advantages of ETF’s Over Other Types of Investments

1. Instant Diversification – Instead of buying into a single stock, an ETF is a collection of assets (a common example is stocks). Therefore, by buying an ETF, you avoid buying a single asset and leveraging yourself out to it, thereby increasing risk. An ETF, like a mutual fund, will allow you to minimize the risks associated with buying a single stock (aka diversifiable risk) and gets you instantly diversified.
2. They Trade Like Stocks – When you buy a stock, you put in an order and the order goes through once the market is open (assuming you don’t have specific conditional orders). This generally isn’t true for mutual funds, where you have to wait a few business days for transactions to occur. ETF’s trade like stocks. You can buy and sell them instantly during market hours – thereby giving you the flexibility for more fluid trading.
3. Ability to Buy More Unique Assets – There is a large variety of ETF’s out there. There are simple ones that buy stocks of a specific industry or company size. But there’s also some more exotic ETF’s that give investors the ability to buy things like Commodities, Bonds, Real Estate, etc. There are some serious risks with these more exotic ETF’s and I’d advise you to tread carefully here.
4. Lower Costs – Because ETF’s are passively managed (i.e. the process of selecting stocks as highly automated and is based on the type of ETF you’re buying), they generally have lower fees to own them when compared to actively managed mutual funds. These costs generally run between .5% to 2%.

Disadvantages of ETF’s

1. Passive Management – Yes, they may be cheaper than mutual funds of the same category, but this advantage also has a downside. Because ETF’s are just a basket of stocks, you don’t have active managers that try to lean the fund towards the better stocks in the category. For example, if you buy an ETF that invests in stocks of financial companies (XLF), it will simply be a basket of financial stocks weighted based on the size of the company (the bigger the company, the more weighted the ETF will be towards that company). An actively managed mutual fund that invests in financial company stocks could be smarter and try to adjust its weighting based on the stronger financial companies. However, better performance from actively managed funds is obviously never guaranteed and their higher costs can often offset the benefit.

A simple ETF example is the S&P 500 ETF called the ‘Spyder’ and ticker symbol SPY. This ETF is a basket of stocks that are included in the S&P 500 index (in other words, the 500 biggest publicly traded companies). The ETF tracks very closely to the S&P 500 – so buying the ETF is like buying a piece of the S&P 500 index. Below I’ve included some details of the SPY and relevant information along with a link to the comparison graph between it and the S&P 500 itself.

Summary Details on the SPY

Comparison Chart Between the SPY and the S&P 500 since Jan 2009. Notice the almost exact correlation:

Why Should I Invest with ETF’s?

The reason is pretty simple. Most investors, especially newer ones, generally don’t know enough about individual companies in order to invest completely in them. However, the investor may understand the motivations for investing in that category (whether it be industry, region of the world, asset class, etc.) that it’s still a good idea to invest in them. Usually there’s an ETF for that category that the investor can get into at a relatively low cost.

How Do I Invest in ETF’s?

Like a mentioned before, one of the beauties of ETF’s is that they trade like stocks. This means that they have ticker symbols, and can be bought through normal investing channels like an online broker. Using the SPY example above, you can simply put an order in to buy a given number of shares of the SPY and you’ll instantly have exposure to those stocks.

What Other Kinds of ETF’s Are There?

Also like I mentioned before, there’s tons of options out there for ETF’s. There’s even one that inversely tracks the market (SH). This means that these ETF’s go up when the market goes down. If you think the economy is going to get worse, then this might be a good option for you. If that’s not enough, there’s even an ETF that has a double inverse correlation to the market. This means that if the market goes down 1%, the ETF will go up 2%. If you’re really sure the market will go down, this is an interesting option.

Comparison Chart Between Proshares Short S&P 500 (SH) and S&P 500. Notice 1-1 inverse correlation

Comparison Chart Between Proshares UltraShort S&P 500 (SDS) and S&P 500. Notice approx 2-1 inverse correlation

My point here is that there’s an option for everyone, regardless of what you want to invest in. There are some major ETF companies that create and manage the ETF’s. These include Barclays, and Morgan Stanley. To see your options in the ETF world, I suggest either going to their websites, or simply googling it. A search I did for “Africa Stock ETF’ returned 189,000 results and one of the top ones was the Africa ETF from Market Vectors (AFK)

The Bottom Line

As you can see, ETF’s provide a great alternative for investors that want to either want cheap and easy diversification in their portfolios or want to invest in more exotic assets. I highly recommend you new investors out there look into these because they you’ll be able to gain exposure to areas you’re interested even if you may not fully understand the individual companies. As you learn more, you can then look into getting into more specific companies.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

A Primer on the Airline Industry, and Why I Would Never Invest in It

As some of you already know, I have a degree in Aerospace Engineering. The choice for pursuing involved a multitude of factors, one of them being since I was a child, I was always fascinated by flying. I would sit at airports wide-eyed seeing the various aircraft scurrying around both in the air and on the ground (I’m not going to lie, I still do this today).

With this fascination, however, sprung a natural interest in the companies that owned and operated those huge aluminum beasts. Since then, I’ve followed the airline industry closely and have tried to understand in depth their operations, challenges, and ultimately, why they’re so bad at making money! Eventually I came to a basic understanding, don’t ever invest in an airline (or at least a US based one).

The Basics

I’m not going to patronize you and go into details on what airlines do – I’m going to assume everyone already knows that. One thing I do think that some people don’t realize is the sheer number of sub-operations that are required to operate an airline. The include:

1. Aircraft – Buying/Leasing/Selling, Inspecting, Maintaining, Overhauling, Field Repairs, etc.
2. Ground Operations – Managing the various offices (on airport and off), terminals and associated facilities (yes, sometimes the airlines actually own those terminals)
3. Information Technology – One of the coolest aspects of airlines. Ever wonder how your luggage gets where it needs to go when it’s among luggage from people going all over the world? It’s all IT baby (and despite people griping about it, airline baggage handling is actually a very accurate process. It’s one of the few business processes the gets even remotely close to a 6 Sigma operation).
4. Logistics – There’s a whole lot of back-end logistics that goes on for airlines. Everything from tracking a plane from origin to destination, to rerouting 100’s of flights due to a storm and accommodating the affected passengers . It’s pretty complex stuff.

There’s a bunch that I’m skipping, but you get the idea

But Herein Lies the Problem

Take a look at the list above again. Notice that pretty much all of those aspects of airlines listed are fixed costs. In other words, even if the airline wasn’t able to sell a single ticket, they would still need to pay those costs. This is known as an industry with a high capital cost structure. It just takes so much money just to run the operation, regardless of how much people actually use the product. This also relates to another concept known as an ‘exploding asset’. And exploding asset is the seat on the airplane. The airline has to pay all the costs for the plane, labor, operations, etc., to get that seat available and give it value. However, as soon as that airplane door closes, if that seat is empty, it no longer has any value. It’s an asset that (figuratively of course) explodes. Airlines have every reason to minimize empty seats – and this is the primary reason why you see flights getting overbooked – to minimize the chances of having those valuable assets ‘explode’.

There’s also a Catch-22

Even with the high fixed costs airlines would probably be able to make some money. But here’s another challenge they face. The biggest single cost for the airlines is fuel, and the cost for that fuel is directly proportional to the price of oil. In the energy markets, the price of oil generally rises when the economy is good. So when the economy is good, the costs for the airlines rise dramatically (sometimes as much as 3 times). However, the airlines can’t charge nearly enough to recover those cost increases.

In the same vain, when the economy is bad, the price for oil generally drops (in the current downturn, oil fell from a high of about $150 a barrel, all the way to $30 and is currently hovering around $70). But now the problem becomes revenue. Fewer people are flying and prices are going down. The airlines can’t catch a break either way.

Competition

Another challenge the airlines face, and this primarily applies to US based airlines is competition. Prior to the 1980’s airlines were regulated. However, since deregulation, they have started to compete more directly with each other. Unfortunately there were (and still are) way too many airlines and the industry has gone through decades of consolidation and liquidation to eliminate this competition (the most recent being the Delta/NWA merger and the ATA and Aloha Airlines bankruptcies). The high level of competition plays into the pricing power issue mentioned earlier, because even when the economy is good, airlines have trouble raising prices because they’re so heavily competitive with each other.

The Bottom Line

With the issues mentioned above, along with many others, the US Airline industry will constantly have trouble being consistently profitable – there are just too many reasons for them not to. Because of this, the industry as a whole has not made a single penny in profit in total over the last 25 or so years. As an investor, I can’t bring myself to buy into a company that faces so many consistent challenges. When pretty much all the major players have filed for bankruptcy in the last 10 years (e.g. United, US Air, Delta, Northwest), it makes it hard to stomach buying their stocks (although I think trading the stocks is still a viable option. Just don’t hold them for too long).

But All Hopes Not Lost!

Although things are bad now, I don’t think it’s the end of the world for the airline industry. Here are a few major business structure changes that I think in time will help the industry become profitable. If you see some or most of these changes happen (they probably need at least 10 years to even begin happening), you should start looking at the stocks again:

1. Continue Consolidating – We need to get rid of more of the weaker players. Some airlines that I really think need to disappear are US Air (horrendous customer service and a perpetual bankruptcy filer), and Frontier (just not big enough to compete)

2. Cut Fuel Expenses – The industry needs to work with the aircraft manufacturers to make a concerted effort to cut fuel costs. The investment needs to be made in technology so this huge burden is lessened. Boeing’s new 787 plane is a step in that direction, but is only a first step.

3. Put Emphasis Back On Customer Service – With the drastic cuts to customer service levels put in place by pretty much all the major airlines, I think there’s opportunity for airlines to use better service as a real competitive advantage. Reduce or eliminate the nickel and diming and treat your passengers with more respect and I think you’ll have a recognizable advantage that people will be willing to pay more for – thereby giving you some previous pricing power.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

The Economics of F1

Formula 1 racing is truly the pinnacle of auto racing, and, in many ways, the most international sport in the world. It is the stage where the best drivers in the world team up with the best car and engine makers to achieve a singular goal - be the first to the finish line.

However, one thing that many people don't realize is that F1 (and auto racing in general) is also probably one of the most 'businesslike' sports in the world as well. Due to the huge costs in both fielding a team and staging a race, F1 is extremely economically sensitive. A top team like Ferrari or McLaren will spend upwards of $500 million a year to design/build/race 10 cars. Even the smallest teams need at least $20-30 million a year, comparable to the top NASCAR teams. Staging a race is not cheap either. Just to have the right to have a race costs $20+ million (in fact, the only other sport that generates more dollars/event is the NFL), then the promotion, infrastructure, etc. costs need to be factored in as well. Needless to say, you really need to pay to play.

I Do Have A Point...

The reason I bring up F1 is because recently there has some significant developments on the business front of the sport. Because of it's economic sensitivity, F1 has been hit hard by the downturn. In fact, one of the major teams - Honda - even pulled out of the sport - an abrupt surprise. Furthermore, the sponsors that help pay for many of the costs associated with running the sport have been pulling out as well (the most popular sponsor was financial institutions).

A Strange Management Structure

Unlike most other sports, F1 is actually split up into 3 main bodies:

1. Teams - The actual teams that participate in the sport. Some are private owners that build cars and race them
2. Commercial - The entity responsible for making the sport profitable and making sure the sports owners' (primarily a consortium of banks) interests are met
3. FIA - The not-for-profit governing body responsible for making the rules of the sport and long term longevity.

As you can probably see, there's bound to be some conflicts of interest here. This has been especially true the last few weeks when the FIA instituted mandatory $40 million budget caps on all teams starting next year. The teams, many of which spend well above that amount were infuriated at this unilateral decision and have threatened to pull out of the sport and start their own series. However, the FIA has so far refused to give in to the teams demands of more say in the rule making process, resulting in a classic game of chicken in the frontier of motorsport.

Dangerous Waters

Conflicts like this really help one understand the business side of a sport and it's impact on daily business - sport! I strongly believe that not coming to a compromise on this issue will cause irreperable harm to the sport and can even lead to the downfall of F1 (something similar already happened in the US with Indycar racing). Each of the divisions of F1 need to have the same goal - a racing product that the fans will enjoy. And they need to work together to achieve this goal. Hopefully they'll come to their senses and reach this compromise before it's too late.

Keep track of the latest F1 news here



Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.