America embraces ETFs

Australian investors watching the US market for clues on investment patterns should note the huge take-up of ETFs.

PORTFOLIO POINT: Exchange-traded funds are growing fast, and now account for more than half the daily trades on US sharemarkets.

Australian investors who want to take advantage of their new offshore buying power, not to mention a rally on Wall Street that has eclipsed rises on the ASX, could learn a few lessons from mums and dads across the Pacific.

US retail investors with sour memories of recent market mayhem understandably have a bias for wealth preservation and safe dividend plays (Michael Feller highlighted three of his favourite American large-caps last week). But bigger and more diversified markets here in New York offer small investors some interesting new opportunities, and they are less focused on straight stock and bond investment via traditional mutual funds.

Indeed, inflows to exchange-traded funds (ETFs) grew at twice the rate of mutual funds (the US version of our own “managed funds”) in 2011, according to figures from Morningstar, which estimates that the relatively new industry now controls over $1 trillion in assets and more than half of all daily trades on US sharemarkets (for an Australian perspective see No looking back now: ETFs ready to take off). As a saying here now goes, “Mutual funds are sold, ETFs are bought.”

The simplest ETFs, which track US stock indices, are now being bought by retail investors as casually as hotdogs at a ball game. But in a nation where interest rates have been locked at zero, certain ETFs also offer attractive yields for much less than the cost of a managed fund.

"Investors looking for above-average returns may see opportunities by investing in ETFs that focus on real estate," says Ron Lecours, who manages more than $US100 million of retirement assets at Ohanesian/Lecours in West Hartford, Connecticut. Surprisingly, even as residential property prices remain at historic lows, investors are still enjoying gains from ETFs with exposure across commercial, office, hospitality and apartment rentals.

Some of the best performers of 2011 were also the most straightforward (as opposed to the derivative-style ETFs that have been getting negative press both in the US and back in Australia).

Vanguard's REIT ETF tracks the MSCI US REIT Index, and returned 14.26% last year. ETFs that follow real estate plays listed on the Dow Jones and S&P US REIT Index also returned between 10% and 13.5% during the same period. (It's worth noting that these are vanilla offerings, which simply track their respective indexes.)

One particularly strong US growth engine is technological innovation, and news of Facebook's impending float and bulging $100 billion valuation has put Silicon Valley back on the radar of retail investors. It's also attracting more talented Ivy League graduates who, before financials had the bonuses beaten out of them, may previously have been seduced by the "models and bottles" lifestyle at a New York investment bank. So much so that the Wall Street Journal recently declared, "Tech is the new Wall Street" (New York Magazine and NY Daily News have also come to the same conclusion).

Alexey Bulankov is a financial planner with McCarthy Asset Management in San Francisco, less than an hour north of Facebook's Palo Alto headquarters. He says there's a lot to be excited about on the west coast of America, which is also home to popular names such as Twitter, the microblogging service, and Zynga, a game developer linked to Facebook.

"The enthusiasm appears to be more measured and mature than in the heyday of the internet bubble," says Bulankov, who recalls a time when Silicon Valley advisers would push “MY DISCO" portfolios (Microsoft, Dell, Intel, Sprint, Cisco and Oracle). Having learned from the previous crash, he says today's investors tend to be more sophisticated when it comes to diversification.

Tech investors are advised to avoid the risk of individual stock-picking '” big names often come with price-tags to match, and there's no guarantee that smaller start-ups will ever get off the ground. Retirement advisors recommend broad exposures via ETFs such as the SPDR Select Sector Fund - Techn, with holdings in stocks covering internet software firms, IT consultants, semiconductor makers, and telcos.

The iShares Dow Jones US Technology ETF, which tracks some of the largest American technology names, and PowerShares Dynamic Technology ETF, with its focus on stocks with capital appreciation potential, also help insulate investors from the blow-up risk of big holdings in single companies, advisors say.

Down in Houston, Texas, wealth advisory firm Salient Partners prefers to bet on a continued US economic recovery via the oil and gas industry '” but not through stocks like Exxon Mobil or ConocoPhillips. Instead, managing director Greg Reid looks over $250 million worth of master limited partnership (MLP) energy investment vehicles, exchange-traded infrastructure assets popular among dividend-focused baby boomers.

Master limited partnerships are mainly in the pipeline business, so their income is tied to the volume of oil or gas going through the pipe rather than the price of the commodity. Without the burden of company tax, they pay quarterly dividends of up to 90% of earnings, minus fees, and international investors may also qualify for special tax exemptions on those returns.

So long as the American economy grows at least 2% annually, and energy demand increases with it, Reid expects the average master limited partnership to yield 12% this year – down from 14% in 2011, and 35% in 2010.

However, like any investment, due diligence is vital: it's important to consider the MLP's cost of capital, credit rating, market cap, liquidity, commodity exposure, and growth opportunities. Because MLPs pay out all available cash, they need external capital to expand and therefore they are particularly credit-sensitive: any squeeze from a European banking crisis could have especially negative effects. Advisors also recommend spreading investments, with a fund that tracks the 50 most prominent MLPs in the Alerian MLP Index, for example.

Of course, none of these are all-in bets. Each position would usually represent no more than 5–7% of a US portfolio, which would still include individual stocks and bonds, among other assets. But it does go to show the kinds of opportunities available to investors willing to research beyond the local exchange.

Online markets thrive
Facebook's IPO is set to mint many millionaires, and even a few billionaires, CEO Mark Zuckerberg and early developers chief among them. But a bumper public debut is also great news for another group of loyalists who quietly bought stakes in the social media giant through emerging illiquid asset exchanges, such as SecondMarket.

These online portal connect investors with existing stakeholders (usually ex-employees or consultants) in a number of private companies – including social media services Twitter and Yelp – and facilitates bids for the securities.

Admittedly, direct investing isn't a retail game at the moment. Buyers must first be deemed “certified investors” by the Securities and Exchange Commission '” the simplest test is a net worth of more than $US1 million '” and SecondMarket only handles transactions over $US100,000. Remember, there's also no prospectus.

However, special purpose funds are starting to buy shares in these companies, making themselves available to retail investors (although fees can be as much as 10%), and new legislation could soon make the process more individual-friendly.

In any case, it's a fascinating space to watch if only for the way it reshapes IPOs in the US. The secondary markets for privately held companies are already worth well in excess of $10 billion, and growing, according to NYPPEX numbers.

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