Four Ways I Use ETF's in Client Portfolios - And Two Ways I Don't

Like many advisors, I have found exchange-traded funds (ETF's) to be very useful in managing client portfolios.

Here are four ways that I typically use ETF's:

1. When client portfolios are relatively small, ETF's offer a diversified way to invest in sectors that seem attractive;

2. ETF's allow me invest in areas where neither I nor my company have sufficient research resources to make informed stock selections.  A good example here would be the emerging markets, which offer attractive longer term opportunities yet I do not feel comfortable buying specific stocks;

3. Occasionally a sector would appear to be very attractive based on historic data but individual stock selection can be difficult.  The best example here in recent years has been the financial sector,where stocks seemed very attractively priced but there were so many "known unknowns" (to borrow Donald Rumsfeld's term) that analyzing individual stocks was difficult.  I turned to an ETF - State Street Financial Sector ETF (XLF) - as a way to get diversified exposure to the group without taking stock specific risks;

4. When a sector offers longer term investment appeal, yet is a relatively small part of the S&P 500, ETF's can play a useful role in client portfolios.  For example, the utility sector offers attractive dividends and a stable business model but is only 3% of the S&P.  Moreover, while I have had the chance over the years to do a considerable amount of work in the utility sector, I must confess that keeping track of rate cases and reserve margins is not one of my more exciting challenges.  Thus, I have made extensive use of State Street's Utility Sector ETF (XLU).

On the other hand, in my opinion ETF's have a couple of drawbacks:

1.  The stock positions in most ETF's are market capitalization weighted.  In certain sectors, this means that the performance of the ETF will be dominated by one or two stocks in the sector.  For example, Chevron and Exxon represent 34% of the capitalization of State Street's Energy ETF (XLE), making it less useful for tracking the performance of the overall energy sector;

2. Almost by definition, ETF's mute exposure to the opportunities (or risks) in any given sector.  While this is useful for risk control, it also reduces the possibility of capturing significant outperformance through fundamental research.

For example, in the first part of last year, regional bank performance significantly outperformed money center bank returns through the middle of the summer.  Then, when it appeared that the euro zone would remain intact, and that regulatory burdens would not be as onerous as some feared, the money center bank stocks roared to life, and wound up the year with much stronger results than the regionals.  An investor in XLF only received the returns of the sector, and would not have captured this performance differences.

As mentioned, I have used the utility ETF XLU in a wide variety of client portfolios, and results have been good.  However, it now appears that we may be on the verge of seeing significantly different performance results among the utility companies, and for accounts that are benchmarked against the S&P 500 it might make sense to swap into specific utility stocks.

Here's what I wrote to my colleagues on Friday:

I am selling my 3% position in the Utilities SPDR (XLU) in my institutional accounts.  The proceeds will be split equally between Duke Energy Corp. (DUK) and NextEra Energy (NEE).

The utility sector largely traded in lockstep last year,  and most stocks ended last year at valuations that were essentially in line with each other.  This was particularly true in the regulated utility space, where Dan Ford of Barclays calculates that the price/earnings ratio spread between large cap regulated companies and small to mid cap companies stood at just 0.7%.  This is very tight vs. the historically normal 7-10% large cap premium.

Power companies had more dispersion in valuation, but all suffered from overcapacity and low power prices in 2012.

I think that the performance of the stocks in the utility group will become more diverse in 2013, and I want to try to position Core accordingly.

My thinking is try to find companies that will be able to “power through” today’s poor rate environment through minimal exposure to regulatory scrutiny.  We believe that DUK and NEE fit the bill.

DUK is the nation’s largest regulated utility.  Sporting a 4.9% dividend yield, the company suffered through a corporate management shuffle last summer, and its valuation is at a discount to the group as a result. The stock trades at 14x forward P/E.

NEE is the holding company for Florida Power & Light.  Florida regulators have provided friendly legislation to the company last year, and the last minute extension of wind power credits by Congress in December should also help the company (NEE get more than 10% of its power from wind power).  NEE is now focusing more on solar. The stock offers a 3.5% dividend yield, and trades at 14x forward P/E.

We should note that the group was also interested in Southern Company (SO) but decided on DUK instead.  SO, in our opinion, has the best management team in the industry but our concerns over its construction of the Vogtle nuclear power plant (scheduled to come on line in 2017) made us go for the safer choice of DUK.