The Dark Side of ETFs

Until now, I've been a big fan of exchange-traded funds (ETFs). After all, they offer choice, flexibility, low costs and tax efficiency, among other benefits. And they're growing like wildfire. But, there is a downside. Two dangers can threaten your ETF portfolio.

#1 - The Liquidity Factor: You Can Buy, But Can You Sell?

With so many new ETFs coming on market, there's a real concern that you may not be able to sell. Now there's no liquidity problem with most of the older, bigger ETFs, such as the DIAMONDS Trust (AMEX: DIA), which trades on average 8.4 million shares a day; the S&P Depository Receipts (AMEX: SPY), with daily volume reaching 87 million; or the NASDAQ 100 Trust (Nasdaq: QQQQ), which trades 128 million shares on average... But what about those ETFs that have zero (0) trades in a day?

And lots of other ETFs have serious liquidity problems too, trading fewer than 10,000 shares a day. Liquidity also depends on popularity, and while some new ETFs can be extremely popular when first introduced, it's also quite possible that some of these "hot" ETFs will be difficult to unload years later!

Best advice: Check the average daily volume of each ETF, and don't invest unless there is good liquidity in BOTH bull and bear markets.


#2 - Poor Diversification

The other threat to your wealth is an incomplete ETF index. That's not a problem with the S&P Depository Receipts, which mimic the S&P 500 Index; or the DIAMONDS Trust, which imitates the Dow 30. But some ETFs, like Merrill Lynch's Internet HOLDRs (AMEX: HHH), is heavily weighted in only three stocks.

Best advice: Check the holdings of an ETF before you invest.

In short, don't sell your mutual funds anytime soon. Ultimately, they may have some advantages over ETFs, especially when it comes time to sell or diversify.

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What Does and Doesn't Matter To The Market

Here is what does and doesn't matter to the market and stock prices:

1. Earnings MATTER. At the end of the day, stock prices follow earnings. Thus, if you think corporate earnings are headed higher, so too, will stock prices.

2. Employment DOESN'T MATTER. Employment is a lagging indicator. If you wait until companies are hiring to get bullish on the market, you will be way, way late for any rally.

3. Interest rates MATTER. Interest rates matter because they help determine the relative attractiveness of stocks versus other assets. For example, if interest rates are high, investors may be more likely to own bonds than stocks. Likewise, when interest rates are low, investors will be much more interested in stocks. We see the proof of this fact at the present time!

4. Inflation MATTERS. Inflation affects stock valuations dramatically. In low-inflation environments, investors are willing to pay more for growth since it will be worth more tomorrow. Why that is important is because low inflation translates into higher price/earnings ratios. And higher price/earnings ratios translate into higher stock prices.

5. Corporate and mutual fund scandals DON'T MATTER. Yes, they make for newspaper headlines, but over time, the impact of such scandals is rather limited. True, investors use these things as excuses for market declines. However, if you analyze what happened during the bear market of 2000 to 2002, the drop in stock prices wasn't the result of corporate scandals. Instead, it was the result of plummeting corporate profits at a time when stock valuations were extremely high. High stock valuations and falling corporate profits is not a good combination for investors, and that was clearly seen in the sharp declines in most market indexes at the time.

Bottom line: The three main engines of stock prices are corporate profits, interest rates, and inflation. Everything else is secondary.

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Wisdom of the Ages

"Each player must accept the cards life deals him or her. But once they are in hand, he or she alone must decide how to play the cards in order to win the game."

-Voltaire, 1694-1778

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Finding Your True Net Worth

Knowing your net worth is an essential step in fine-tuning your financial plan. It can help you to more accurately decide how to invest, how quickly to pay off debt and how to plan your estate and other financial matters, such as whether to lend money to family members.

Calculating your net worth may seem basic at first glance: add up assets and subtract liabilities. But the net worth equation is a bit more complicated. Costs such as real estate brokerage commissions, taxes and other expenses triggered by liquidating non-cash assets can affect the final figure. As a result, always remember to factor in these expenses so that you don't overestimate your true net worth, which could potentially lead to ill-informed financial decisions.

When you set about determining your net worth, consider what it would cost to turn the following assets into cash:

Investment securities. Drawing on assets held in taxable accounts or conventional retirement accounts triggers federal and state income taxes. Sales from Roth IRAs or Roth 401(k) accounts do not trigger taxes.

For example, say you hold investments worth $1 million in taxable brokerage accounts, which includes $300,000 in investment profits. If you've held these securities for more than one year, selling them would incur federal long-term capital gains taxes of 15% for a federal tax bill of $45,000. (Selling securities you've held one year or less will trigger potentially higher short-term rates.) State taxes might cost you another $15,000 or so. As a result, the true value of those investments might be around $940,000 - not $1 million.

Likewise, withdrawls from conventional IRAs and 401(k) accounts incur income tax - and in most cases they'll trigger a 10% federal penalty for investors who are younger than 59-1/2 (a state penalty may also apply).

Real estate. An accurate picture of your real estate assets requires more than an estimate of your property's current market value. You also must account for the effects of brokerage commissions and taxes. Brokers typically charge up to 6% to help sell buildings, and may charge up to 10% for sales of undeveloped land.

You can earn a tax-free capital gain of up to $250,000 when you sell your primary residence if you're a single homeowner and have lived there for at least two out of the last five years ($500,000 if you're married). Be sure to subtract any potential capital gains taxes from your real estate values before calculating your net worth. Sales of non-residence properties are subject to the same capital gains taxes as a residence.

Personal property. It's easy to overestimate the value of personal property such as automobiles, boats, jewelry, furniture or art. For an accurate picture of the value of cars or trucks, visit the websites for Kelley Blue Book (www.kbb.com) or the National Auto Dealers Association (www.nada.com). NADA also offers boat appraisals at www.boats.com. Consult appraisers to value other items, and be sure to subtract any costs that would be necessary to sell them.

Effective financial planning requires an accurate picture of your net worth. Factoring in the costs of liquidating non-cash assets can help you zero in on the true value, giving you the information you need to make the right decisions for managing your wealth. And don't forget to consult with a tax advisor for any questions you may have.

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The Secret Your Banker Hopes You Never Find Out About!

Here's a little story.

It's about a woman who is in her forties and very rich. She's a multi-millionaire, who never has to work another day in her entire life.

Recently, she was interviewed on a radio show where she revealed how she had become so rich.

She's an accountant who knows something totally different from most other accountants. She knows the real secret behind assets and liabilities.

She follows a simple truth about assets and liabilities that has made her rich, and if you follow this same truth then it can make you rich too.

The rule is this:

"Assets put money IN your pocket, while liabilities take money OUT of your pocket."
Sounds simple enough, right?

Well, you'd be surprised how many people, and even accountants, don't understand or follow this powerful truth.

Here's how important this principle can be...

Most people who own their home believe that their home is an asset. What they don't understand is that it's not THEIR asset, it's their mortgage lender's asset!

Every month when they make their mortgage payment, they have to take money OUT of their own pocket to pay it.

That payment money then goes IN the pockets of their bank or financing company.

If we look back at the truth about assets and liabilities:

"Assets put money IN your pocket. Liabilities take money OUT of your pocket." Now if the money is going OUT of the home owner's pocket each month that means the home is a LIABILITY.

And since it's going IN the pockets of the financing company, then it IS an asset, but it's an asset for THEM!

The woman I referred to earlier has many, many assets that continually put money IN her pockets. She has more money coming into her pockets through true assets than money going out of her pockets from liabilities.

If YOU follow this same principle of acquiring true assets that bring in more money than you spend on liabilities, then YOU too will find yourself rich enough to never have to work again.

Understanding this truth is the biggest cornerstone of all wealth. I suggest reading this section over again until you fully understand the principle of wealth.

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In BARRON'S This Week

If you either invest in mutual funds or merely follow them then you should read the article entitled, "Best of the Best" - beginning on page 29 of the February 5, 2007 edition of BARRON's.

The article points out some newcomers, led by GE Asset Management, that dominate the one-year rankings in BARRON'S annual mutual-fund-family survey.

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