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INVESTING with EXCHANGE- TRADED FUNDS Higher Returns with Lower Costs—Do It Yourself Strategies Without Paying Fund Managers MARVIN APPEL MADE EASY
INVESTINGwith
EXCHANGE- TRADED FUNDS
Higher Returns with Lower Costs—Do It Yourself
Strategies Without Paying Fund Managers
M A R V I N A P P E L
AP
PE
L
$24.99 U.S./$29.99 Canada
www.ftpress.com | An imprint of Pearsonwww.ftpress.com | An imprint of Pearson Press
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ETFs offer exceptionally low expenses, outstandingperformance, and unparalleled transparency. But,the number and variety of choices can be over-whelming. Now, one of the field's leading expertscuts through the ETF hype, offering a start-to-finishplan for choosing the right ETFs and using them tobeat the market, year after year.
Dr. Marvin Appel explains exactly how ETFs work,what they can and cannot do, and why they’re notall equally attractive. Then, drawing on objectivedata and proven, back-tested strategies, he showsyou how you can quickly move into the right ETFsat the right time, consistently staying on the win-ning side of major market trends.
Appel illuminates every facet of ETF investing:quantifying potential risk and reward, using ETFsto improve diversification, implementing simple”active strategies,” deciding when to move intocash, and more. He also presents a full chapter oninternational ETF investing, as well as a discussionon how ETF investing can reduce your taxes.
From start to finish, this book candidly assessesrisks, costs, and rewards, helping you become an informed ETF consumer and a powerfully effective ETF investor.
USE ETFS TO INVEST LIKE THE BIG PLAYERSDrive down costs and fully leverage diversification,the only “free lunch” on Wall Street
LEARN WHAT YOUR INVESTMENT ADVISORSWON’T TELL YOUThe objective truth about ETF costs, risks, and opportunities
BUILD YOUR “ONE-DECISION” PORTFOLIOProfitable investing has never been this easy
DRIVE EVEN GREATER PROFITS WITHPROVEN “ACTIVE” STRATEGIES Simple asset allocation strategies you can implementin just minutes
CHOOSE ETFS THAT MATCH YOUR INVESTMENT STYLEBuild a profitable portfolio you’re comfortable with
,!7IA1D1-igjhdi!:P;m;o;t;TISBN 0-13-186973-6
I N V E S T I N G
ABOUT THE AUTHORDR. MARVIN APPEL
is CEO of Appel Asset
Management Corporation
and Vice President
of Signalert Corporation,
Registered Investment
Advisors in Great Neck,
New York, which together
manage over $300 million for individual clients.
He also edits the highly acclaimed investment
newsletter, Systems and Forecasts.
He has been featured on CNNfn, CNBC,
CBS Marketwatch.com, and Forbes.com, and
has presented at conferences ranging from
the World Series of Exchange Traded Funds to
the American Association of Individual Investors.
The New York State Legislature has invited
Dr. Appel to present his economic and
investment outlook.
Cover photograph by Ryan McVay/Stone+/ Getty Images Inc.Cover design by Chuti Prasertsith
“Today, exchange-traded funds are the most innovative and rapidlygrowing investment vehicles. Marvin Appel’s new book provides,
in a highly readable framework, a wealth of information on whatthey are and—more importantly—how private and professional
investors can use them to build wealth through a simple and easy-to-implement investment program.”
—C. MICHAEL CARTY, Principal and Chief Investment Officer, New Millennium Advisors, LLC
“In the ever-expanding complex world of ETFs, Marvin Appel has cut through all the fluff and created a one-stop guide to not
only using them, but using them profitably. The sections on diversification and the use of relative strength in comparing assetclasses are invaluable. Individual investors and financial advisors
alike will get a significant return on investment by spending time with this book.”
—BOB KARGENIAN, CMT, President/Principal, TABR Capital Management, LLC
The first step-by-step investment program built around low-cost, top-performance ETFs!
Back-tested, verifiable strategies from one of the world’s leading ETF experts!
All you need is a discount brokerage account, a few minutes on the Internet each month, and this book!
ETFs give investors the best of all worlds: instant diversification, unprecedentedflexibility for profiting from market shifts, and incredibly low costs. Now, there’s a step-by-step, plain-English guide to profiting from
ETFs from one of the world’s leading experts.
www.signalert.comwww.ftpress.com
MADE EASY
Investing with Exchange-Traded Funds Made Easy
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Investing with Exchange-Traded Funds Made Easy
Higher Returns with LowerCosts—Do It Yourself StrategiesWithout Paying Fund Managers
Marvin Appel
Upper Saddle River, NJ • New York • London • San Francisco • Toronto • SydneyTokyo • Singapore • Hong Kong • Cape Town • Madrid
Paris • Milan • Munich • Amsterdam
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Vice President, Editor-in-Chief: Tim MooreExecutive Editor: Jim BoydEditorial Assistant: Susie AbrahamDevelopment Editor: Russ HallAssociate Editor-in-Chief and Director of Marketing: Amy NeidlingerCover Designer: Chuti PrasertsithManaging Editor: Gina KanouseProject Editor: Christy HackerdCopy Editor: Karen A. GillIndexer: Lisa StumpfCompositor: Scan Design, Inc.Manufacturing Buyer: Dan Uhrig
© 2007 by Pearson Education, Inc.Publishing as FT PressUpper Saddle River, New Jersey 07458
FT Press offers excellent discounts on this book when ordered in quantity for bulkpurchases or special sales. For more information, please contact U.S. Corporate andGovernment Sales, 1-800-382-3419, [email protected]. For sales out-side the U.S., please contact International Sales at [email protected].
Company and product names mentioned herein are the trademarks or registered trademarks oftheir respective owners.
All rights reserved. No part of this book may be reproduced, in any form or by any means, withoutpermission in writing from the publisher.
Printed in the United States of America
First Printing: October 2007
ISBN: 0-13-186973-6
Pearson Education LTD.Pearson Education Australia PTY, Limited.Pearson Education Singapore, Pte. Ltd.Pearson Education North Asia, Ltd.Pearson Education Canada, Ltd.Pearson Educatión de Mexico, S.A. de C.V.Pearson Education—JapanPearson Education Malaysia, Pte. Ltd.
Library of Congress Cataloging-in-Publication Data
Appel, Marvin.
Investing with exchange traded funds made easy: higher returns with lower costs—do it yourself strategies without paying fund managers / Marvin Appel.
p. cm.
ISBN 0-13-186973-6 (hardback : alk. paper) 1. Exchange traded funds. 2. Stock indexfutures. I. Title.
HG6043.A67 2006
332.63’27—dc22
2006019379
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To my children—Emily, Caroline, and Alexandra. You brighten my world just by
being yourselves.
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CONTENTS
Chapter 1 Exchange-Traded Funds (ETFs): NowIndividuals Can Invest Like the BigPlayers 1ETFs Are a Special Type of Mutual Fund 2ETFs Avoid the Expense of Fund Managers 2ETFs Are Traded on Exchanges 4ETF Investors Have Hidden Costs Throughthe Bid-Ask Spread 7The Creation/Redemption Process Keeps ETFShare Prices Close to the Market Value of theUnderlying Shares 16ETF Performance Is Not Weighed Down byTransaction Costs 21ETF Shares Are Often More Tax-EfficientThan Mutual Funds 21Special Risks of ETFs 22Conclusion 23Endnotes 24
Chapter 2 The Multifaceted Stock Market: A Guideto Different Investment Styles 25The First Decision: Stocks, Bonds, or Cash 26Size Matters 29Each Investment Style Has Multiple ETFs 34
Midcap ETFs 35All-Cap or Total-Market ETFs 37Growth and Value ETFs 39
Conclusion 40Endnotes 40
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Chapter 3 A One-Step Strategy for SelectingSuperior Investments: Indexing 43Investments That Track Market Indexes HaveOutperformed Most Mutual Funds 46The Evidence in Favor of Indexing 47Indexing Has Delivered Greater Profits Than the Average Mutual Fund, Except in the Small-Cap Area 49How a Few Mutual Fund Managers HaveBeaten the Indexes 50Conclusion 52Appendix 3—Index Construction Methodologies 53
Example of Index Construction—Equal Weighting 53Example of Index Construction—Price Weighting 53Example of Index Construction—CapitalizationWeighting 54The Newest Indexing Scheme—Free-FloatWeighting 55
Endnotes 56
Chapter 4 Investment Risk: A Visit to the Dark Side 57Drawdown—An Intuitive Measure of Investment Risk 58
How to Use Drawdown 59A 40-Year History of Bear Markets 64What if Your Investment Was Not AroundDuring a Bear Market? 70Example of Risk Assessment: An EmergingMarket ETF 73Market Risks and Planning for Your Future 77Appendix 4A: Where to Find QuantitativeInvestment Risk Information 79
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Appendix 4B: Calculation of Drawdown with aSpreadsheet 79Appendix 4C: Volatility of Past Returns as aRisk Measure 83Endnotes 86
Chapter 5 How Well Are Your Investments ReallyDoing? Risk-Adjusted Performance 87The First Risk-Adjusted Performance Measure—Annual Gain-to-Drawdown Ratio 88Another Risk-Adjusted Performance Measure—The Sharpe Ratio 91Risk-Adjusted Performance Review 94Conclusion 96Appendix 5A—Calculation of the CompoundedAnnual Rate of Return 96Appendix 5B—Calculation of the Sharpe Ratio 98Endnote 101
Chapter 6 Diversification: The Only Free Lunch onWall Street 103Reduce Risk, Not Profits, with Diversification 104Diversification Versus Picking Only the Best 106How to Determine What Should Be in theOptimal Portfolio 107Example—Determining a Good Mix of Stocksand Bonds 108Interpretation of the Sharpe Ratio 110The Uncertainty of Future Investment Returns 110Conclusion 113Endnote 113
CONTENTS ix
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Chapter 7 The One-Decision Portfolio 115A Risk-Reducing Investment Mix 116Indexes Used to Test the One-Decision Portfolio 119Performance History for the One-DecisionPortfolio 119The One-Decision Portfolio for Less-Conservative Investors 123ETFs You Can Use to Create Your Own One-Decision Portfolio 125Rebalancing 126Why Only U.S. Investments Are Included inthe One-Decision Portfolio 127Conclusion 128Appendix 7—A Brief Discussion of the BondMarket 129Credit Risk 130Interest Rate Risk 131Intermediate-Term Bond ETFs 133Endnotes 133
Chapter 8 When to Live Large: An Asset AllocationModel for Small- Versus Large-CapETFs 135Why Market Capitalization Matters 136Trading Rules 138Results 139Real-World Implementation with ETFs 143Conclusion 145Appendix 8—ETF Distributions and Taxes 147ETF Share Prices Drop by the Amount of aDistribution 149Endnotes 150
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Chapter 9 Boring Bargains or Hot Prospects?Choosing Between Growth and ValueETFs 151The Concept of Relative Strength 154History of Relative Strength Changes BetweenGrowth and Value 156Recognizing the Emergence of a New TrendUsing the Relative Strength Ratio 161Results with Small-Cap Value Versus Growth 166Results with Large-Cap Value Versus Large-Cap Growth 169Real-World Implementation with ETFs 170Conclusion 171Endnotes 173
Chapter 10 When Is It Safe to Drink the Water?International Investing 175How to Identify Whether the Long-TermTrend Favors U.S. or Foreign Stocks 181Results of Using the EAFE/S&P 500 AssetAllocation Model 184Outlook for International Investing 187Conclusion 188Endnotes 189
Chapter 11 What Bonds Can Tell You About Stocks:How to Use Interest Rates 191A Basic Introduction to the Bond Market 192Why Rising Interest Rates Have Usually (ButNot Always) Been Bad for Stocks 193An Indicator of Rising Interest Rates 196Yield Curve Indicator 197
Interest Rates and the Implied Economic Forecast 198The Rules for the Yield Curve Indicator 199
CONTENTS xi
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Track Record for the Yield Curve Indicator 201Composite Interest Rate Indicator 203Conclusion 205Endnotes 205
Chapter 12 It’s a Jungle Out There: Selecting fromAmong Different ETFs with SimilarInvestment Objectives 207The Drawdown Chart—A New Tool 208Example 1—Small-Cap ETFs 211Example 2—Growth Versus Value ETFs 214Example 3—Utility Sector ETFs 218Conclusion 221Endnotes 222
Chapter 13 The Ultimate ETF Investment Programin Just 30 Minutes Per Month 223The Ultimate ETF Investment Program 224Step 1: Diversification 224Step 2: Decide Whether International or U.S.Stocks Are Favored; If U.S. Stocks AreFavored, Evaluate the Interest Rate Climate 227Step 3: Select the Best Investment Style fromLarge-Cap Value, Small-Cap Value, Large-CapGrowth, or Small-Cap Growth 228Results of the Ultimate ETF Strategy 231Conclusion 232Endnotes 235
Appendix Internet Resources for ETF Investors 237ETF Sponsor Websites 238General ETF Websites 239Index Provider Websites 239Current and Historical Market Data 240Fundamental Economic Data 241
Index 243
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ACKNOWLEDGMENTS
It is with love and gratitude that I acknowledge my father, GeraldAppel, for teaching me everything I know about investing and forestablishing an ethical and intellectually challenging business envi-ronment in our offices in Great Neck. I have also been blessed withunwavering love and support from my mother, Judith Appel.
Joanne Quan Stein read every draft each step of the way, assistedwith the research, and held me to the production schedule. Withouther keen eye for logical gaps in my exposition, many explanations inthese pages would have remained in my mind, accessible to thereader only through ESP.
Bonnie Gortler and Audrey Deifik also reviewed my drafts onshort notice despite their many other work commitments. Theirinsights improved the book. I am grateful (and relieved) that the edi-torial commentary from my three colleagues Joanne, Bonnie, andAudrey was tougher than the comments I received from the profes-sional editors at Prentice-Hall.
Russ Hall, Rudy Morando, and Karen Gill suggested numerousimprovements to make the material more readily accessible to thereader. Their feedback was thorough and prompt. Last and cer-tainly not least, I am grateful for the encouragement I receivedfrom Jim Boyd.
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ABOUT THE AUTHOR
Marvin Appel originally trained as an anesthesiologist at HarvardMedical School and Johns Hopkins Hospital. He concurrently earneda Ph.D. in biomedical engineering from Harvard University. How-ever, in 1996, he changed careers and joined his father in the field ofinvestment management, where he has been able to put his engineer-ing and computer training to work in analyzing the stock market. Heis now CEO of Appel Asset Management in Great Neck, New York,which manages $55 million in client assets in mutual funds,exchange-traded funds, and closed-end funds using active asset allo-cation strategies.
Dr. Appel is the author of “Systems and Forecasts,” a highlyregarded newsletter on technical analysis that his father started in1973, and he has been a regular contributor to “Dental Economics”and “Physician’s Money Digest.” Dr. Appel’s market insights have beenfeatured on CNNfn, CNBC Power Lunch, CBS Marketwatch.com,and Forbes.com. He has been invited to testify to the New York StateLegislature regarding his market forecasts. He has presented hisinvestment strategies to numerous conferences, including the Ameri-can Association of Physician Specialists Annual Scientific Meeting, TheWorld Series of Exchange Traded Funds, the National Association ofActive Investment Managers annual conference, The Indexing andETF Summit, and chapter meetings of the American Association ofIndividual Investors, among others.
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