falcon2382 (32.11)

Time to get into SDY?

August 01, 2008 – Comments (0) | RELATED TICKERS: SDY , SPY , XLF

This is my first post. I have been meaning for quite some time to get a blog rolling, but I just couldn't find the time. Well, I was reading a Seeking Alpha article, The problem with Designer ETF's, that basically bashed SDY to hell. Several other people responded to the author in a way that I did not find to be very productive, thus I felt compelled to respond to the author's points myself, and consequently wrote a fairly detailed explanation as to why I think SDY is so compelling right now, but also attempted to counter much of his argument. All that said, my response is pasted below. I encourage you to provide your thoughts and feedback not only to what i wrote, but also to what he wrote as I think he did bring up some interesting points. In the end, I think SDY is a tremendous bargain right now and is trading at a .08% discount to NAV when it usually trades at a slight premium. Also note, his thesis wasn't directly tied to SDY but to all "designer" ETF's.

My response to Timothy Siegel:

 Timothy, I also have some objections to much of what you said, but I don't read these articles to waste my time arguing or proving that I am right, I do so in order to challenge what I take for granted and to share my thoughts with others willing to respond to comments so that we can become better investors, and as you have illustrated more than your fair share of tolerance, I want to thank you for your time and energy. But I also want to hear what you have to say about the following response to your article:

What interests me most about your thesis is how you seem to advocate for a more "human" managed selection of stocks than for a selection of stocks chosen by a computer algorithm while admitting that market cap itself is an emotionally charged way of valuing a company (all with which I totally agree). Yet, you seem to ignore the time-oriented part of the investing process that is, by its very nature, about human decision to allocate and or reallocate funds according to perceived changes in the market. I don’t think the ETF’s take away from this human element. The formulaic, non-human, objectivity of the ETF is precisely why it is a good investment tool—it is a “control” in a world that is more than uncertain at times. In the case of SDY, which I recently purchased at $43/share, the unchanging formula is what attracts me to it. I know what I can count on. The ETF is more heavily weighted in financials than any other sector and this is why it has greatly underperformed the greater market. However, if you share my prognostication for the market moving forward, I believe many other sectors will soon be catching up with financials. This judgment is the “human” part of my investing strategy, and since I am only 25, I have a time horizon that provides ample opportunity for this imbalance to work itself out—meanwhile the dividends will compound the total number of shares I own. Further, because of the “rigid” formula of the ETF, if a company can't afford to keep its dividend or has to cut it after 25 years of increases, then it gets booted automatically. This is good because something fundamental in the company’s health has changed and unlike humans, the computer algorithm can’t find ways to justify holding on to a loser that has “broken the rule.” At the same time, the computer program also doesn’t get scared and sell a good company at a loss simply because it was taken down with its sector. But the best part is that I didn’t have to pay a transaction fee to get rid of the loser, or to buy its replacement. Yet, if there are any capital gains I am able to receive them (again without a transaction cost). And on that note, how can you not consider the dividends and management fee structure in your analysis? It’s crucial! The AVERAGE mutual fund (which is generally not actively managed either) has an expense ratio over 1.2%. SDY only has an ER of 0.35%.

Another point I’d like to address is your very comparison of SDY with the S&P 500 strictly from a capital apreciation/depreciation standpoint. It was only recently that I chose to invest in SDY, and it was BECAUSE it was down so much in relation to the greater market. Or rather, it was because I realized that the ETF is more heavily weighted in financials than other broader market ETF's, but without the concentration of a strictly financial ETF, and without all the “bad eggs” (i.e. indymac, Washington Mutual, etc...). So after deciding that the financial companies that are included in SDY were among the healthiest in the industry, I welcomed the extra exposure, expecting that at some point the banks that weather this crisis will be handsomely rewarded, not only because they once again proved themselves (all of the Banks held by SDY made it through the S&L crisis and the fall of LTMC), but because they will gain market share simply by not going bankrupt. Moreover, if you want to make a comparison you should be aware of what the comparison is really telling you. What good is it to blindly compare the S&P 500 to any ETF if you don’t consider the underlying stocks? If, for example you had compared SDY to XLF you would have seen just why SDY is a compelling investment right now. At the time of this writing, the SDY boasts a dividend yield of 4.87% while XLF (a strictly financial ETF) is 4.55% (the S&P is only 1.67%). Thus, one might conclude that with SDY you get diversification with a huge dividend, exposure to the financials once they do bounce back, and peace of mind knowing that the fifty companies you own in this ETF have not only been around for over 25 years, not only paid a dividend for over 25 years, but have INCREASED that dividend during that time period. Again, I think it is relevant to remember the other crises we have been through during the past 25 years.

I don't think it is fair to talk about ETF's as if they all have the same purpose, function, and risk/reward. If that were the case then we wouldn't need different ETF's; SPY or DIA would serve everyone's needs. I have a long time horizon and I welcome the extra dividend that SDY provides over SPY as we work our way through the current mess. In fact, this is a very very important reason (there’s the “human” part again) to consider SDY since most bear markets turnover slowly and through a basing process. When we reach that point—and I think we are there or at least very close—I expect the compounded dividends to pay me better than both treasuries and the greater equity market as I wait for the economy to find support. The S&P contains a boatload of discretionary retailers and companies that earn their money from consumer services and products, leisure activities and is it that hard to see that the energy companies which have become quite bloated recently might also drag on the S&P. The future losses of these sectors over the next year or two (or three) won’t affect SDY nearly as much as the greater market at which point SDY, I believe, will seem like a golden egg. Any thoughts?