Dion Money Management Blog   Money Management for Retirees and Their Families

The anticipation and release of the third quarter GDP numbers on Thursday added to heightened market volatility for the first time in weeks. First, Goldman Sachs cut their projection by 10 percent, reducing their estimate to 2.7 percent. This announcement weighed on investors until the actual report showed that GDP had risen by 3.5 percent. The stock market rallied on that news, reversing the four-day slide of the S&P 500 from October highs.

Some of the good news was tempered by the components of growth, which were heavily influenced by government spending. Based on the advanced estimates, the cash for clunkers program contributed 1.66 percent to the overall number, which was up from 0.19 percent in the previous quarter. Extracting this stimulus would bring the growth closer to two percent. Both imports and exports were higher last quarter, but imports grew faster, thereby subtracting from growth based on the government’s calculations.

Although the report has the hallmarks of government-sponsored consumption, this would not be the first time that fiscal and monetary stimuli were the underpinnings of an initial recovery. Nevertheless, with personal income falling and savings rates turning down again, we still need more to support the economy than higher federal deficits. Corporate balance sheets remain robust, so corporate spending could still provide a significant boost through hiring and capital investments.

The fixed-income market has staged a remarkable recovery in 2009, as the stress within the financial system has subsided as a result of government support and an improving appetite for risk on the part of institutional and individual investors alike. Because the decline had less to do with corporate insolvency issues than ones of liquidity, better access to credit and the resulting improvement in the aforementioned balance sheets supported the subsequent rally.

High-income funds, in particular, have recovered the losses incurred over the past year, and spreads are now in line with previous recession peaks, offering a substantial risk premium still. Valuation remains attractive despite the performance of high-yield bonds so far in 2009, and the next 12 months should bring additional appreciation as money continues to flow from low-yielding income funds to these higher-yielding securities. This will continue to support client positions, especially Federated High Income Bond (SVAAX) and Fidelity Capital and Income (FAGIX).

Risks to this outlook include rising government yields, although historically rising rates have had a more limited impact on high-yield bonds, and renewed stress in the credit markets. At this point, however, market sentiment remains positive and high-income valuation still provides a favorable opportunity to participate in additional upside.

Disclaimer

While low interest rates and volatile market conditions have pushed many investors into high-yield corporate debt ETFs like SPDR Barclays Capital High Yield Bond (JNK) or inflation-fear funds like SPDR Gold Shares (GLD), there is still a strong case to be made for a core investment in companies that have high dividends and offer income over time.

High-dividend-yielding companies may not always be the most exciting to watch, but they can provide a steady stream of income and value to a well-diversified portfolio. Included in my new ETF Action Portfolio is the Dow Jones Select Dividend Index ETF (DVY), an ETF that tracks approximately 100 of the highest dividend-yielding companies.

High yield can often go hand in hand with high risk, and this ETF is designed to screen dividend-paying companies before including them in the portfolio. The highest dividend-yielding stocks are often companies that have fallen hard and fast in the market, so it is important to have some type of selection process to weed out the more dangerous options.

DVY tracks the Dow Jones Select Dividend Index, and does not include companies that have cut their dividends in the past five years or paid more than 60% of earnings in the form of dividends. REITs, which often pay high dividends but are extremely risky, are omitted altogether.

Currently, DVY’s top10 holdings include Lorillard (LO), Eastman Chemical Company (EMN), PPG Industries (PPG), Kimberly-Clark (KMB) and Eaton (ETN). The most heavily weighted sectors in the portfolio are utilities, consumer goods, industrials and financials, with 23%, 20%, 19% and 12% allocations, respectively. The fund has a reasonable expense ratio of 0.40% and a relatively balanced portfolio, with less than 20% of total assets allocated to the top 10 holdings.

America’s population is aging. As investors move toward retirement and look for income-generating funds, it is important to choose funds that not only currently pay a high dividend, but also have expectations of continuing to pay dividends and grow payouts. DVY’s screening process helps to screen for consistent dividend payers who will not flame and burn out overnight.

DVY’s top holding LO saw earnings impacted by the financial turndown, but managed to gain market share in one of its discount brands. LO’s flagship brand, Newport, has maintained a loyal following, while discount brand Maverick gained market share during the economic slowdown. Sales of cigarettes and alcohol have traditionally been recession-resistant, and LO has a strong industry presence.

Eastman Chemical, DVY’s second-largest holding, had strong third-quarter earnings on the back of strong results from its CASPI and fibers segments. Lower prices for raw materials helped to improve the firm’s profit margin. EMN, whose goal is to increase chemical production derived from coal to 50% from 20%, has strong prospects for the next couple quarters.

Alternatives to DVY include the SPDR S&P Dividend ETF (SDY) and the WisdomTree Total Dividend ETF (DTD). Out of these three funds, DVY has the highest trading volume. SDY has a similar sector allocation to DVY, but half the number of underlying holdings. SDY and DTD have 0.35% and 0.28% expense ratios, respectively.

Disclaimer

The gut-wrenching losses during the market tumble have been felt by the savviest financiers of Wall Street, including Warren Buffet who has lost nearly $10 billion of his personal fortune.

While the losses were plentiful, some of the most daring investors were actually able to turn profit during the mess. By betting against real estate when everyone else remained optimistic, hedge fund manager John Paulson was able to net $15 billion in returns. This equated to a personal profit of nearly $4 billion. His forethought during this period has gained the admiration of other famous investors such as George Soros .

A native of Queens, N.Y., Paulson appears to have been destined to have great economic insight from birth. His maternal grandfather, Arthur Boklan, a Wall Street banker during the 1929 crash, was able to remain prosperous during the Great Depression even as the rest of the nation suffered. Paulson’s father was CFO of Ruder & Finn.

After high school, Paulson attended New York University where he graduated valedictorian of his class in 1978. Upon graduation, he immediately moved on to the Harvard Business School where he graduated as a Bakers Scholar,.

Paulson headed to Wall Street, where he jumped from firm to firm. His resume includes big names such as Bear Stearns, where he worked on their mergers and acquisitions team and Gruss & Co. where he was employed as a mergers arbitrageur.

In 1994 with $2 million of his own money, Paulson started his own hedge fund company. Though $2 million in assets is considered meager for a hedge fund, Paulson was able to use his careful investing choices to build an attractive track record. During the tech bubble that burned many, Paulson gained popularity by shorting firms, betting on mergers, and most notably, not losing his clients any cash. From 1999 to 2003 he saw his assets under management balloon to $600 million.

Although his success during the tech bubble strengthened Paulson’s reputation within the hedge fund community, his bet on the housing market is what has put him on the map.

In 2005, while looking for the next bubble to play after tech, Paulson and his analysts were turned onto the housing market. During this time, optimism was in strong supply with mortgage companies boasting that housing prices could never fall. Believing the hype, investors pooled into collateralized debt obligations.

While the CDOs were ballooning, the prices of instruments designed as insurance policies against default called credit-default swaps were unusually low. Paulson, who was interested in finding a way to play what he perceived to be the market’s inevitable downfall, saw these instruments as an ample opportunity. He began pouring his funds into CDSs while shorting CDOs.

His bet lost money in the beginning but eventually worked out handsomely. In 2007, when many were watching their nest eggs deteriorate before their eyes, Paulson was rolling in returns. His fund jumped 600% netting staggering returns.

In late 2008, the financier set up the Paulson Recovery Fund to invest in the same financial institutions that faltered during the subprime crisis, including Bank of America(BAC), Goldman Sachs(GS), JPMorgan(JPM), and Capital One(COF).

Paulson also has taken steps to help struggling homeowners in the sublime mortagage crisis. In 2009, he made a $15 million donation to the Center for Responsible Lending to support programs designed to help homeowners avoid foreclosure.

Today, Paulson remains at the helm and continues to make bold investments in companies. Most recently, the financier placed a $78 million bet on the struggling insurer, Conesco(CNO). It will be interesting to see if the investor’s foresight once again proves profitable.

Disclaimer

Positive earnings from maritime shipper DryShips(DRYS) earlier this week have once again drawn investor attention to the shipping industry.

As a global economic recovery thaws frozen international trade and oil prices climb, the highly cyclical business of shipping seems to be on the upswing.

One way to gain exposure to the global shipping industry is through shares of the Claymore/Delta Global Shipping ETF(SEA). This ETF is up nearly 30% year to date, as oil prices and China’s emergence as a major steel producer help to spur the firms that make up SEA’s underlying index.

Despite the oil bubble in 2008, a global commodity boom has been afoot for the last decade. As emerging markets have tackled the expansion of infrastructure, and China has stood ready to supply steel, all eyes have been on the most efficient way to transport these goods: global shipping.

SEA attempts to offer investors a diversified exposure to shippers, and not simply concentrate on firms that just ship dry bulk or oil. The 30 companies in SEA’s portfolio include h dry-bulk and tanker shippers alike. Dry-bulk ships transport finished goods like sneakers and dry commodities like iron. SEA offers exposure to dry-bulk shippers like Diana Shipping(DSX) and Navios Maritime(NM) through its underlying portfolio.

The top component in SEA’s underlying portfolio, however, is Teekay(TK), a tanker company that operates 100 ships and owns or charters an additional 36 shuttle tankers that carry crude oil from offshore platforms in the North Sea. TK also has 17 ships that transport liquefied natural gas. In addition to TK, SEA’s portfolio includes other tanker firms like Frontline(FRO) and General Maritime(GMR).

While demand for commodities and short supply should continue to drive shipping in the near term, it is likely that shipping profits could taper in the future. Said Morningstar analyst John Gabriel: “In our view, the current backlog of ships — which currently stands at about 65% of the world’s fleet — will likely catch up to demand within the next one to two years.”

Gabriel added that, “in short, industry wide fleet expansion is likely to bring an end to recent outsized profits.”

SEA is a narrowly themed sector ETF that offers unique exposure to commodities and the shipping industry. Since this sector is highly cyclical, interested investors should consider this fund for only a small portion of their portfolios. For the short term, it looks like SEA still has room to run. In the long term, however, the many forces within the shipping industry, such as fixed costs and fleet size, could turn the tide on this ETF.

In an effort to avoid the regulatory uncertainty plaguing many popular futures-based commodity funds, Jefferies (JEF) has continued to expand its equity-based commodity ETFs with two new fund offerings.

The Jefferies TR/J CRB Global Agriculture Equity Index Fund (CRBA) and the Jefferies TR/J CRB Global Industrial Metals Equity Index Fund (CRBI) began trading yesterday, following in the footsteps of Jefferies’ first commodity ETF, the Jefferies TR/J CRB Global Commodity Equity Index Fund (CRBQ). (New Commodity ETF Skirts Limits)

CRBA and CRBI are actually slices of Jefferies’ original CRBQ, which launched earlier this month. CRBQ has already attracted a robust average daily trading volume of 67,000 shares, a testament to the growing interest in commodities.

CRBA has a 0.65% expense ratio and tracks a basket of firms that derive their business from agriculture. Top holdings include Deere & Co. (DE), Potash of Saskatchewan (POT) and Archer Daniels Midland (ADM). CRBA’s underlying portfolio includes 34 global agriculture companies, with America as the largest country allocation, at 48%.

The new metals offering, CRBI, tracks 34 global equities and also has an expense ratio of 0.65%. Top holdings in CRBI’s underlying portfolio include Anglo American (AAL.LN), Rio Tinto (RTP) and BHP Billiton (BHP).

Jefferies’ new equity-based ETFs will skirt some of the problems recently experienced by their futures-based peers. The Commodities Futures Trading Commission will be handing down new regulatory limits on futures positions, effectively limiting the size of ETFs that track to-be-regulated futures contracts.( ETF Regulation Battle Bad for Investors)

Ahead of the regulation, ETFs like United States Natural Gas (UNG) and PowerShares DB Commodity (DBC) have restructured their portfolios to stay within futures contracts limitations. Across the spectrum of futures-based funds, the upcoming regulation has caused disruptions in creation of new shares and portfolio strategy. (Commodity ETF Rebuilt)

When Jefferies launched CRBQ, Adam De Chiara, co-president of Jefferies Asset Management, acknowledged the problems faced by futures-based peers in a press release, noting, “unlike many futures-based commodity ETFs, potential new futures regulation should not impact the ability of these ETFs to issue shares.” Also addressing futures-based funds, De Chiara noted that the Jefferies funds would, “avoid the cost and complexity of continually buying and selling expiring futures contracts.”

CRBA and CRBI will not be the first ETFs, however, to track agriculture and metals through a basket of equities. Market Vectors Gold Miners ETF (GDX) is a popular ETF that tracks gold miners through a basket of equities. Market Vectors Agribusiness ETF (MOO) tracks a basket of agriculture firms.

Regulatory uncertainty in the futures-based ETF business has made less complex instruments, like the new Jefferies ETFs, increasingly attractive. Definitive regulatory action on the part of the CFTC is expected soon, but in the meantime, investors should avoid complex futures-based funds.

Trick or treat? The new inflation protection ETFs from IndexIQ are a mixed bag of securities that could be more harmful than helpful to your portfolio. As the two new funds mash together a mix of equities and ETFs, fees, strategy and risk will all be uncertain.

IQ CPI Inflation Hedged ETF(CPI) and IQ ARB Global Resources ETF(GRES) seek to provide “real return” and help protect investors against inflation.

In its effort to provide return above the rate of inflation as measured by changes in the Consumer Price Index, CPI invests in top holdings like iShares Barclays Short Treasury Bond(SHV), SPDR Barclays Capital 1-3 Month T-Bill ETF(BIL), iShares Barclays 20+ Year Treasury Bond Fund(TLT), and SPDR Gold Trust(GLD).

GRES attempts to hedge against inflation by providing investors with a diversified portfolio of commodities related investments, shying away from overweighting in energy. Currently, GRES’ top holdings include Sandvik AB(SAND), Sumitomo Metal Mining(STMNF), ProShares UltraShort S&P 500(SDS), ProShares UltraShort MSCI EAFE(EFU), and Barrick Gold(ABX).

One of the most problematic aspects of these ETFs is their underlying structure. Since CPI is an ETF of ETFs, its 0.48% expense ratio will be on top of the fees associated with the underlying ETFs. Layering fees on top of fees can add up quickly.

Not only can the collection of CPI’s various fees rise quickly, these fees can also vary depending on the underlying holdings. Some ETFs, with complex strategies or narrow focus, have higher fees than other funds. CPI will have a very unpredictable fee structure because fees can change if it adds more expensive ETFs to its underlying mix.

GRES’ fee structure will also likely vary widely depending on the fund’s current holdings. GRES is structured to hold stocks along with the ETFs in its underlying portfolio. A 0.75% base fee will be tacked on to whatever expenses are inherent in the underlying components. Again, as the holdings in the basket change, or switch from equities to ETFs, the fees for GRES could change dramatically.

Both funds have the potential to add and subtract leveraged ETFs from their underlying portfolios. This is problematic from a fee and risk prospective. Leveraged ETFs often have high fees and short-term strategies. The high fees from these leveraged ETFs will push up the overall fees for the ETFs.

Leveraged ETFs are sophisticated instruments that are usually only appropriate in short-term trading situations. The funds tend to be very volatile and often inappropriate for long-term, buy-and-hold investors. CPI and GRES, which will be rebalanced monthly, may be forced to hold volatile, losing, positions in leveraged ETFs for too long of a period.

The creation of a series of funds that protect against inflation through the use of different types of securities is not necessarily a bad idea. But using the ETF structure to execute a flexible inflation protection strategy with multiple types of securities seems to be beyond what is reasonable.

CPI and GRES try to force active trading strategies to protect against inflation into monthly-rebalanced ETFs. The result is a risky and expensive mix of securities that could be unpredictable and harmful to consumers.

Disclaimer

Recent economic conditions have provided ample fuel for distressed-debt and high-yield corporate bonds.

A recovering economy has encouraged investors to regain their appetite for risk, and improved cash flow has prompted firms to pay interest on their debt.

There are a number of ways for investors to gain access to distressed-debt and high-yield corporate bonds. Year to date, the SPDR Barclays Capital High Yield Bond ETF(JNK Quote) has climbed nearly 33%, while the introduction of the Third Avenue Focused Credit(TFCVX Quote) has given investors a more actively managed strategy.

I believe that both of these funds still have tremendous upside potential through the end of 2009. Investors are looking for yield, and as the year draws to a close, investors tend to look back and add funds to their portfolio that have been performing well.

SPDR Barclays Capital High Yield Bond ETF

JNK tracks the Barclays Capital High Yield Very Liquid Index. The fund currently has 109 holdings with an average credit quality of B2 and the average duration is 4.6 years. Top holdings include bonds from GMAC(GJM Quote) and AIG(AIG Quote).

JNK’s 0.40% management fee makes this ETF more expensive than aggregate bond index ETFs like Barclays Aggregate Bond Fund(AGG Quote), but investors are paying for a narrow focus.

Since the underlying debt is risky and volatile, owners of JNK should be aware of any differences between the fund’s market price and its underlying value. Even though more than a million shares of this fund trade hands in an average day, there can still be discrepancies between this fund’s pricing and its underlying debt.

Third Avenue Focused Credit

Third Avenue Focused Credit has the following stated objective: “Seeks total return from a combination of capital appreciation and interest income, by focusing capital in our highest-conviction ideas across the credit spectrum.”

This new fund from Third Avenue will focus on areas like performing bonds and loans, debt under stress, capital infusions, distressed assets and restructurings. The portfolio is designed to be concentrated on 50 to 60 holdings.

The biggest differences between JNK and TFCVX are fees and management. While JNK is a passive ETF investment, TFCVX is managed by Jeffrey Gary, who headed BlackRock’s(BLK Quote) high-yield and distressed investment team before joining Third Avenue. Returns will be driven, for better or worse, by Gary’s ability to select individual situations for investment.

For this expertise, investors will pay fees of 1.71% for retail shares and 1.27% for institutional shares, although the first year will be reduced to 1.4% and 0.95%.

While I think that both JNK and TFCVX are good plays for the final stretch of 2009, they are only appropriate for a small portion of a risk-tolerant portfolio. As investors enter into 2010, I believe that they will eventually be attracted back towards quality companies and away from junk bonds and distressed debt.

In the meantime, however, high-yield debt still offers potential for return. The market for high-yield debt has recovered significantly since March, but credit spreads between this debt and Treasuries are still at the high end of the range because the rally was from such low levels.

Buying either JNK or TFCVX to capture short-term returns is a safer bet than trying to pick individual corporate debt issues. With high yield comes high risk, and these funds help to mitigate the danger of any single issuer defaulting. Still, I expect these funds to be extremely volatile even as they offer significant upside potential.

Disclaimer

The House Financial Services Committee is scheduled to take action this week on new financial regulations that single out mutual fund products, a step that could impact mutual fund companies like Fidelity, Federated(FII) and Vanguard.

The Investor Protection Act of 2009 would allow the Securities and Exchange Commission to create new requirements for the type of information that fund companies have to divulge before selling mutual funds to investors. The new legislation would amend the Investment Company Act of 1940.

While additional disclosures could be beneficial, and even necessary, for investors, the burden to supply them would fall squarely on mutual funds. The risk is that brokers and investors will choose less regulated products with fewer requirements.

Both mutual fund managers and investor protection groups are questioning the additional regulation. “I don’t know why mutual funds are continually picked out for higher levels of disclosure,” noted Paul Frank, manager of the ETF Market Opportunity Fund(ETFOX), a mutual fund that utilizes ETFs.

“The hoops that we have to jump through already are nearly too burdensome, and now to move the bar higher just doesn’t make sense,” Frank added. “I guess the Congress doesn’t owe their seats to anyone running a mutual fund, so they are throwing more regulations at us to make the public think they are being protected.”

In an interview with Investment News, Barbara Roper, director of investor protection for the Consumer Federation of America, noted that, “there’s not a reason in the world why you ought to single out mutual funds.” She also said that “if pre-sale disclosure is a good idea, it’s a good idea for all the products and services that brokers recommend.”

Other financial products, such as annuities and separately managed accounts, would not be subject to the “pre-sale disclosure rules” currently being debated. The new legislation would require mutual fund companies to provide prospective purchasers of mutual funds with specific information or documents before the purchase of such funds.

Currently, fund prospectuses are provided to customers upon the completion of a transaction. New legislation suggests that it could be necessary for investors to be provided with a summary prospectus and disclosure showing the costs of a fund in a comparative context could be necessary before purchase.

While additional disclosure and increased education is good for investors, the new process could be onerous for mutual fund companies. Pre-sale disclosure requirements could slow down the investment process and encourage brokers and investors to utilize other, less regulated, investment alternatives.

Take, for example, an investor choosing between an open end S&P 500 mutual fund like the Vanguard 500 Fund(VFINX) and the SPDR S&P 500 ETF(SPY). Both funds share many of the same top holdings, like Exxon Mobil(XOM), Microsoft(MSFT), General Electric(GE) and JPMorgan Chase(JPM). VFINX has a low expense ratio of 0.18% while SPY has a gross expense ratio of 0.10%.

If new regulation makes it more complicated to purchase shares of mutual funds like VFINX, more investors may seek out alternatives like SPY.

While it is important for regulators to keep finding ways to increase investor education and protection, the standard should be applied across the board. Currently, financial products are managed by an alphabet soup of regulators and a wide range of rules.

If the current “pre-sale disclosure” regulation before the House Services Committee passes, mutual funds may be singled out unfairly and suffer as a result.

Disclaimer

The demand for shares of physically backed gold ETFs continues to climb as investors’ concerns about declining purchasing power and inflation spur investment.

According to September data from the National Stock Exchange, SPDR Gold Shares(GLD) is second only to SPDR 500(SPY) when it comes to ETFs with the largest amount of assets.

SPDR finished September with more than $35 billion in assets. As of Oct. 23, State Street reports that there are now nearly $38 billion in assets in GLD.

While GLD may be the largest physical gold ETF, it is not the only U.S. ETF to be backed by physical gold holdings. iShares Comex Gold(IAU) had $2.4 billion in assets at the end of September. According to the fund’s Web site, IAU’s assets were $2.55 billion as of Oct. 23.

ETF Securities, whose founder launched the first physically backed gold fund in Australia in 2003, has also grabbed a slice of the pie with its U.S. gold fund. The company’s Physical Swiss Gold Shares(SGOL) launched on Sept. 9, 2009, and has already attracted more than $201 million in assets as of Oct. 23.

All three funds have a similar structure and fee schedule. GLD and IAU both have management fees of 0.40%, while newcomer SGOL has a 0.39% fee. All three funds offer investors exposure to a physical stockpile of gold held for investors by the trust.

The biggest difference between the funds is size and where the gold is stored. GLD is the largest fund when measured by assets and also has the highest trading volume. GLD’s three-month average daily trading volume is more than 12 million shares. IAU has a three-month average daily trading volume of 260,000 shares, while SGOL has an average daily trading volume of 100,000.

Liquidity is an important factor when deciding between two similar ETF funds, but all three of these physically backed gold ETFs have ample trading volume. Because the average investor would not have difficulty trading in or out of any of these three funds, the decision may come down to fees and storage.

Those investors who are frequently trading physically backed gold ETFs on their own may find SGOL’s small difference in management fees to be the deciding factor. Investors who are comfortable with only the biggest funds might choose GLD instead.

SGOL’s gold bullion is held in Zurich, Switzerland. All of the vaults that contain this gold are approved by the London Bullion Market Association (LBMA) to meet “good delivery standards.” Gold bullion held for the fund is inspected twice a year by an external auditor, and gold bar identification numbers are published on the fund’s Web site.

The gold that underlies GLD is held in the form of allocated 400-ounce London Good Delivery bars in the London vault of HSBC (HBC) Bank USA, or in the vaults of subcustodians. GLD’s gold bars are also held to the “good delivery standards” of LMBA. While the trustees of GLD are allowed to inspect the gold holdings twice a year, there seems to be a slightly different auditing process than SGOL.

While SGOL has an external auditor inspect the gold holdings twice a year, GLD simply notes that: “The Trust’s independent auditors may audit the Gold holdings in the vault as part of their audit of the Financial Statements of the Trust.” Investors who like guaranteed outside audits might prefer SGOL’s process.

Shares of IAU are backed by gold held by the custodian in the vicinity of New York, Toronto, Montreal, London and potentially other locations in the future. Gold held for IAU meets the same LMBA standards as GLD and SGOL. IAU also has the option to inspect the gold or have independent auditors inspect the gold.

GLD, SGOL and IAU are all offer exposure to physical gold in a cost-efficient format. Selecting a fund comes down to individual preferences about the quantity of underlying gold, liquidity concerns and geographical location.

As physically-backed gold funds grow in size, concerns will inevitably arise about the location and safety of the gold holdings. The central location of SGOL’s bullion and the process that ETF Securities uses to audit their gold holdings both internally and through independent auditors give this fund an edge.

While GLD still outmatches the U.S. competition when it comes to size, investors concerned with the auditing process or geographic diversification should consider SGOL. Investors looking to hold a large position in physically backed gold ETFs might consider splitting assets between GLD and SGOL to achieve diversification by issuer, location and vault.

Disclaimer

IPO investing is a difficult task, market by asymmetric information and volatile aftermarket performance. While picking the right IPO can be like winning the lottery, an investment in the wrong stock can have similarly dramatic results.

As the economy heats up, more companies will be gathering the assets needed to “go public” and listing on exchanges across the globe. The chances that you’ll pick the next Google (GOOG) are low, and risks are high, so a compelling case exists for fund-structured IPO strategies.

Direxion, creator of Direxion Daily Financial Bull(FAS) and Direxion Daily Financial Bear(FAZ) has announced its intention to launch the IPOX Global Long/Short mutual fund to capture the global IPO market. The fund will take an active approach to evaluating IPOs, and go long or short stocks accordingly.

Recognized most notably for leveraged ETFs and mutual funds, Direxion’s newest fund will use the same index provider as the existing First Trust US IPO Index ETF(FPX). Also currently available to investors is the open-ended IPO Plus Aftermarket Fund(IPOSX).

Dr. Josef Schuster, architect of the IPOX Indexes, reports that the global IPO market captures an average of 2,100 firms and $2.5 trillion market cap over a four-year rotational cycle. This means huge potential returns for investors, if they can pick the right funds.

By using an ETF like FPX or a mutual fund like IPOSX, investors can avoid security specific risk. Schuster notes that, “as an effect of the consequences of ‘going public,’ the return dispersion of constituents becomes huge over time.” The risk/reward ratio for these firms is huge.

FPX, IPOSX and the upcoming Direxion fund use difference approaches to IPO investing that employ varying degrees of active management.

The most passive of the group, FPX, is a modified value-weighted price index that tracks 100 of the largest and most liquid U.S. public offerings. The holdings are ranked quarterly by market cap, and the fund seeks to capture the most successful IPOs over time. The fund has a 0.60% expense ratio and has a year-to-date return of nearly 39%. IPOSX, and actively managed approach from Renaissance Capital, aims to invest in successful firms during and after the IPO process. Since investment in individual IPO offerings can be prohibitively expensive, this actively managed portfolio aims to capture a swath of the most popular offerings and make them accessible to investors. IPOSX has an expense ratio of 2.5% and a year to date return of 12.77%.

Perhaps the greatest challenge faced by Direxion’s upcoming IPO offering will be drumming up investor interest. Both of the existing IPO funds have only about $10 million in assets. FPX has a three-month average daily trading volume of just 3,000 shares.

While IPO investing can be highly profitable, the risks of investing in an illiquid ETF can also be high. FPX’s thin trading can pose a threat to risk-adverse investors who need to quickly trade in and out of the stock.

Market recovery should help to increase the number of IPOs, and potentially the investor interest in IPO funds. While it may be best to stay on the sidelines for now, these funds are ones to watch.

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