ETF Haters Keep On Hatin (XLB, XLE, IEZ)

The boo-birds, naysayers and haters just keep on bashing exchange-traded products. It's almost becoming a national past time on par with baseball, the Super Bowl and Fourth of July barbecues. Latest up on the ETF hit parade is the notion that if an investor is somehow fortunate enough to choose the best-performing stock in a given ETF, that stock will outperform the fund. It stands to reason and if it's true, it's probably fair to say best single stocks trumping funds can be applied to mutual funds, too. After all, by some estimates, 70% or more of mutual fund managers cannot outperform the S&P 500. Right? So let's see if owning an ETF's best-performing stock really does beat the fund. First, the argument needs to consider how much legwork one should be expected to perform. Even if we strip out all inverse and leveraged ETFs, bond funds and the ETFs and ETNs based on physical commodities we're still left with hundreds of plain vanilla long equities-based ETFs, some of which track indexes of 300, 400, 500 stocks or more. Obviously, that would be a time-consuming tax. Maybe the question is best answered by looking at an ETF's top components. The Energy Select Sector SPDR XLE offers some insight regarding the stocks vs. ETF debate. Dow components Exxon Mobil XOM and Chevron CVX, the two largest U.S. oil companies, account for almost a third of XLE's weight. Schlumberger SLB and Occidental Petroleum OXY are the ETF's third- and fourth-largest holdings and ConocoPhillips is number five. At the start of trading today on a year-to-date basis, XLE was a better bet than Exxon, Chevron and Conoco, but lagged Occidental and Schlumberger. Change your time horizons to the past year, two years and five years and it's worth noting XLE is never the top performer. It's also never the worst. This is almost certainly the case with any number of sector funds and we conducted a similar evaluation of several other SPDRs funds, including the Materials Select Sector SPDR XLB and the Consumer Staples Select Sector SPDR XLP with similar results. Over various time frames, the ETFs beat a lot of their components, get beat by a few and rarely, if ever are the worst laggards. Of course the argument that buying an ETF's best individual stock is a winning strategy is dependent on several flawed arguments. First and perhaps most important, looking at an ETF's top performing stock is obviously dependent on current or past data. No one has a crystal ball. XLE's best performer today or last month may be its worst laggard next week or next year. Second, the reality is most investors, professionals included, probably won't pick the stock that winds up to be an ETF's top performer. And if someone does pick an ETF's star stock, there's no guarantee the investor holds it for the entire move. Take the example of National Oilwell Varco NOV and the iShares Dow Jones US Oil Equipment Index Fund IEZ. It's pretty safe to say NOV has been one of the best large-cap oil services stocks in recent years. NOV has hammered IEZ over the past five years. The stock is up almost 150% over that time, but who held it from $88 to $23 in 2008 and rode it all the way back to where it is today? Answer: Only those with crystal balls, the best dumb luck known to man, a death wish or the dollar-cost averaging folks that were just convinced NOV was going to come back. It's probably fair to see all four groups were lightly populated. It's fine and dandy to say single stocks beat ETFs (and mutual funds), but the premise of ETFs has never been nor will it ever be to replace single stocks in portfolios. ETFs are sector/country/thematic instruments that are arguably less risky than single-stocks. Remember, an obvious advantage of ETF is they mitigate stock-specific risk. Said differently, it would be nice to own DuPont DD if it was always the best stock in XLB, but where would one rather be if DuPont went bankrupt tomorrow (we're NOT saying that will happen). Holding DuPont shares or XLB? Bottom line is the single-stock-beats-ETF theory works until it doesn't and only when one is fortunate enough to pick what turns out to be the gold-star component of a given ETF.