Three ETF Picks for 2011

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I got inspired, in part, because yesterday CNBC asked me to make three ETF picks for 2011.

It was a fun segment, but time is short in TV and it's hard to make a nuanced argument. So I thought I'd lay out the full case for my choices here.

1) China - Using GXC:

China is the world's economic powerhouse, and no global recovery will take place without it.  And yet, after a pullback, Chinese stocks are cheap. The SPDR S&P China ETF (NYSEArca:GXC) currently trades at a P/E of 13.8, compared to 15.7 for the SPDR S&P 500 ETF (NYSEArca:SPY).  It's also trading at a 25 percent discount to Brazil, a more comparable economy. Plenty of people smarter than me are calling for another strong year for China - Credit Suisse has made non-Japan Asia its No. 1 call for 2011, and I think they're right.

Add in the fact that most people are systematically underweight China because it's under-represented in global indexes - China currently makes up a smaller percentage of the MSCI All Country World Index than Switzerland --- and you see why an extra allocation to China makes sense.

But most people go about this the wrong way. By far the dominant China ETF is the FTSE China 25 Index Fund (NYSEArca:FXI), which was first to market and currently has almost  $8 billion in assets.  People who want China buy FXI reflexively. But FXI's portfolio only holds the 25 largest companies in China - the biggest of the big - meaning it mostly holds state-owned giants like PetroChina that export goods to the West. If you want to buy into the internal dynamism of the Chinese economy, a fund like GXC that includes exposure to mid- and smaller-cap companies is a better bet.  An even more adventurous bet would be the Guggenheim China Small Cap ETF (NYSEArca:HAO).

2) Commodities - Using USCI

The case for commodities is slightly more nuanced. Commodities have been in a systematic bull market for a number of years, and those trends appear to be intact.

But what's interesting to me is the fact that oil futures, after years of trading in contango, have been flirting with backwardation recently.  They're not all the way there, but they're close. Backwardation is a sign that the supply/demand balance has tipped in favor of demand; it denotes scarcity in the markets. And that's bullish for prices.

My favorite play in this market is one of the newer funds, the United States Commodity Index Fund (NYSEArca:USCI). USCI is based on an index strategy developed by Yale Professor K. Geert Rouwenhorst, the father of modern commodity indexing, who co-authored the landmark paper, "Facts and Fantasies about Commodities Futures" with Gary Gordon and revealed commodities as a viable new asset class. This is the kind of strategy that used to get wrapped up in a hedge fund and billed at "2 & 20"; now it's available in an ETF and costs 0.95 percent per year.

The returns since it launched in August have trumped all other broad-based commodity ETFs.

Source:Bloomberg

That advantage may shrink in 2011, and there are markets where it will underperform, but as a long-term holding in commodities it's a strong choice.

3) Anything but VXX

$327 million flowed into the iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca:VXX) on Monday. It will all be sacrificed on the altar of the angry, voracious, money-eating god of contango.

VXX has been a wonderfully efficient way for investors to lose money in 2010. Through yesterday, investors poured over $2 billion in cash into VXX, and yet the fund currently has only $1.1 billion in assets under management. Anytime those two numbers are reversed, you know something bad is happening, and that's definitely the case here.

The contango in VXX wipes away any chance investors might have had. Because of that killer curve, second-month contracts on VIX are 6.7 percent higher than first month. If the curve stayed this way, the contract you buy at $22 today, you'll have to sell at $20.60 next month - that's the butcher's bill.  If you had to repeat that over 12 months, you'll lose a lot more - 82 percent  of your original investment.

Almost anything is better than VXX - you probably have a better chance of return by handing money out to strangers and waiting for some karmic return of your generosity. But if you're really interested in playing volatility, make sure it's for the right reasons. As a short-term hedge for near-term volatility, VXX can be a valuable tool. For long term investment strategies, however, it's the worst.

This has been an an amazing year for exchange-traded funds, and 2011 should be even better. The three funds I chose here are what I'm looking toward, but there are plenty of great funds and smart choices out there. What are some of yours? Let us know in the comments below.

Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2010 Index Publications LLC . All Rights Reserved.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: FXI , GXC , HAO , SPY , VXX

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