Tactical Investing: Pick ETFs or Stocks?

You wouldn't try to cut down a tree using a scalpel. Likewise, you wouldn't attempt to perform heart surgery using a chainsaw. While these are far-fetched examples, the point is: Different tasks call for different tools.

Along the same lines, we as investors all have different objectives, risk tolerances, and time horizons. Given our unique circumstances and differing opinions on the economy and stock market, it's very likely that an investment that fits the bill for one investor may be completely unsuitable for another.

Before sifting through the investment universe for the most appropriate tool for the job, investors should be able to answer one central question: What is my investment thesis? For long-term core positions, there's a good chance that investors can get the exposure they seek through exchange-traded funds. However, when thinking about shorter-term tactical bets (or satellite positions), the line gets blurred. Usually, the decision boils down to which ETF is the best tool for the job. At other times, the right tool might not be an ETF at all but, rather, a stock. Regardless, the key is to match the thesis with the investment vehicle that most closely correlates with your conclusion.

For example, you might think that biotechnology stocks have been unfairly beaten down with the rest of the market but still possess very promising prospects. Furthermore, you may expect that the industry's recent merger activity will continue, as big pharma firms look to spruce up their drying pipelines with innovative technologies amid an oncoming blitz of generic competition.

Unless you're a biomedical chemist, however, it can be intimidating to try to size up the effectiveness and efficacy of the drugs in a given biotech's pipeline. Further, it's extremely difficult to come up with the present value of a potential drug's future cash flows before it even makes it through the regulatory process. In this case, it makes a ton of sense to go the ETF route, either via  SPDR S&P Biotech (XBI) or  iShares Nasdaq Biotechnology (IBB). A small position in one of these ETFs would allow investors to participate in the industry's potential upside while simultaneously diversifying away company-specific risks.

Let's say, however, that your investment thesis is that discretionary consumer spending will rebound sometime in the next year. In studying stock market performance coming out of previous recessions, you might have noticed that discretionary consumer stocks tend to lead the rally. Thus, this time around you plan to position your portfolio to take advantage of this trend. Despite the grim near-term outlook for the U.S. consumer, you might be inclined to take a small position in  Consumer Discretionary Select Sector SPDR (XLY), considering that the stock market is a forward-looking discounting mechanism.

While XLY will provide some exposure to a bunch of retailers, restaurants, and leisure companies, an investor might be discouraged to learn that nearly 30% of the portfolio is dedicated to the media industry. This alone isn't a deal breaker, but we can see how some investors would prefer avoiding exposure to firms such as  Comcast (CMCSA),  Time Warner , and  News Corp.  when trying to execute this "early recovery" thesis. Furthermore, for those who think that the housing market still has plenty of rough sledding ahead, the portfolio's more than 10% combined stake in  Home Depot (HD) and  Lowe's (LOW) is probably less than desirable. Looking to international consumer discretionary ETFs for more-suitable exposure also turns up disappointing results; the automotive industry makes up more than 20% and 30% of iShares S&P Global Consumer Discretionary (RXI) and SPDR S&P International Consumer Discretionary , respectively.

Similar issues arise with the popular "clean energy" and "infrastructure" trades. ETFs with clean-energy themes tend to lump in all types of renewable energy technologies, from solar and wind to biofuels. An investor who thinks that solar power has a bright future but believes that the prospects for biofuels are overly optimistic is better off picking stocks. Instead of buying  PowerShares WilderHill Clean Energy (PBW), this investor would probably be better off going with a name such as  First Solar (FSLR), the solar industry leader and low-cost producer. Investors aiming to ride the coattails of the various stimulus packages being passed around the globe via SPDR FTSE/Macquarie Global Infrastructure 100 (GII) or iShares S&P Global Infrastructure (IGF) might also be disappointed to learn that utilities comprise about 90% and 40% of those ETFs, respectively. In this case, investing in engineering and construction companies might be a more appropriate way for these investors to put the thesis into action.

Making tactical sector and industry bets has never been easier; by using ETFs, investors can gain exposure to a given sector's underlying fundamentals while diversifying away company-specific risks. But not all investors take a top-down view of markets. Understanding this, we've introduced a feature now available on Morningstar's ETF Screener Beta that we think will appeal to bottom-up stock-pickers. The new feature allows investors to input individual stock tickers and sort the ETF universe by which funds court the highest (or lowest) exposure to a given stock.

An example should help clarify the use of this feature. Let us assume that there is an investor who is interested in picking up shares in  Newmont Mining (NEM) to participate in the "re-flation trade." After a brutal 2008, though, she's apprehensive about picking individual stocks. She's not particularly attached to Newmont itself but has conviction in her thesis for mining companies in general--global demand for commodities will recover and inflationary pressures over the long haul will drive commodity prices higher, helping boost profitability. She'd prefer diverse exposure to a wide range of miners and materials firms but doesn't want to dedicate a large portion of her portfolio to buying a small basket of mining stocks. Besides, the transaction costs alone would make this proposition a losing one.

In this situation, the investor could try out our new feature by going to the top of the ETF Screener page and clicking on the Add Criteria button. From there you should see a list of 13 screening categories. Click on % Exposure to a Stock (second category from the bottom). Here you can input the tickers for as many individual stocks as you're interested in. Make sure to click the Add button beside the text box with your mouse after entering each ticker (hitting Enter on your keyboard will take you back to the screener home page and away from the criteria list). Note: You'll see a notification in green for every stock that you successfully add. After you finish adding tickers, simply click Close Criteria and you're ready to roll. On the left there should be a new column for each stock ticker that you've added. By clicking on the column headers, you can then sort the entire ETF universe in ascending or descending order, according to how they weight a given stock in their respective portfolios.

In our example with Newmont Mining, we find that  Market Vectors Gold Miners ETF  (GDX) and  Materials Select Sector SPDR (XLB) have healthy Newmont stakes of 8.6% and 7.6%, respectively. If the investor in our example is particularly interested in precious-metals mining, then GDX would be the obvious choice. On the other hand, for broader-based exposure to metals and mining companies, XLB would be a more appropriate pick.

Formulating a solid investment thesis only gets you part of the way there. We encourage investors to take advantage of the extremely useful tools available on Morningstar.com. These tools are here to help you understand and find what you're looking for. After all, you wouldn't tee off at the golf course using a putter. Likewise, you don't want to end up trying to act on your infrastructure thesis by investing in a regulated utilities ETF. 

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.