ETF Investing

Shadow Stocks: The Low-Risk, High-Profit Way to Play the Leading Global Trends

Shadow Stocks: The Low-Risk, High-Profit Way to Play the Leading Global Trends

by Horacio Márquez, Guest Advisory Panelist, Investment U
Friday, July 18, 2008: Issue # 823

Hundreds of businesses are growing at breakneck speed overseas right now. But unless they have an ADR listed on a U.S. exchange, they can be hard (and expensive) for U.S. investors to buy. “Shadow Stocks,” have made it easy – and safe – to purchase these fast-moving shares. Horacio Márquez, a former head of research for Merrill Lynch and a regular contributor, explains the top three reasons they’re so profitable.

Most investors know them as exchange traded funds or ETFs. But we refer to them as “shadow stocks,” and with good reason.

We’ve labeled them this way because they “shadow” the performance of a particular market, index, or sector. They’re baskets of stocks that – like mutual funds – enable you to buy or sell a portfolio of securities in a single purchase.

Unlike mutual funds, however, you can trade shadow stocks just as you would an individual stock: You can buy and sell them at intraday prices on U.S. stock exchanges, you can buy options on them and you can even sell them “short.”

These relatively new, highly focused forms of mutual funds offer investors a diversified way to play economic sectors, global financial trends, market events and other so-called “special situations.”

Shadow Stocks – The Most Powerful ETFs in 2 Decades

But no matter how you label them – whether you refer to them as shadow stocks or as exchange traded funds – one thing is certain: For individual investors, shadow stocks are the most innovative, and most powerful investment vehicle to hit the financial markets in at least two decades.

There are three key reasons why this is true. Shadow stocks:

  • Offer a risk/reward profile that’s much better than either individual stocks or regular mutual funds can offer.
  • Provide a way to make investment plays that would otherwise be out of reach.
  • Give you terrific diversification and liquidity, offering significant safety.

Now that we’ve listed these important benefits, let’s look at each one in more detail…

Shadow Stock Profit Secret No. 1

Shadow stock profit secret number 1: It’s not the stock you buy; it’s the sector you play.

I’m always stunned by how few people actually are aware of this basic fact. But study after study bears this out: More than 50% of any gain an investor realizes in an individual stock is due to the sector it’s in, not the stock itself.

Indeed, because they are so well focused, shadow stocks (or ETFs), allow you to play the sector, theme, or global trend that will generate most of your gain.

What’s more, since they are a “fund,” shadow stocks offer risk diversification that individual stocks could never offer. If you identify a great global trend to play for a profit – but pick the wrong stock (it has an earnings disappointment, a liability lawsuit, or gets caught up in a financial crisis) – you could actually incur major losses, despite having chosen a winning trend.

Shadow Stock Profit Secret No. 2

Shadow stock profit secret number 2: Shadow stocks put the “Out of reach” back within your reach…

Last year, we uncovered this fascinating investment opportunity – only to realize there was no direct way to profit from it.

Our global money-flow analysis pointed to Taiwan as a lucrative long-term investment opportunity. Drilling down, we uncovered a terrific profit play: Hon Hai Precision Industry Co. Ltd. (TPE: 2317), a Taiwan-based company that manufactures all three of the hot new video game consoles that have been duking it out in the $10 billion worldwide video-gaming market.

With those gaming systems we’re talking, of course, about:

  • Sony Corp.’s (ADR: SNE) PlayStation 3
  • Microsoft Corp.’s (NYSE: MSFT) X-Box 360
  • And Nintendo Co. Ltd.’s (OTC ADR: NTDOY) Wii

Hon Hai isn’t some little wannabe: As the maker of every global gizmo from Hewlett-Packard Co. (NYSE: HPQ) PCs to the hot new Apple Inc. (NASDAQ: AAPL) iPhone, Hon Hai has grown into a global leader so dominant that BusinessWeek magazine labeled it as an “earnings machine.” In fact, it’s now the biggest electronics manufacturer on the planet.

Sounds like a great investment, right?


Unfortunately, Hon Hai wasn’t registered with the U.S. Securities and Exchange Commission, meaning its shares weren’t available to U.S. retailer investors.

We didn’t give up, of course. While we couldn’t get around the SEC regulations, we did find another investment that held a big stake in Hon Hai – along with dozens of other Taiwanese companies with the same kind of potential.

It was a “shadow stock” – an exchange traded fund called the iShares MSCI Taiwan Index (NYSE: EWT). And Hon Hai’s Taiwanese shares were the fund’s largest holding. [Please see today’s Crib Sheet below for more shadow stock ideas.]

That brings us to our last guideline…

Shadow Stock Profit Secret No. 3

Shadow stock profit secret number 3: Shadow stocks offer a margin of safety that single shares don’t.

Shadow stocks, because of their built-in diversification, are automatically safer to own than individual shares. With individual stocks, it’s possible to buy into the right trend – and still not make any money, because you bought the wrong stock. It’s possible to have one stock in a hot sector crash and burn because of problems unique to that company.

That will never happen with shadow stocks. Because they are actually a diversified fund, if you pick the hot sector, you’ll pick up the profits that go with it. And you’ll never get scorched just because one stock turned turtle.

Good investing,

Horacio Márquez

Editor’s Note: Horacio Márquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises – cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. 

Today’s Investment U Crib Sheet

  • Here are the top five Shadow Stocks over the last 12 months. It should be no surprise that this list is dominated by energy…Top 5 Shadow Stocks/ETFs in last 12 months

  • Leading Shadow Stocks GAZ and UNG invest primarily in U.S. natural gas. Both are trading at a slight premium to their net asset value (NAV), and have pulled back almost 20% from their high earlier this month.

  • This year’s winners are often next year’s losers, and next year’s winners are often this year’s losers. So here are the five index funds trading at the largest discount to their NAV. Shadow Stocks/ETF winners for next year, 2009

  • GIFD invests in international fixed income securities. The countries with the largest investment percentages are the Netherlands, Canada, the United Kingdom and Australia. It yields 6.4% and has paid dividends since its inception in 1983.DCA seeks capital appreciation in addition to investing in income securities. Invested domestically, its largest industries are hotels/lodging, office and collateralized debt. It’s yielding 13.19%.

  • Underperforming dividend payers can be great bargains, but they can also signal problems. Here are several warning signs that could tip you off beforehand… and one international bank that’s paying serious dividends found in Investment U Issue #816, As Bank Stocks Fall… Beware of the Dividend Trap.

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