The Future of These Top ETFs

Exchange-traded funds have made it simple for even beginning investors to put together a smart portfolio of stocks and other investments. But surprisingly, ETFs are getting a huge amount of attention from an unexpected source: institutional investors like hedge funds.

Last week, I took a look at hedge funds and which stocks have grabbed their managers' attention. Although you'll find many of the same top-name stocks in many hedge fund portfolios, gauging changes in sentiment can show you where the so-called smart money is moving right now -- and may be able to help you get a jump on the rest of the investing crowd.

The most surprising place to find ETFs
Given how much money investors pay hedge funds in fees -- often, a straight-up 2% annual fee plus 20% of the profits (if any) in any given year -- you'd think picking individual stocks would be part of the package. That's why you might be shocked to realize that a huge number of hedge funds include ETFs in their portfolios, and they often make up sizable chunks of their assets under management.

But when you think about it, owning ETFs can make a lot of sense even for institutional investors. After all, ETFs have a number of advantages:

• Broad-market ETFs make a good placeholder for general exposure, which can be especially useful when keeping your money in cash pays you almost nothing in interest.
• The ETFs that hedge funds choose tend to be extremely liquid, which lets them get in and out of positions quickly. You can't say the same about every individual stock you'll find in hedge fund portfolios, especially small-cap names that don't have a lot of trading volume.
• ETFs can give you diversified exposure to a given sector of the market. That's valuable if you're more concerned about an overall trend than you are about which individual company is most likely to capitalize on it.

So to see where hedge fund managers are using ETFs to maximum advantage, I once again turned to the hedge fund tracking service AlphaClone. Looking at sentiment readings among their top ETF holdings, here are the ETFs with the highest positive sentiment readings, along with their changes from the previous quarter:

Source: AlphaClone.

Just as we saw with stocks, trying to figure out exact reasons for changes in sentiment when looking at a collective view is pretty much impossible. But some general trends make it through the noise to make the overall picture somewhat clearer.

At the broadest level, it's interesting to see how much overall sentiment toward ETFs dropped. Whether funds wanted to focus on commodities like gold, domestic S&P 500 companies, or red-hot emerging markets, overall interest appears to have plunged.

That could support two conclusions: Either funds are cutting their exposure to risky investments entirely, or they're substituting individual investments in place of broader-based ETFs. Given that the huge bounce in stocks over the past two years appears to be slowing if not stopping entirely, the second conclusion seems more likely, as hedge funds seek out bigger returns by picking stocks and narrowing down their investment focus.

However, some smaller-scale moves raise some curious issues. Note how the iShares emerging markets ETF lost substantial share, while Vanguard's similar fund bucked the trend and gained in sentiment. That may reflect the Vanguard fund's lower cost. Although bigger funds may have some cost savings, especially for high-volume institutions that rely on narrow bid-ask spreads to reduce the frictional costs of trading, at some point a fund with lower fees may gain enough ground to offset any other costs. That seems to be happening now with this fund pair.

Lastly, the trends suggest that fund managers want value for their investing dollars. In response to the Japanese disasters, investment sentiment toward Japan skyrocketed. Even as small-cap stocks have rallied to new records, the megacap stocks you'll find in the Dow Jones Industrials have largely lagged -- yet interest in the Dow-tracker ETF also rose sharply.

What it all means
For your own ETF portfolio, keep in mind that funds have different goals from their ETF investments. While funds have to beat the markets to generate more fees, you can often be content with matching gently rising market returns. So although seeing what the pros are doing with ETFs has some information, don't let falling sentiment lead you to dump your ETF strategy without further reflection.

Meanwhile, if you'd like to enhance your ETF portfolio, take a look at these three ETF picks. They're all poised to post gains as the economy continues to recover.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.