The new millennium has ushered in the era of Exchange-Traded Funds (ETFs). ETFs have accumulated hundreds of billions of dollars in assets while initiating a paradigm shift towards indexing strategies in the minds of most retail investors. ETFs general accolades are three fold: lower fees, more transparency and increased tax efficiency. On the surface, ETFs may appear quite simple, but these securities can be quite complex. In order to get the most out of ETFs, advisors and investors need to know about the structure, opportunities, and limitations of these securities.
Below we list many of the factors that you need to know about ETFs, from the basics to the more sophisticated aspects of these products. We present investment ideas naming specific example products and a ‘Take Away’ for easy application to your own portfolio.
- ETFs Are Tax Efficient
- UITs vs. ETFs: Structure Matters
- Sampling Does Not Mean Replication
- Expense Ratios Are Not The Only Expense
- Bigger Is Not Always Better
- A Name Does Not Always Match Its Holdings
- Global ETFs: Not Really All That Global
- Inverse ETPs Are Not The Same As A Short Position
- Leveraged ETPs Come In Three Very Different Flavors
- Market Capitalization Size Matters
- Cap Weighting Has Some Drawbacks
- Equal Weight ETFs Are Tilted Towards Small Cap
- Equal Sector Weighting ETFs Can Balance A Portfolio
- Be Aware Of Revenue Weighting And Biases
- RAFI Weighting Is Based On Four Factors
- International ETFs Have Sector Bias
- Beware Target Retirement Date ETFs
- Value/Growth ETFs Often Overlap In Holdings
- Ex-Sector ETFs Avoid Troubled Sectors
- Ex-Japan ETFs: Powerful Tools
- Country-Specific ETFs Are Impacted Beyond Their Borders
- Factor ETFs Target Specific Characteristics
- Infrastructure ETFs: Playing An Inevitable Trend
- Targeted ETFs Are Not Always Pure Plays
- Targeted Mining ETFs Are Not Always Pure Plays
- Business Development Company ETPs: Access To The Next Big IPO
- Money Market ETFs: Safe Havens In Market Storms
- ETNs Have Credit Risk
- ETNs Mature
- ETNs Are Not Evil
- Your ETF May Be State-Owned
- Preferred Stock ETFs
- AlphaDEX ETFs: Interesting Methodology, Compelling Results
- Take A Look At ‘Contango ETNs’
- TrendPilot ETNs: A Trend Following Strategy
- Invest In Southeast Asia
- Real Estate ETFs: Not Residential!
- Socially Responsible ETFs Offer Good Values
- Understanding ETFs of ETFs
- Watch For New ETPs
1. ETFs Are Tax Efficient
One of the main advantages of ETFs is their tax-efficient structure. Exchange-traded products generally maintain lower capital gains distributions (for domestic U.S. investors this is extremely important) than mutual funds because of the manner ETFs create and redeem shares. Many mutual funds often trigger tax events when shares are redeemed, i.e. remaining investors experience a tax event because someone else decided to sell their shares. When redemptions occur in ETFs they are done so ‘in-kind’ and are not considered sales. As such, these transactions do not trigger a taxable event.
Take Away: ETFs do not subject investors to taxes within the structure, which can be the case in other forms of collective investment schemes.
2. UITs vs. ETFs: Structure Matters
The term ‘exchange-traded product (ETP)’ includes a number of product structures, ranging from exchange-traded notes (ETNs) to true ETFs to grantor trusts and unit investment trusts (UITs). Many of the “first generation” ETPs are actually UITs, a structure that has a couple of peculiarities. First, UITs must fully replicate their underlying index, and they are prevented from lending out shares (which often is a source of additional income for ETFs). Second, UITs do not reinvest any dividends, an activity that true ETFs can accomplish.
The S&P 500 SPDR (SPY) is a UIT, whereas the iShares S&P 500 Index Fund (IVV) and Vanguard S&P 500 ETF (VOO) are true ETFs. Because of the differences surrounding dividend reinvestment, SPY generally lag true ETFs slightly in bull markets and outperform in bear markets. In other words, in some instances products such as IVV and VOO, which are true ETFs, might have some advantages over the extremely popular SPY.
Take Away: Pay attention to the boring details such as structure; they might have a big impact on returns.
3. Sampling Does Not Mean Replication
Many investors assume that index-based products, such as most ETFs, achieve their investment objective by holding a portfolio that mirrors the specified benchmark. Often that is not the case at all! Almost all ETFs maintain the flexibility to engage in something called ‘sampling’. This involves constructing a portfolio of only a portion of the total universe of a larger index. In many cases it is not practical to build an ETF with thousands of individual holdings (including some with significant liquidity issues).
Sampling is not necessarily a bad thing; in many cases, it helps keep costs down and avoid bad execution on thinly traded securities. It can result in tracking error, and those wishing to avoid this phenomenon would be advised to seek out products that match the underlying index perfectly.
Take Away: Not all index-based products are constructed the same way; a ‘sampling’ strategy may offer reduced expenses at the cost of tracking error.
4. Expense Ratios Are Not The Only Expense
When comparing potential ETF investments, one of the easiest metrics to examine side-by-side is the expense ratio charged. While this value certainly provides some insights in the cost efficiency of a product, it is not the only measurement of the cost of investing in an ETF. The commissions charged can also be significant depending on individual circumstances; minimizing or avoiding those fees can be one easy way to keep costs in check. There are other fees that are difficult to quantify exactly, including the cost of bid-ask spreads when moving in and out of a position.
It should also be noted that some ETF expense ratios don’t include the costs associated with rebalancing the portfolio. For some futures-based products those fees can add up and represent a meaningful expense that isn’t included in the indicated expense ratio.
Take Away: Some ETFs carry fees beyond the face value of their expense ratios.
5. Bigger Is Not Always Better
One of the most common mistakes an investor makes when entering into an ETF trade is assuming that a fund with a large asset base is the best choice available. While a healthy AUM typically points to a solid investment thesis, it may also be due to a number of other factors like age. Some funds have simply been around longer than others, allowing them to attract more assets in the first place. When it comes time to look for a new ETF, if two products have similar strategies, chances are you are going to pick the fund with more assets, as it seems like a logical indicator of the strength of a particular product.
One of the best examples of this pitfall comes from the FTSE China 25 Index Fund (FXI). The fund has just 27 holdings with the top ten receiving more than 60% of total assets. This makes for a generally non-diverse product, the exact opposite of what most ETF investors look for, but because FXI has been around since 2004, it was able to garner a fair amount of assets which had a snowball effect for the future. There are a number of better options for Chinese exposure, but you have to be willing to look for them. This example can be generalized to the industry as a whole, as this same mistake is made with countless other asset classes and investments. As a good rule of thumb, you should always explore similar funds, despite their size, prior to investing.
Take Away: Total assets under management should not be the only factor you consider when making an investment decision between products from the same category.
6. A Name Does Not Always Match Its Holdings
Investors should never judge an ETF by its name. For most funds, the name gives almost all of the relevant details. In some cases, however, titles can be misleading. For instance, small cap ETFs often maintain a large percent of their allocations in mid caps. The SPDR S&P Middle East & Africa ETF (GAF) has about 90% of its portfolio in one country. Take advantage of the transparency of ETFs before investing, and make sure the portfolio is consistent with your objectives.
Take Away: A name does not make an ETF. Always look closely prior to investing.
7. Global ETFs: Not Really All That Global
Some of the most broadly based equity ETFs invest in a collection of investment products that generally includes dozens of economies from around the globe. In many cases, however, these ‘global ETFs’ are not really reflective of the global economy thanks to a bias towards developed markets in general (and the United States in particular).
Consider the iShares MSCI ACWI Index Fund (ACWI) as an example. Though this ETF offers exposure to dozens of economies, it is clearly tilted towards the United States (which represents about 45% of assets). China, the world’s second largest economy, makes up less than 3% of assets. Emerging markets amount to less than 10% of ACWI’s holdings. So, be sure, only developed markets will drive the returns of ACWI.
|Middle East||< 1%|
ACWI can still be a very useful tool for a wide range of objectives, but as a fund that truly reflects the global economy, some modifications are needed.
Take Away: Global ETFs are not always as well rounded as their name might suggest.
8. Inverse ETPs Are Not The Same As A Short Position
The popularity of ETFs has been stirred up by the abundance of inverse ETFs available to investors. While these can be very useful tools, it’s important to understand exactly how they work; specifically, a position in an inverse ETF is not the same as a short position in the underlying asset. Most inverse ETFs seek to deliver daily results that correspond to daily movements in the specified index. As such, over multiple trading sessions the performance of an inverse ETF might not line up perfectly with the change in value of a short position.
It’s also worth noting that the biggest loss possible with an inverse ETF is 100%. With a short position, losses are theoretically unlimited.
Take Away: Make sure to understand the complexities and how often a product resets exposure before buying into an inverse ETF.
9. Leveraged ETPs Come In Three Very Different Flavors
There has been a great deal of confusion in recent years over leveraged ETPs, with many investors failing to grasp the nuances of these products and the potential pitfalls associated with casual use. Another misconception about leveraged ETFs is that there is only one type.
In reality there are three very different types of leveraged ETPs based on the frequency of reset, which has a huge impact on the risk/return profile:
- Daily Reset Leveraged ETFs: These ETFs, which include the lineups from Direxion and ProShares, seek to deliver amplified results over the course of a single day only. At the end of each session, leverage resets and the fund sets out the next morning with another daily objective.
- Monthly Reset ETPs: These ETPs seek to deliver leveraged results over the course of a month, meaning that the leverage resets only once every four weeks or so. Though the impact of compounding returns still exists in these products, it occurs much less frequently.
- Lifetime Reset ETPs: There are now several ETNs that seek to deliver leveraged results over the term of the note–which can stretch for more than a decade. These ETPs are unique in that the effective leverage realized when establishing a position can be very different from the initial target–sometimes as much as 8x.
Take Away: The nuances of leveraged ETFs are extremely important in determining risk profiles.
10. Market Capitalization Size Matters
International investors using ETFs have an important decision to make: whether to use ETFs that are dominated by large cap stocks or those that focus specifically on small caps. The choice between these two can end up having a major impact on the risk/return profile. Obviously, large and small cap stocks will perform differently in specific market environments. Generally, large cap stocks will be more stable whereas small caps can be more volatile but also exhibit greater long-term capital appreciation potential.
There are other factors to consider as well. For example, many investors view small caps as a way to establish better more direct access to the local economy. While large caps tend to be multi-national corporations that generate revenue around the globe, small caps depend more directly on local consumption.
Take Away: Not all ETFs are created equal. There is a significant distinction between large and small caps.
11. Cap Weighting Has Some Drawbacks
Investors have rightly expressed concern over inefficiencies baked into market capitalization weighting, the strategy that is behind many of the most popular equity ETFs on the market.
The biggest potential drawback with market cap weighting relates to the link between the weight a stock is assigned in an index and its stock price; higher prices mean a bigger allocation. That can translates into a tendency to overweight overvalued stocks and underweight undervalued ones, which can obviously create a drag on portfolio returns.
Take Away: Cap weighting is not always the best option. Always consider alternatives.
12. Equal Weight ETFs Are Tilted Towards Small Cap
Increasingly popular in recent years, equal weight ETFs have become as an alternative to market cap weighting. Proponents of equal weight strategies note that this methodology delivers better balance and can eliminate the tendency to overweight overvalued stocks that is built into cap-weighting. It is difficult to argue with the results of equal weighting; the S&P Equal Weight ETF (RSP) has consistently outperformed SPY over the last several years. But it is important acknowledge some of the biases in equal weight ETFs, and understand how those biases can impact performance in different environments.
Compared to a market cap weighting approach, equal weight translates into a tilt towards small cap and mid cap stocks. Doing so can increase overall volatility, which can be a positive in bull markets and a negative in bear markets. Equal weight can also have bias resulting from rebalancing, when the best performing components are sold off and the proceeds are used to purchase those stocks that have lagged behind recently. This delivers something of a contrarian strategy.
RSP vs SPY Breakdown
|Market Cap||RSP Weighting||SPY Weighting|
Take Away: Be sure to understand the biases introduced by alternative weighting strategies.
13. Equal Sector Weighting ETFs Can Balance A Portfolio
The equal weight methodologies behind RSP and other similar ETFs focus primarily on the individual stock level, assigning an equivalent allocation to each component security. But equal weighting can also be implemented on a sector level, meaning that the breakdown between types of companies can be balanced across a portfolio. That’s exactly what the ALPS Equal Sector ETF (EQL) accomplishes; it consists of equivalent positions in nine different sector SPDRs.
This approach could be appealing for several reasons. First, it allows investors to participate in rallies in any corner of the markets. Second, it effectively builds in a mechanism to prevent overweighting sectors in which a bubble is forming.
EQL Sector Breakdown
Take Away: ETFs with equal-weighted sector exposure can offer an appealing risk/return profile for some investors.
14. Be Aware Of Revenue Weighting And Biases
One of the alternative weighting methodologies that has popped up in recent years involves allocating assets based not on market cap or earnings but on top line revenue. Revenue weighting might have appeal to investors looking to shift exposure to stocks with low price-to-sale multiples. But there are some interesting side effects to consider as well.
Revenue weighting will shift holdings towards companies with lower profit margins, all else being equal. That occurs because low or negative earnings are not considered in the weight calculation, only top line revenue. It can also have a tendency to overweight high debt companies. In a cap weighting methodology, big debt burdens would reduce the value of equity, but there is not a similar reduction for revenue weighting.
Take Away: Take note of the inherent biases when comparing similar products with different weighting methodologies.
15. RAFI Weighting Is Based On Four Factors
One of the more popular alternatives to market cap weighting developed in recent years is a technique from Research Affiliates that involves determining possibly a better indication of firm size. Rather than determining the allocation to a stock based on its price, RAFI weighting involves four factors: book value, revenue, cash flow, and dividends. There are a number of ETFs linked to RAFI indexes, including several from PowerShares. Some of these ETFs have delivered very impressive returns in recent years, thanks in large part to this unique weighting methodology.
Investors should note that there are some potential biases in RAFI weighting; the focus on dividends as one of the key metrics can result in a value tilt, while the focus on revenue can skew portfolios towards low margin or high debt companies.
|Small/Mid Cap U.S. Stocks||PRFZ|
|Large Cap U.S. Stocks||PRF|
|Asia Pacific Ex-Japan Stocks||PAF|
|Ex-U.S. Large Cap Stocks||PXF|
|Emerging Market Stocks||PXH|
|U.S. Corporate Bonds||PHB|
|U.S. Junk Bonds||PFIG|
Take Away: RAFI funds focus on book value, revenue, cash flow, and dividends when choosing their holdings.
16. International ETFs Have Sector Bias
ETFs are a handy tool for tapping into international equity markets; there are now “pure play” ETFs for just about every major global economy. When using these funds, it’s helpful to understand the limitations and biases. One of the common tilts in international equity ETFs relates to the sector breakdown; it’s fairly common for energy and financial companies to account for a big allocation of holdings, with sectors such as consumers, utilities and health care receiving very small weightings (in many cases, weights of 0%). This feature simply reflects the nature of the underlying economies, where banks and oil firms dominate and health care and utilities are quite small. But as these sectors grow, these biases could create a drag on returns.
For some larger international markets, sector-specific ETFs now exist for balancing out the sector breakdown. ECON (emerging markets) and CHIQ (China) are just two examples of consumer-centric ETFs that can be used to offset the tilt towards energy and banks in popular ETFs.
Take Away: Many of the foreign equity ETFs have a bias towards the energy and financials sector, which can have an unfavorable impact on overall returns.
17. Beware Target Retirement Date ETFs
Some ETFs offer an entire, diversified portfolio in a single ticker symbol. Some even adjust asset allocations as investors age, reducing risk exposures as a desired retirement date approaches. While there are some potential uses for target retirement date ETFs, there are a number of pitfalls in these products as well.
For starters, an additional layer of fees in these ETFs eats into returns over the long run. Besides, making asset allocation decisions based solely on a desired retirement date is potentially irresponsible. Factors such as income, spending habits, and risk tolerance should also be considered. Finally, many of these products appear to be dreadfully underweight in emerging markets, overlooking a potentially significant source of long-term capital appreciation.
S&P Target Date 2050 Index Fund (TZY) Breakdown
|Developed Markets Stock||87%|
|Emerging Markets Stock||4.2%|
|U.S. Fixed Income||7.3%|
|Non-U.S. Fixed Income||0%|
|U.S. Real Estate||1.5%|
Take Away: Target retirement date products have several significant drawbacks.
18. Value/Growth ETFs Often Overlap In Holdings
Many ETFs break down the universe of stocks into two pools: value and growth. Investment strategies that focus on a specific type of security have been around for decades, and many investors have embraced ETFs as an efficient tool for separating certain asset classes. A deeper look at these value and growth ETFs reveals considerable overlap between these products. Consider the iShares S&P 500 Growth Index Fund (IVW) and S&P 500 Value Index Fund (IVE); the former has about 280 holdings while the latter has about 370. Simple math tells us that many of the S&P 500 components are included in both ETFs–meaning they’re classified as both value and growth stocks.
Rydex offers a suite of style ETFs that take the business of separating value and growth stocks a bit more seriously; RPV and RPG hold only the S&P 500 components that exhibit the strongest value and growth characteristics, respectively.
Take Away: There is a considerable overlap between what many indexes consider to be value and growth stocks.
19. Ex-Sector ETFs Avoid Troubled Sectors
Most investors looking to generate non-market dependent returns spend most of their time identifying asset classes that are positioned to outperform. But in many cases, this can just as easily be derived by what your portfolio excludes. Staying out of troubled asset classes can be an efficient way to beat the markets. This is especially true from a sector perspective, as there are often significant gaps between the various segments of the global economy.
For investors looking to avoid the financial sector, WisdomTree offers a couple of potentially interesting products. DTN and DOO offer broad exposure to U.S. and international markets, but avoid banks and other financial institutions. In 2011, these ETFs crushed comparable products that include financials, demonstrating the power of ‘ex-sector ETFs’.
DTN vs. SPY
Take Away: Ex-sector funds can help you avoid sluggish segments of the economy.
20. Ex-Japan ETFs: Powerful Tools
Since the late 1980s, the once almighty Japanese economy has lost its impervious growth status and fall into the doldrums; the benchmark Nikkei index is about 75% below its all time high set in the early 1990s, as the country has failed to generate meaningful GDP growth and maintain a meaningful export market. More recently, natural disasters and the yen’s safe haven status have maintained pressure on the economy.
Many ETFs offer exposure to Asia, but the vast majority of them allocate heavily to Japan. The need to avoid Japan has led to a number viable alternatives that eliminate Japanese exposure altogether. Investors looking to maintain Asian exposure without the stagnant Japanese economy will find ETFs like AAXJ, AXJS, PAF, and EPP helpful.
Take Away: Ex-Japan ETFs can help you avoid a sluggish corner of an otherwise booming Asian economic region.
21. Country-Specific ETFs Are Impacted Beyond Their Borders
In an increasingly interconnected global economy, isolating exposure to a desired region can be a tricky task. The Spain ETF (EWP) serves as an interesting example of some of the potential complications. The two largest holdings of that fund are telecom giant Telefonica and banking firm Banco Santander (the two stocks make up about 40% of the portfolio). While headquartered and listed primarily in Spain, both of those companies have significant operations in South America–specifically in Brazil. While Spain accounts for a big chunk of revenue as well, almost all of the growth comes from Brazil and neighboring economies. In other words, the Spain ETF can be impacted more significantly by development across the Atlantic than in changes in Spain’s local economy.
There are a number of other examples of a similar phenomenon among international equity ETFs; in many cases, a substantial portion of holdings will derive revenues and growth from some place other than their home country.
Take Away: Globalisation leads to skewed allocations in country ETFs.
22. Factor ETFs Target Specific Characteristics
Though the most popular equity ETFs out there are generally of the “plain vanilla” variety, interest in more targeted and precise products has been steadily increasing. One area of particular interest is “factor ETFs,” products that offer targeted exposure to stocks exhibiting characteristics such as high volatility, low beta, or high momentum.
For the most part, the strategies underlying these factor ETFs are nothing new; investors have been implementing these techniques on their own for decades. But the combination with the ETF wrapper gives investors a way to achieve low cost, low maintenance access to a technique that could otherwise be time consuming and expensive. Think of factor ETFs as a fund manager in a box–except with a much, much lower price tag.
Take Away: Factor ETFs provide unique exposure at a low cost.
23. Infrastructure ETFs: Playing An Inevitable Trend
Emerging market investing has become a staple for any long-term portfolio, as the growth that these economies can potentially offer has been far too enticing for most investors to pass up. As these respective nations begin to develop and expand, there is one inevitable trend that will emerge: infrastructure. With soaring populations, increased urbanization, and rapidly developing economies, a solid infrastructure is a must.
There are now a number of ETFs to play the developing infrastructure of several emerging markets, and it seems likely that this number will only grow in coming years. For the time being, investors can make a play on this important sector for India with INXX, Brazil with BRXX, and China with CHXX, as well as a more general emerging market base with EMIF.
|IGF||S&P Global Infrastructure|
|PXR||Global Emerging Markets Infrastructure|
|EMIF||S&P Emerging Markets Infrastructure Index Fund|
|BRXX||Brazil Infrastructure Index Fund|
|INXX||India Infrastructure ETF|
|CHXX||INDXX China Infrastructure Index Fund|
|GII||SPDR FTSE/Macquarie GI 100 ETF|
Take Away: Infrastructure ETFs can be a useful tool for tapping into the trend of increasing urbanization across the globe.
24. Targeted ETFs Are Not Always Pure Plays
Many of the most recent additions to the ETF lineup have been extremely targeted products that focus on very specific corners of the global stock market; examples include funds targeting smartphones, cloud computing stocks, and social networking companies. These ETFs can have the potential to be powerful tools for isolating investments. But they can also be less effective at delivering the exposure desired than one might imagine.
In many cases, the universe of publicly-traded companies engaged in such a narrow range of operations is limited; for example, there are few stocks whose operations are focused exclusively on cloud computing. In these instances, creating an ETF involves expanding the definition quite a bit. That is why the Cloud Computing ETF (SKYY) holds stocks such as Netflix and the Social Media ETF (SOCL) has a position in Google. These features do not make such ETFs less undesirable, but the correlation between the name of the fund and the nature of the holdings can sometimes be less than perfect.
Hyper-Targeted Sector ETFs
|Solid State Drives||SSDD|
Take Away: Targeted ETFs do not always offer a ‘pure play’ on the given market segment they intend to track.
25. Targeted Mining ETFs Are Not Always Pure Plays
There are a number of ETFs out there that offer exposure to mining stocks, which have become a popular way to establish a position in companies engaged in natural resource production. In addition to some broad-based funds, there are a number of mining ETFs that target specific types of raw materials, including gold, silver, and even platinum and copper.
When considering these products, be sure to review the underlying index methodology. A pair of copper ETFs highlights the issue that can potentially arise. COPX focuses on mining stocks that are engaged primarily in copper mining. CU, on the other hand, casts a much wider net that includes diversified mining companies (with an adjustment to weighting based on the percentage of operations focused on copper). The former therefore has a copper-focused portfolio, while the latter includes a number of stocks with operations focusing on other metals.
Take Away: Mining ETFs do not always offer a ‘pure play’ on the given metal, so be sure to look at the holdings before buying into a position.
26. Business Development Company ETPs: Access To The Next Big IPO?
Most investors generally divide investments into three buckets: large, medium, and small. There are now exchange-traded products that allow exposure to companies that are generally too small to be publicly traded, opening up a new asset class that has potential to deliver impressive long-term returns.
There are a couple ETFs out there that invest in stocks of publicly-traded private equity firms and business development companies, which in turn generally hold portfolios full of privately held entities. These investments can take various forms, including traditional equity, preferred stock, or various types of debt. The PowerShares Private Equity Portfolio (PSP) and Business Development Company ETN (BDCS) are two such products that might be worth a closer look by many investors.
Take Away: There are a number of ETFs which offer exposure to private equity investments; an asset class that has been historically out of reach for mainstream investors.
27. Money Market ETFs: Safe Havens In Market Storms
There are now ETFs for just about every objective–including products that can act as a substitute for a lock-box under your mattress. Not every ETF is designed to deliver impressive long-term returns; some focus exclusively on preservation of capital. For investors looking for a safe place to ride out a storm in equity markets, a handful of ETFs that effectively act as money market products might be worth a look.
The actively managed MINT is one interesting option; the ETF seeks results that exceed returns on money market funds. Other possibilities include Guggenheim’s actively-managed GSY and State Street’s BIL; both of those ETF maintain lower interest rate risk than MINT.
Take Away: Money market ETFs offer a way to safely put your cash to work during times of uncertainty on Wall Street.
28. ETNs Have Credit Risk
One increasingly common variation on the ETF is the exchange-traded note (ETN), a debt instrument whose returns are linked to the performance of a specified benchmark. There are some advantages to ETNs; they don’t encounter tracking errors, and can represent an opportunity to enhance tax efficiency in certain asset classes. But there are some potential drawbacks as well. Specifically, ETNs are debt securities, and as such they expose investors to the credit risk of the issuing institution. That means that if the bank behind the note heads into bankruptcy, they may default on their obligations to investors. Admittedly, the likelihood of a bankruptcy filing from an ETN issuer is incredibly remote, but if the recent financial crisis taught us anything it’s to never say never.
Unfortunately, these warnings are more than just hypothetical. Lehman Brothers, the now-defunct Wall Street giant that went belly up during the financial crisis, was once an issuer of exchange-traded notes.
Take Away: ETNs carry the potential to fold due to a problem with the underlying issuer.
29. ETNs Mature
ETNs have various distinctions that make them unique exchange-traded tools. They exhibit credit risk from their underlying issuer and mature. Sometimes the maturity date is in the name of the actual ETN, but often investors are left unaware that they are investing in a temporary instrument. Before buying into an ETN, you should always check the fact sheet as it will date of maturity.
The process of an ETN reaching its end is less scary than it sounds. It is similar to an ETF closing, but without all of the panic and desperation. Upon maturity, the ETN will simply return the cash back to investors, assuming that the issuer is still solvent enough to pay out. Note that traders and investors alike still tend to exist trades prior to maturity date so it is always a good idea to closely monitor your holdings as their investment life comes to an end.
Take Away: ETNs will eventually mature and are traded accordingly.
30. ETNs Are Not Evil
Exchange-traded notes are viewed with skepticism by a number of investors, primarily because of the credit risk associated with these debt instruments. While that risk cannot be overlooked, it can also be a mistake to avoid ETNs altogether. As highlighted above there are some instances where ETNs offer substantial advantages over ETFs, including as tools for accessing commodities or implementing trend-following strategies.
Those aren’t the only instances of an ETN having significant appeal as a superior investment vehicle. This structure also might make sense for those considering a merger arbitrage strategy, where high portfolio turnover is common. ETFs can have a tendency to incur short-term capital gains on positions held for less than a year, while ETNs can provide a loophole to avoid this potentially unfavorable tax treatment since there are no underlying holdings.
Take Away: ETNs feature unique nuances and risks, although this product structure does offer noteworthy advantages over ETFs when accessing certain asset classes, including commodities and MLPs.
31. Your ETF May Be State-Owned
There are some other interesting biases that often pop up in international equity ETFs, including a tendency of these products to maintain significant weights towards companies in which the local government holds a significant stake. In both developed and emerging markets ETFs (including those focused on U.S. stocks), it is not uncommon to see significant allocations to companies that are controlled by the state.
The presence of state-owned companies isn’t necessarily a bad thing, but it can be cause for concern. When the government is calling the shots, there is a significantly higher likelihood of taking actions that are not in the best interest of shareholders (e.g., selling off oil reserves, capping prices, etc.). Unfortunately, there’s no easy way to identify these securities or the allocation that various ETFs effectively make to state-owned ETFs; as a rule of thumb, weightings tend to be higher in ETFs that focus on large cap and mega cap stocks. Unfortunately, it requires a bit of old-fashioned research if you’re interested in seeing the allocation in an ETF you hold.
Take Away: A number of developed and emerging markets ETFs have major allocations to companies that are controlled by the government.
32. Preferred Stock ETFs
Most investors have little or nothing in the way of an allocation to preferred stock in their portfolios. For those looking to enhance the current returns derived without taking on a significant amount of risk, this hybrid asset class might be worth a look. Preferred stock functions more like traditional debt in the sense that it delivers a steady distribution to shareholders that is superior to common dividends. Distribution yields in excess of 5% exist from preferred stocks, which places these securities somewhere between high quality corporate bonds and junk bonds on the risk spectrum.
Most preferred stock ETFs focus on the U.S. market but others exist; CNPF focuses on Canadian securities, while IPFF casts a slightly wider net.
Preferred Stock ETFs
|Ticker||ETF||30 Day Yield|
|PFF||iShares S&P U.S. Preferred Stock Index Fund||6.45%|
|PGF||Financial Preferred Portfolio||6.74%|
|PSK||SPDR Wells Fargo Preferred Stock ETF||6.17%|
|IPFF||S&P International Preferred Stock Index Fund||2.93%|
|CNPF||Canada Preferred ETF||3.46%|
Take Away: Preferred stock ETFs can offer an attractive risk/return profile along with a current income similar to a bond.
33. AlphaDEX ETFs: Interesting Methodology, Compelling Results
Many investors bifurcate the ETF universe between active and index-based products. In reality, however, there is a significant amount of gray area in between. One example of products that blur the line between active and passive management are the AlphaDEX ETFs offered by First Trust. Although technically passive in nature as they seek to replicate specified indexes, these products certainly have an element of active management as well.
The underlying indexes utilize a quantitative focused methodology in an effort to identify component stocks that have the greatest potential for capital appreciation, i.e. an automated process of stock-picking! The results have been generally impressive over the last few years; many AlphaDEX ETFs have outperformed their cap-weighted peers by a wide margin.
Take Away: AlphaDEX ETFs offer a compelling methodology that has a proven track record of outperforming its peers in the past.
34. Take A Look At ‘Contango ETNs’
When attempting to access asset classes such as commodities or volatility through futures-based strategies, investors often become frustrated with the headwinds presented by contango. There’s no easy solution to this problem, but there are a number of creative products that seek to exploit some inefficiencies in various futures markets. Specifically, UBS maintains a suite of ETNs that combine long exposure in mid-term futures with short exposure in short-term futures with the goal of creating a portfolio that offers access to the underlying asset while also mitigating the adverse impact of contango.
These are somewhat complex, but potentially very useful products:
- Long Short S&P 500 VIX Futures ETN (XVIX)
- Natural Gas Futures Contango ETN (GASZ)
- Oil Futures Contango ETN (OILZ)
Take Away: Some ETNs actually strive to take advantage of contango in futures markets.
35. TrendPilot ETNs: A Trend Following Strategy
One of the noteworthy innovations to arise over the last several years involves the combination of exchange-traded products and trend-following strategies. These techniques have been popular for decades: investors move in and out of positions depending on recent momentum and value relative to certain historical moving averages. RBS offers a suite of Trendpilot ETNs that deliver low maintenance to such strategies, shifting exposure between cash and asset classes such as gold, stocks, and oil depending on recent momentum.
Some have complained that these ETNs are too pricey, charging between 50 and 100 basis points. But there are some unique advantages to these products as well. Specifically, the ETN structure allows investors to avoid paying commissions when moving between cash and other allocations, and allows investors to avoid any taxes when doing so. For many investors those advantages will be more than enough to offset the somewhat pricey management fees.
|Large Cap Stocks||TRND|
|Mid Cap Stocks||TRNM|
Take Away: TrendPilot ETNs offer access to a ‘hands-off’ investment strategy along with favorable tax treatment.
36. Invest In Southeast Asia
Southeast Asia holds the world’s most dynamic economies and fastest-growing markets, which have been thriving for the last several years thanks to favorable demographic trends, strong trade relationships with China and India, and progressive policies that have opened doors to foreign investments. Yet many portfolios have relatively small allocations to the emerging economies of Southeast Asia as the result of the methodologies behind popular emerging markets indexes.
The MSCI Emerging Markets Index, which serves as the basis for EEM and VWO, allocates less than 4% of its portfolio to Malaysia, just 3% to Indonesia (the world’s fourth most-populous country), 2% to Thailand, and less than 1% to the Philippines. For investors who use EEM or VWO to access emerging markets, these rapidly expanding economies generally represent less than 5% of total equity exposure. Given the tremendous potential for growth in coming decades, that strategy might be less than optimal.
A few country-specific ETFs can be useful for bulking up exposure to Indonesia, Malaysia, the Philippines, and Thailand. Another potentially useful tool for bulking up exposure to this region is the Global X FTSE ASEAN 40 ETF (ASEA), which includes these four markets as well as developed Singapore.
Southeast Asia ETFs
|Country / Region||ETF|
Take Away: Increasing your exposure to the emerging markets of Southeast Asia can offer lucrative growth potential over the coming years.
37. Real Estate ETFs: Not Residential!
There are a number of ETFs out there that offer exposure to real estate, and some investors are under the impression that these vehicles might be useful tools for betting on rising home prices in the United States. But that’s really not the case at all; most real estate ETFs hold real estate investment trusts (REITs) that in turn invest primarily in commercial and industrial real estate. So instead of single family homes and McMansions, real estate ETFs hold office buildings and storage facilities. If you are looking to bet on rising home prices, you’re going to have to look beyond the ETF universe.
Take Away: Real estate ETFs do not allocate to residential housing markets. Instead these products invest in commercial and industrial properties.
38. Socially Responsible ETFs Offer Good Values
The ETF lineup consists of products that slice and dice domestic and international stock markets in just about every way imaginable. That includes funds that are designed to target stocks of “socially responsible” companies that maintain positive environmental, social, and governmental factors–basically, the companies that do things the right way. These ETFs can appeal to investors who have a problem investing in companies deemed to be immoral or unethical; they can be a way to focus on high quality companies without sinking in too much time and research.
Moreover, there is an interesting (and potentially compelling) investment thesis behind socially responsible ETFs. Companies that are model corporate citizens and strive to stay on the right side of the law are likely to avoid costly lawsuits and negative publicity while building loyal customer bases. Those can be key ingredients to a long-term business strategy, and can position these companies to experience long periods of sustained growth in profitability.
Some of the socially responsible ETFs include:
- MSCI USA ESG Select Social Index Fund (KLD)
- KLD 400 Social Index Fund (DSI)
- ESG Shares North America Sustainability Index ETF (NASI)
- Europe MSCI EAFE ESG Index ETF (EAPS)
Take Away: For some investors, socially responsible ETFs may offer a compelling investment thesis.
39. Understanding ETFs of ETFs
Most ETFs out there hold portfolios that consist of individual stocks or bonds. There are also a number of ETFs whose holdings are other ETFs, including many target retirement date funds and some of the hedge fund replication products. This is often the case when a product is designed to cover multiple asset classes or a huge number of individual securities; using ETFs to accomplish this can be more efficient that gathering each security individually.
There are a couple items to consider when evaluating these products. First, a quick look at the holdings may portray these funds as excessively concentrated. For example, EQL has just nine individual holdings–the sector SPDRs. But each of those has dozens of individual stocks, and EQL effectively offers exposure to 500 different securities.
Investors should also note the impact on fees; ETFs of ETFs effectively include two layers of management fees in the form of the explicit rate on the ETF and the rate charged by each component ETF (in some cases, the management fee will be waived). Phrases such as ‘Acquired Fund Fees’ generally refer to the expenses charged by the component ETFs.
Take Away: ETFs of ETFs are a unique breed of products; make sure to carefully examine expenses and holdings when evaluating these products.
40. Watch For New ETPs
Investors are, without a doubt, creatures of habit. So it should be no surprise that there is a tendency to gain familiarity with an exchange-traded product or family of products and repeatedly use those funds in managing their portfolios. Limiting your choices, however, could be a mistake considering the pace of expansion an innovation in the ETF industry. Hundreds of new exchange-traded products are debuting every year, with many of them representing meaningful improvements or enhancements to the existing crop of ETPs.
It makes sense to stay up to date on the latest additions to the ETF lineup, as there is a decent chance that some of the newcomers include funds that can accomplish your objectives with even greater efficiency than those that have been around for years and have accumulated massive Assets Under Management and Average Daily Volume figures.