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The Individual Investor’s Guide to Exchange-Traded Funds 2012

The Individual Investor’s Guide To Exchange Traded Funds 2012 Splash image

The exchange-traded fund (ETF) industry continues to expand, though the rate of growth has slowed. Net assets controlled by ETFs totaled a record $1.163 trillion as of June 30, 2012. Though a large number, it represents just a 7.8% increase from 12 months prior.

As you can see in Table 1, the percentage increase was the smallest since the 12-month period ended June 30, 2009. In terms of absolute dollar growth, the industry experienced the second-smallest mid-year 12-month increase since June 30, 2005.

 

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Impacts on Growth

Does this mean the industry is becoming mature? We think it is too early to tell. Volatile market conditions have impacted growth and certainly have played a role in keeping some investors skittish about allocating more money to equity investments. This sentiment would have limited growth in total assets. Fund families are continuing to introduce new exchange-traded products, a sign of continued growth. New to this year’s guide are more than 240 funds that were started after July 1, 2011. (Most of these new funds can be found in the online version of the guide, at AAII.com, as they were too small for inclusion in the print version.)

We also looked at the 25 largest exchange-traded funds to see if there was any consolidation at the top, which would be a sign of a maturing industry. The two largest funds, SPDR S&P 500 (SPY) and SPDR Gold Shares (GLD), did get larger with total assets increasing by 12.6% and 12.4%, respectively. Below those two, the data gets more mixed. Vanguard MSCI Emerging Markets ETF (VWO) grew by just 3.0%. iShares MSCI EAFE Index (EFA) and iShares MSCI Emerging Markets Index (EEM) saw their total assets decrease by 13.4% and 12.0% respectively. Some large funds did grow significantly, including iShares iBoxx $ Investment Grade Corporate Bond (LQD) and Vanguard Total Bond Market ETF (BND). The ninth and 11th largest funds saw their assets increase 64.7% and 69.8% over the past 12 months, respectively.

The differing rates of growth reflect the attitudes of investors. The Investment Company Institute reported a 40% year-over-year increase in bond ETF assets as of the end May 2012. In contrast, domestic equity ETFs saw their assets rise by just 2.4% over the same period. We saw similar trends when we looked at the 25 largest ETFs; three bond funds led the group in net asset growth: iShares iBoxx $ High Yield Corporate Bond (HYG), Vanguard Total Bond Market ETF and iShares iBoxx $ Investment Grade Corporate Bond.xls

Actively Managed ETFs

Speaking of bond funds, PIMCO made a splash in the ETF industry by launching the PIMCO Total Return ETF (BOND). This is an exchange-traded version of its popular, actively managed mutual fund, PIMCO Total Return (PTTDX). The ETF has already attracted $1.72 billion in assets since its inception on February 29, 2012. To put this number in perspective, the average ETF in the intermediate-term general bond category has $2.06 billion in assets. In other words, the PIMCO Total Return ETF has attracted a significant amount of money in a short period of time. Nonetheless, its mutual fund counterpart still dwarfs it in size, controlling $263 billion in assets.

Though the launch of PIMCO Total Return ETF was a big success, to date, investors have largely ignored actively managed ETFs. Only two other actively managed ETFs have attracted more than $1 billion in assets: PIMCO Enhanced Short Maturity Strategy (MINT) and WisdomTree Emerging Markets Local Debt (ELD). Four out of five actively managed ETFs have less than $100 million in assets.

Over time, we think this will change. Mutual fund companies that are currently staying out of the ETF market will likely move to protect their market share. The timing of when remains uncertain, given the regulatory and logistical hurdles that need to be worked through. We think growth in actively managed ETFs will primarily occur in the fixed-income space, particularly since bond benchmarks are more difficult to follow. This makes active strategies more popular in the fixed-income market.

In the ETF table, actively managed ETFs are those that are not designated as either an index fund (I) or an enhanced index fund (E) in the columns to the left of the fund name. You will notice that most ETFs in the list are designated as index funds. We use the same designation for index funds in this guide as we do in our annual Guide to the Top Mutual Funds to make comparisons easier.

A New Performance Statistic

In this year’s guide, you will find a new performance statistic: 12-month market return. This total return number is calculated by examining the change in a fund’s share price along with the reinvestment of all distributions for the 12-month period ended June 30, 2012. All other return statistics calculate the change in a fund’s net asset value (NAV). This is why you will now see return data listed as either NAV or market return.

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Net asset value calculates the change in value for a fund’s assets. It is the figure used to determine the price of mutual funds. We use it for exchange-traded funds to give you an accurate tally of how the fund itself has performed. ETFs and exchange-traded notes (ETNs) will commonly trade very close to their NAVs, with minimal variations.

Some ETFs and ETNs will trade at discounts or premiums to their NAVs. Buying a fund for a premium means you are paying more than a dollar for a dollar’s worth of assets, a behavior that immediately hurts your portfolio’s return. This is why it is important that you compare the ETF’s or ETN’s share price to its NAV right before you purchase the fund. If the fund or the note is priced at a premium, you may want to wait for the price to move in line with the NAV. ETF sponsors will list the NAV on their websites.

To help you assess whether an ETF or ETN has traded at a discount or a premium valuation, we are now showing 12-month total return performance on both an NAV and a market price basis. If there is a significant variance between the two numbers, the fund or note has traded at a price different than its NAV. For example, iShares Silver Trust (SLV) saw its NAV fall by 23.1% over the past 12 months, while its market price fell 21.2%—two percentage points less. This implies that investors were willing to pay a premium for the fund. Astute investors were also able to pick up the fund at a discount if they monitored the fund closely. In June 2012 alone, SLV shares traded both at a 4.4% premium (June 5, 2012) and a 3.4% discount (June 21, 2012). There have been more egregious occurrences involving other funds, which is why it is very important to check the NAV before making an investment decision. (Obviously, if you are seller, a premium valuation is a good thing.)

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‘Table 1. Size of ETF Universe’

A Warning About ETNs

FINRA issued an investor alert about exchange-traded notes (ETNs) in early July. The regulator is concerned that investors do not understand how ETNs work or the risks they pose.

ETNs are debt securities. They are designed to exist for only a limited period of time (typically 10 to 30 years), at which point they will pay investors a return based on the performance of an index or other benchmark. Some ETNs can be called prior to maturity or may be subject to an “accelerated maturity.” Because ETNs are debt instruments, investors incur credit risk—the risk that the issuer will not make good on their debt obligations. ETNs do not buy and hold assets.

In contrast, ETFs are designed to last into perpetuity. (They can, however, be closed at their provider’s discretion.) ETFs buy and hold physical assets, and their performance is based on their actual holdings, not the return of a benchmark or an index.

ETNs can provide access to certain benchmarks, but care needs to be used when investing in them. As is the case with any investment, make sure you fully understand the characteristics and risks before buying ETNs. In the next two sections, we will use the abbreviation ETF to refer to both exchange-traded funds and exchange-traded notes covered in this guide.

How to Use This Guide

Exchange-traded funds have lowered the cost and increased the accessibility of investing in a wide variety of securities, including large-cap stocks, emerging market debt, precious metals, currencies and even agricultural commodities. However, more choice does not necessarily equate to higher returns. Therefore, investors should tread carefully.

Financial goals, diversification needs and risk tolerances should be the primary determinants when selecting an exchange-traded fund. Specifically, ask what asset classes and categories need to be included in your portfolio and then look for ETFs that match those requirements. Asset allocation ideas can be found in the Financial Planning section of AAII.com. Our Model Fund Portfolio provides an idea of how to build and manage a diversified portfolio using a mix of mutual funds and exchange-traded funds. (We believe investors should compare both types of funds and use the one that provides the best exposure to a specific asset class or investment strategy.) The Model Fund Portfolio is reviewed in the March, May, August and November AAII Journal issues; the latest commentary starts here in this issue. Monthly updates are available at AAII.com.

Once asset class and category are determined, use this guide to find an appropriate exchange-traded fund. Most funds are named based on their underlying index (e.g., SPDR S&P 500 tracks the performance of the S&P 500 index). Understand that the construction of the underlying index will have a significant impact on the fund’s performance. For example, Exxon Mobil Corp. (XOM) has a far larger weighting in iShares S&P 500 Index (IVV) than it does in Guggenheim S&P Equal Weight (RSP). The bigger the weighting, the greater the influence on an ETF’s performance. The column labeled “percent of portfolio in top 10 holdings” shows how much weight is allotted to a fund’s largest positions.

All ETF sponsors list current holdings and the weighting of those holdings on their websites. This information not only provides additional insight into how dependent a fund is on its top two or three holdings, but it can also help improve an investor’s portfolio diversification. Specifically, pay attention to whether a company accounts for a large position in two or more funds you are interested in.

Expenses matter, and lower expenses are preferable. Expenses are influenced by the underlying securities; funds that use foreign securities, invest in commodities, or use aggressive long or short strategies carry higher expenses. Some brokers waive commissions on select ETFs, but the savings on the commissions need to be weighed against the annual expense ratio and the suitability of the ETF. An increase of 20 basis points (0.2%) in annual expenses equates to $20 more in costs on a $10,000 investment. In other words, selecting an exchange-traded fund solely because commissions are waived may actually turn out to be a more expensive decision.

Again, be sure to look at a list of the fund’s current holdings and read through the prospectus before buying any exchange-traded fund. A listing of ETF sponsor websites is presented here.

Which Funds Were Included

The funds listed in the print version have at least $200 million in total assets. This is the same minimum requirement used in last year’s guide. The rule was relaxed for funds held within the Model Fund Portfolio, which is why you will see Guggenheim S&P MidCap 400 Pure Value (RFV) and Guggenheim S&P SmallCap 600 Pure Value (RZV). The rule was also relaxed for CurrencyShares Japanese Yen Trust (FXY) for the second consecutive year because it remains the largest long ETF providing direct exposure to the yen.

In previous years, funds in existence for less than 12 months were excluded. This rule was not applied this year, as it would have had only a minimal impact on funds included in the 2012 guide. A comprehensive listing of ETFs and ETNs with performance data and additional information is available on AAII.com. This expanded spreadsheet includes funds of all sizes and covers nearly 1,500 funds.

Ultra and Contra ETFs

Several members have expressed interest in ETFs that move inversely to stock market indexes. In response, ultra market (long) and contra stock market are two of the categories included in this guide. The ultra category includes funds that are designed to move in the same direction as their underlying index, but to experience two to three times the price movement. The contra categories (stock and bond) contain funds that are designed to move in the opposite direction as the underlying index. Some of these funds may experience inverse price movements that are two to three times greater than those of the underlying index.

Funds that move with a greater magnitude than the index they track use leverage. For every dollar invested, an investor has the potential to earn double or triple the return he would otherwise earn. At the same time, the magnitude of potential losses is two to three times greater. In other words, these are very risky investments.

In addition to the considerably higher level of volatility, these funds have a much greater potential for tracking error. Tracking error is the extent to which a fund’s actual return differs from the index’s return. It can result in actual returns being significantly different from what an investor anticipated based on the performance of an index. ProShares, one of the providers of ultra and contra funds, clearly warns investors not to hold such funds for longer than one day. Specifically, ProShares states, “Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period.” This warning applies to both ultra and contra funds. These ETFs are suitable only for speculative trading for the time period listed in the prospectus (typically a single day); they should not be used for a longer-term holding. Investors concerned about market risk will be better served by maintaining proper diversification across asset classes, staying focused on long-term financial goals, and conducting a thorough analysis of all investments.

A Key to Terms and Statistics

Most of the information shown in the listing is provided by Morningstar, Inc., or calculated from the data they provided. Any data source has the potential for error, however. Before investing in any exchange-traded fund or exchange-traded note, you should read the prospectus, annual report and quarterly reports.

When a dash appears in an ETF listing, it indicates that the number was not available or does not apply in that particular instance. For example, the three-year annual return figure would not be available for funds that have been operating for less than three years. We did not compile bull and bear ratings for ETFs not operating during the entire bull or bear market period.

Return numbers that are in the top 25% of all funds within the investment category are shown in boldface. When the risk is in the lowest 25% for the category, this number is also bolded.

Figures given for the category averages are calculated based on the entire universe of ETFs.

The following provides an explanation of the terms we use in the ETF listings. The explanations are listed in the order in which the data and information appear in the listing.

Index Fund: The letter “I” before a fund’s name indicates that the fund is designed to mimic the performance of an index, such as the S&P 500; the amounts invested in each security are proportional to its representation in the index that the fund tracks. (Some funds may hold fewer securities than the actual index if they believe the same return characteristics can still be achieved.) The online version of this guide reports on the indexes tracked by these funds. In some cases, an index has been specifically created for the fund and may have different return characteristics than other indexes with similar names.

Enhanced: The letter “E” before a name indicates that the fund is designed to outperform its underlying index by improved security selection or following a strategy that reduces comparative volatility.

Exchanged-Traded Note (ETN): The letter “N” before a fund’s name indicates that the investment is an exchange-traded note. As stated earlier, an ETN is a debt security designed to mimic the performance of an underlying index. The credit quality of the issuer needs to be considered when researching an ETN.

ETF Name: The exchange-traded funds are presented alphabetically by name within each category.

Ticker: The ticker symbol for each exchange-traded fund is given in parentheses for those investors who may want to access data online or through a touch-tone phone.

Total Return (%): Returns are based upon changes to a fund’s net asset value (NAV) or, where designated, share price (market return), assuming the reinvestment of all income and capital gains distributions (on the actual reinvestment date used by the fund) during the period. The return calculation is net of expenses. The year-to-date, 12-month, three-year and five-year returns are calculated through June 30, 2012. The three- and five-year returns are presented on an annualized basis. Returns that are in the top 25% of all ETFs within the investment category are shown in boldface.

Bull Market Return: Reflects the ETF’s net asset value performance in the most recent bull market, starting March 1, 2009, and continuing through March 31, 2012. Returns in the top 25% of all ETFs within the investment category are shown in boldface.

Bear Market Return: Reflects the ETF’s net asset value performance in the most recent bear market, from November 1, 2007, through February 28, 2009. Returns in the top 25% of all ETFs within the investment category are shown in boldface.

Yield (%): The total annual income distributed by the ETF divided by the period-ending net asset value. Calculated on a per share basis, this ratio is similar to a dividend yield and would be higher for income-oriented funds and lower for growth-oriented funds. The figure only reflects income; it is not a total return.

Tax-Cost Ratio (%): Measures how much an ETF’s annualized return is reduced by the taxes paid on distributions, assuming the maximum marginal tax rate. A tax-cost ratio of 0.0% indicates that the fund did not make any taxable distributions. If a fund had a 3.0% tax-cost ratio, it means that on average each year, investors lost 3.0% of their assets to taxes. The lower the ratio, the more tax-efficient the ETF. The ratio is calculated using the last three years of data.

Risk Index—Category and Total: The category risk index is the standard deviation of an ETF’s return divided by the standard deviation of return for the average ETF in the category. The total risk index is the standard deviation of an ETF’s return divided by the average standard deviation of return for all funds. Standard deviation is a measure of return volatility and is computed using monthly returns for the last three years. A risk index of 1.00 denotes average risk. Values above 1.00 indicate greater risk than average while values below 1.00 indicate less risk than average. Risk numbers that are in the lowest 25% of all funds within the investment category are shown in boldface.

Total Assets ($ Mil): Presented as millions of dollars, this is the amount of total assets an exchange-traded fund has under management. This is the total value of the fund’s portfolio. Size can be affected by the age of the fund, the index it follows and the number of competitive funds.

Average Daily Trading Volume (Thousands): Average daily volume of shares traded for the last three-month period through June 30, 2012.

Portfolio (%)—Stocks: The percentage of assets held in common stocks, both domestic and foreign. Bonds: The percentage of assets held in debt securities that are not convertible into common stock. Other securities: The percentage of assets held in futures, options, preferred stock, trusts or other alternative securities. Cash: The percentage of assets held in cash or cash equivalents.

Percent of Portfolio in Foreign Issues: The percentage of the ETF’s assets that are invested in foreign stocks and foreign bonds.

Portfolio Turnover Ratio (%): A measure of the trading activity of the ETF, which is computed by dividing the lesser of purchases or sales for the year by the monthly average value of the securities owned by the fund during the year. Securities with maturities of less than one year are excluded from the calculation. The result is expressed as a percentage, with 100% implying a complete turnover within one year.

Number of Holdings: The total number of individual securities held by the ETF. These can include stocks, bonds, currencies, futures contracts and option contracts. This figure is meant to be a measure of portfolio risk: The lower the number, the more concentrated the fund is in a few issues. Some ETFs may hold fewer shares than the index’s name would suggest if the ETF’s manager believes he can mimic the returns of the index without holding all of the securities that comprise it.

Percent of Portfolio in Top 10 Holdings: Investments, expressed as a percentage of the total portfolio assets, in the ETF’s top 10 portfolio holdings. The higher the percentage, the more concentrated the fund is in a few companies or issues, and the more the fund is susceptible to market fluctuations in those few holdings. Used in combination with the number of holdings, the percent of portfolio in the top 10 investments figure can indicate how concentrated an ETF is.

Expense Ratio (%): The sum of administrative fees and adviser management fees divided by the average net asset value of the ETF, stated as a percentage. Brokerage costs incurred by the fund are not included in the expense ratio.

Copyright 2012 American Association of Individual Investors and Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is nor guarantee of future results.

 

More on ETFs

Active Funds and Other Changes in the ETF Industry

Using ETFs in a Tough, Sideways-to-Bear Market

Building & Managing Your Portfolio

How to Safely Navigate Through Crowded ETF Waters

The EZ Approach to ETF Portfolio Building

Nine Timeless Rules for Investing in Mutual Funds (and ETFs)

Trolling for More Data

Websites for Exchange-Traded Funds

Exchange-Traded Fund Categories

Exchange-traded funds (ETFs) are growing in number and track a variety of indexes. Many ETFs, however, have shared investments that generally lead to other characteristics that are similar. These shared characteristics allow us to divide exchange-traded funds into categories; here we define the ETF categories used in AAII’s Guide to Exchange-Traded Funds. In the guide, the individual fund listings appear alphabetically within each category.

Stock ETFs

ETFs that invest in common stocks typically follow indexes based on market capitalization, country, style, sector, industry or a combination of these characteristics. The underlying index may either be well known, such as the S&P 500, or one that has been created for the fund to follow. Over the stock market cycles, large stocks behave differently from small stocks, domestic stocks do not move in unison with foreign or emerging market stocks, and stocks in different sectors or industries react differently to the same economic and business conditions.

For investors to make initial investment decisions on stock-based ETFs and to compare and evaluate the ongoing performance of investments in stock-based ETFs, grouping similar funds together into cohesive categories is a logical first step.

Large-Cap Stock: In funds categorized by stock size, the “cap” stands for capitalization (market share price times number of shares of common stock outstanding). Large-cap stocks are usually stocks of national or multinational firms with well-known products or services provided to consumers, other businesses or governments. Most of the stocks in the Dow Jones industrial average, the S&P 500 and the NASDAQ 100 are, for example, large-cap stocks. While some large-cap stocks are more volatile than others, a well-diversified ETF portfolio of large-cap stocks would perform similarly to most investors’ conception of the stock market. Large-cap stocks, as a category, also tend to pay the highest cash dividends, although many large-cap stocks pay no dividends. Large-cap stock funds, in summary, tend to have the lowest volatility and highest dividend yield in the domestic common stock group.

Mid-Cap Stock: Mid-cap stocks are, as their name implies, smaller than the largest domestic stocks. They are usually established firms in established industries with regional, national and sometimes international markets for their products and services. The S&P MidCap 400 index is the best-known benchmark for mid-cap stocks. These ETFs would tend to have lower dividend yields than large-cap funds and to have somewhat higher volatility.

Small-Cap Stock: Small-cap stocks are often emerging firms in sometimes emerging industries. But also, these small companies can be established firms with local, regional and sometimes even national and international markets. The most well-known benchmark for this group is the S&P SmallCap 600 index. These stocks must have liquid enough trading for ETFs to invest and, although small, are still listed on the New York Stock Exchange, the American Stock Exchange or NASDAQ. Small-cap ETFs tend to be more volatile than large-cap and mid-cap ETFs, have very low dividend yields, and often do not move in tandem with large-cap and mid-cap funds.

Micro-Cap Stock: Micro-cap stocks are also often emerging firms in sometimes emerging industries, but have comparatively lower market capitalizations (total shares outstanding times price). These stocks can be traded less frequently, though the ones selected for inclusion within an index must have enough volume for ETFs to invest in. These micro-cap funds tend to be more volatile than large-cap and mid-cap ETFs, have very low dividend yields, and often do not move in tandem with large-cap and mid-cap funds.

Preferred Stock: Preferred stocks are a hybrid security. Preferred shareholders receive quarterly dividends, but lack most of the voting rights that common stock shareholders have. Dividends on the preferred stock must be paid before dividends on common stock are. If a dividend payment on preferred stock is missed, the dividend payments accrue indefinitely until paid. In the event of bankruptcy, the interests of preferred stock shareholders come before common stock shareholders, but after the interests of bondholders. Prices of preferred shares are influenced both by interest rate fluctuations and the profitability of the issuer. Therefore, they do not necessarily move in tandem with either bonds or common stock.

Ultra Market (Long): Ultra market ETFs seek to produce a return that is two-to-three times higher than the underlying index for a specific day. For example, if the underlying index rises 1%, an ultra market ETF may rise 2%. These are very aggressive funds and are designed to be used for short periods of time. Holding such funds for longer periods can result in returns that may be worse than expected.

Long-Short: These ETFs follow one of two strategies. The first is to use both long and short exposures in an attempt to profit from the market’s volatility. The second is to use options, such as covered calls, to produce a stream of income that is not tied to the market’s fortunes.

Long-short funds hold sizable stakes in both long and short positions. Some funds are market-neutral, dividing their exposure equally between long and short positions in an attempt to earn a modest return that is not tied to the market’s fortunes. Others shift exposure to long and short positions depending upon their macro outlook or the opportunities they uncover through bottom-up research.

Contra Stock Market: Contra market ETFs seek to produce a return that is the inverse of how the underlying index performed for a given day. For example, if the underlying index falls 1%, a contra stock market ETF may rise 1%. A fund labeled “double,” “2x” or “3x” is intended to produce a return that is two-to-three times inverse of the underlying index. (If the index falls 1%, these ETFs may rise by 2% or 3%.) Contra stock market funds invest in short stock positions and derivatives. These are very aggressive funds and are designed to be used for short periods of time. Holding such funds for longer periods can result in returns that may be worse than expected.

Market Volatility: Market volatility ETFs have performance tied to the movement of a volatility index such as the VIX. The VIX (the Chicago Board Options Exchange Market Volatility Index) measures the implied volatility of S&P 500 index options. The VIX is a hypothetical measure of volatility based on metrics involving options trades and expectations of stock market volatility over the next 30-day period. The VIX tends to climb when anxiety over the short-term outlook for equity market increases and falls when stock market goes up. These are very aggressive funds and are designed to be used for short periods of time. Holding such funds for longer periods can result in returns that may be worse than expected.

Sector Stock: Sector ETFs concentrate their stock holdings in just one industry or a few related industries. They are diversified within the sector, but are not broadly diversified. They may invest in the U.S. or internationally. They are still influenced and react to industry/sector factors as well as general stock market factors. Sector funds have greater risk than diversified common stock funds. As is clear from this sector category list, some sectors are of greater risk than others—technology versus utilities, for example. By definition, a sector fund is a concentrated, not diversified, fund holding.

Commodities ETFs

Commodities ETFs and ETNs track the price movement of physical commodities, including metals, oil, natural gas, and grains. These funds may either invest in the physical commodity (typically via a trust that actually holds the commodity) or through the use of futures contracts. ETNs are debt securities and the credit rating of the issuing firm must be taken into consideration. Commodities move independently of stocks as their prices can be impacted by global politics, weather patterns and labor rest, as well as the state of the economy. Commodities can appreciate when inflation is strong and depreciate during deflationary periods. Commodity investments should account for no more than a small percentage of one’s portfolio. Contra Commodities Market ETFs seek to produce a return that is the inverse of how the underlying index performed for a given day. For example, if the underlying index falls 1%, a contra commodities market ETF may rise 1%.

Balanced ETFs

In general, the portfolios of balanced ETFs consist of investments in common stocks and significant investments in bonds and convertible securities. The range as a percentage of the total portfolio of stocks and bonds is usually stated in the investment objective, and the portfolio manager has the option of allocating the proportions within the range. Some asset allocation funds--funds that have a wide latitude of portfolio composition change--can also be found in the balanced category.

Many ETFs included in this category are target date funds. A target date fund differs from a pure balance fund in that its portfolio allocation adjusts as the target date draws near. Specifically, the target date fund’s portfolio reduces its risk (more of the portfolio is shifted out of stocks and into bonds) as the target date approaches.

Global balanced ETFs invest internationally.

A balanced ETF is generally less volatile than a stock ETF and provides a higher yield.

Global Stock and Foreign Stock ETFs

Global stock and foreign stock ETFs invest in the stocks of foreign firms. Some stock funds specialize in a single country, others in regions, such as the Pacific or Europe, and others invest in multiple foreign regions. In addition, some stock funds--usually termed “global funds”--invest in both foreign and U.S. securities. Contra Foreign Stock Market ETFs seek to produce a return that is the inverse of how the underlying index performed for a given day. For example, if the underlying index falls 1%, a contra foreign stock market ETF may rise 1%.

International funds provide investors with added diversification. The most important factor when diversifying a portfolio is selecting investments whose returns are not highly correlated. Within the U.S., investors can diversify by selecting securities of firms in different industries. In the international realm, investors take the diversification process one step further by holding securities of firms in different countries. The more independently these foreign markets move in relation to the U.S. stock market, the greater the diversification benefit will be, and the lower the risk of the total portfolio.

In addition, international ETFs overcome some of the difficulties investors face in making foreign investments directly. For instance, individuals must thoroughly understand the foreign brokerage process, be familiar with the various foreign marketplaces and their economies, be aware of currency fluctuation trends, and have access to reliable financial information in order to invest directly in foreign stocks. This can be a monumental task for the individual investor. There are some risks unique to investing internationally. In addition to the risk inherent in investing in any security, there is an additional exchange rate risk. The return to a U.S. investor from a foreign security depends on both the security’s return in its own currency and the rate at which that currency can be exchanged for U.S. dollars. Another uncertainty is political risk, which includes government restriction, taxation, or even total prohibition of the exchange of one currency into another. Of course, the more the exchange-traded fund is diversified among various countries, the less the risk involved.

Bond ETFs

Bond ETFs are attractive to investors because they provide diversification and liquidity, which is not as readily attainable in direct bond investments.

Bond funds have portfolios with a wide range of average maturities. Many funds use their names to characterize their maturity structure. Generally, short term means that the portfolio has a weighted average maturity of less than three years. Intermediate implies an average maturity of three to 10 years, and long term is over 10 years. The longer the maturity, the greater the change in fund value when interest rates change. Longer-term bond funds are riskier than shorter-term funds, and they usually offer higher yields.

Taxable Bond Funds: Bond ETFs are principally categorized by the types of bonds they hold.

  • Government bond funds invest in the bonds of the U.S. government and its agencies, while mortgage funds invest primarily in mortgage-backed bonds. General bond funds invest in a mix of government and agency bonds, corporate bonds (investment grade), and mortgage-backed bonds. Government and general bond funds are further categorized by maturity: short-term, intermediate-term and long-term.
  • A special category of inflation-protected bond ETFs hold Treasury inflation-protected securities (TIPS).
  • Corporate high-yield bond ETFs provide high income but invest generally in corporate bonds rated below investment grade, making them riskier.
  • Convertible bond ETFs invest primarily in preferred stocks and bonds that are convertible into common stocks. These securities exhibit characteristics of both stocks and bonds by offering yield and the possibility of capital appreciation.

Contra Bond: Contra bond ETFs seek to produce a return that is the inverse of how the underlying bond index performed for a given day. For example, if the underlying index falls 1%, a contra bond ETF may rise 1%. A fund labeled “ultrashort,” “2x” or “3x” is intended to produce a return that is 200% or 300% inverse of the underlying index. (If the index falls 1%, these ETFs may rise by 2% or 3%.) These are very aggressive funds and are designed to be used solely on a single day. Holding such funds for longer periods can result in returns that may be worse than expected.

Municipal and State-Specific Bond Funds: Tax-exempt municipal bond ETFs invest in bonds whose income is exempt from federal income tax. Some tax-exempt funds may invest in municipal bonds whose income is also exempt from the income tax of a specific state.

International Bond Funds: International bond ETFs allow investors to hold a diversified portfolio of foreign corporate and government bonds. These foreign bonds often offer higher yields, but carry additional risks beyond those of domestic bonds. As with foreign common stocks, currency risk can be as significant as the potential default of foreign government bonds--a particular risk with the debt of emerging countries. International bond funds are categorized as general or emerging.

Currency ETFs

Currency ETFs are designed to track changes in exchange rates between two or more currencies. Most currency funds seek a total return reflective of changes between the U.S. dollar and a foreign currency. Some currency ETFs, however track the changes in exchange rates among several currencies. Exchange rates move independently of stock prices, but can be volatile, are difficult to forecast and may not be suitable for all investors.

 

Choosing an ETF: Pointers to Keep in Mind

Tom Lydon of ETF Trends offers these tips for investors when investigating an ETF for purchase:

  • Understand what the underlying index represents: 99% of ETFs follow an index, and holdings and percentage of holdings are very transparent.
  • Understand the ETF’s structure: Some ETFs are securities-based where others—such as commodities and currencies—represent futures or physically backed holdings.
  • Know the costs: Some ETFs have expense ratios as low as eight basis points, others can be 90 or 100 basis points. With more creative ETFs coming to market, don’t assume all ETFs are cost effective.
  • Understand liquidity: ETFs trade like stocks and have bid/ask spreads. Tracking volume and the spread is easy but requires monitoring.

 

ETF & ETN Contact Information

Fund Family Name Web Address
AdvisorShares http://www.advisorshares.com
AlphaClone http://www.alphaclonefunds.com
ALPS http://www.alpsinc.com
BLDRs http://www.powershares.com/bldrs
Columbia http://www.columbiamanagementetf.com
CurrencyShares http://www.currencyshares.com
DBX http://www.dbxetf.com
Direxion Funds http://www.direxionshares.com
EGShares http://www.egshares.com
ELEMENTS http://www.elementsetn.com
ETFS http://www.etfsecurities.com
FactorShares http://www.factorshares.com
Fidelity Investments http://www.fidelity.com
First Trust http://www.ftportfolios.com
FlexShares http://www.flexshares.com
FocusShares http://www.focusshares.com
Global X Funds http://www.globalxfunds.com
GreenHaven http://www.greenhavenfunds.com
Guggenheim http://www.guggenheimfunds.com
IndexIQ http://www.indexiq.com
iPath http://www.ipathetn.com
iShares http://www.ishares.com
Market Vectors http://www.vaneck.com
Pax World http://www.paxworld.com
PIMCO http://www.pimcoetfs.com
PowerShares http://www.powershares.com
Precidian Funds http://www.precidian.com
ProShares http://www.proshares.com
QuantShares http://www.quant-shares.com
RevenueShares http://www.revenuesharesetfs.com
Russell http://www.russell.com
Schwab Funds http://www.schwab.com/schwabetfs
SPDRs (State Street Global Advisors) http://www.spdrs.com
Teucrium http://www.teucriumcornfund.com
UBS AG fundgate.ubs.com
United States Commodity Funds LLC http://www.unitedstatescommodityfunds.com
Vanguard http://www.vanguard.com
VelocityShares http://www.velocityshares.com
WisdomTree http://www.wisdomtree.com


Discussion

Robert Burtness from MN posted over 2 years ago:

My portfolio includes a grouping of etf's under the title ETF MARKET OPPORTUNITIES sym: ETFOX. I subscribe to Barron's Magazine and I cannot locate this etf anywhere in the magazine. Seems to be a strange hybrid. Are there other etf's like this? Morningstar shows it as a 5-STAR fund. However, contrary to other etf's it has a 2.06 expense ratio which is very high and the return is not particularly good for a large growth stock investment. May I have your thoughts please? Thank you. Robert Burtness at rburt6@charter.net. This article was very informative and I plan to print it out for further study.


Charles Rotblut from IL posted over 2 years ago:

Hi Robert,

ETFOX is not an exchange-traded fund. Rather, it is a mutual fund that invests in ETFs. You are paying a high expense ratio in the hopes that the mutual fund manager is able to correctly put together the correct mix of ETFs over the long-term.

Keep in mind that the fund has to beat its benchmark by 2% each year just to get you a return similar what you would be able to get by simply investing in a diversified ETF, such as the SPDR S&P 500 (SPY) or the Dow Jones U.S. Index (IYY).

-Charles


Charles Rotblut from IL posted over 2 years ago:

Hi Robert,

ETFOX is not an exchange-traded fund. Rather, it is a mutual fund that invests in ETFs. You are paying a high expense ratio in the hopes that the mutual fund manager is able to correctly put together the correct mix of ETFs over the long-term.

Keep in mind that the fund has to beat its benchmark by 2% each year just to get you a return similar what you would be able to get by simply investing in a diversified ETF, such as the SPDR S&P 500 (SPY) or the Dow Jones U.S. Index (IYY).

-Charles


Joe Petti from CT posted over 2 years ago:

Great Article!
Many of us are retired or close to it and it would be great if you can list those ETF's that provide Monthly Dividends.

I have found about 30 so far and appreciate the monthly checks from those I have purchased.

Also, How are the expenses for ETF's collected? I BUY and SELL at the BID & ASK as in purchasing equities. How do I end up paying the fee?


Anthony Howd from NH posted over 2 years ago:

The ETF data base is AWESOME and very helpful, however, in constructing my portfolio, I need to break it down by Category, Sub-Category and industry. The Morningstar listing doesn't provide a granular breakdown with definitions. I checked the Morningstar site but, if they have such a breakdown, it's not apparent. Can you help?

Thanks...Anthony Howd


Charles Rotblut from IL posted over 2 years ago:

Thanks Anthony.

We do not have the level of detail you are asking for. It's difficult to break funds down into industry groups, because industry classifications vary and many funds cover sectors instead of individual industries.

-Charles


Robert Borger from VA posted about 1 year ago:

I recently discovered that there are ETFs that invest in Master Limited Partnerships. These seem to ahve the advantages of high income distributions without the tax paperwork and complexities of MLPs.

Can you give me the scoop? Are these as good a deal as I have been led to believe, or am I missing something?


Charles Rotblut from IL posted about 1 year ago:

Robert,

I spoke with the manager of the Alerian MLP fund (AMLP) last year. You can read a transcript of the interview in the Nov 2011 Journal:
http://www.aaii.com/journal/article/master-limited-partnerships-income-from-a-unique-structure-and-industry

-Charles


Robert Borger from VA posted about 1 year ago:

Charles,

Thank you, excellent interview.

Question: I am restricted to $1,000 or less to invest in an MLP in an IRA; does the same restriction apply to an MLP ETF?

Also, the 1 and 37 rule seems to indicate that my returns are going to be reduced by a big expense fee; how does this affect real returns?


Charles Rotblut from IL posted about 1 year ago:

Robert,

You are not restricted to investing $1,000. Rather the unrelated business taxable income cannot exceed $1,000 per year. The investors relations department with a MLP should be able to give you some idea what past year's UBTI ran.

Expenses reduce your returns on a dollar for dollar basis at the time they are incurred. Because you will never see the money lost to expenses again, they also reduce your future returns do to the impact of compounding; you have less money to grow.

That said, you need to consider the perceived value of the services you are receiving for those expenses. For some people, avoiding the tax issues associated with MLPs and getting exposure to a large number of MLPs is worth the expense ratio charged by AMLP.

-Charles


John Mahlum from WA posted about 1 year ago:

How safe are ETFs? A stock broker advised me that, because of their structure, ETFs can become illiquid during periods of high market volatility. Is that true?

What are the risks of ETFs, and how do they compare with the risks of mutual funds?


Charles Rotblut from IL posted about 1 year ago:

John,

ETFs trade like stocks. Some are very actively traded and always have buyers and sellers. Some have comparatively low volume and can be harder to buy and sell immediately. If you stick with the larger ETFs, typically, those that track broad and well known indexes, such as the S&P 500, you should be fine. It is the ETFs that target small, very specific indexes that tend to have the lower volume and can be harder to quickly buy and sell.

Mutual funds are bought and sold from a mutual fund company. The advantage is that you can sell them at the end of each trading day. You don't know what the price is until the end of the day, however, whereas ETFs have updated quotes throughout the trading day.

Both ETFs and mutual funds can be good investments. Does your broker offer low cost, no load mutual funds or does he only suggest ones that come with a load (a fee to buy or sell the fund)? If the latter, it may be to his advantage to steer you away from ETFs, because he does not want to lose commissions.

-Charles


Vaidy Bala from AB posted about 1 year ago:

Is there any study done S&P 500 vs ETF to find performance that you can refer me to or give information? Also your mention it is difficult to sell/buy small cap ETFs, does this pose a risk for retired investor who might need money quickly?
A response will be appreciated.


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