State-Based Exchange-Traded Funds

Update: The exchange-traded funds highlighted in this article were liquidated at the end of 2010.

Exchange-traded funds (ETFs) are continuing to prove themselves as ever-present and almost chameleon-like in their ability to take on many new forms as a perceived need arises. The latest additions to the ETF world are state-based ETFs.

How It Works

Exchange-traded funds are portfolios of securities that are usually passively managed and track an index, offering an alternative to traditional index mutual funds. ETFs are listed on an exchange and trade intraday.

Many ETFs track indexes that were created specifically to meet the asset manager’s goals. State-based ETFs are no exception. As of this writing, there are two state-based equity index ETFs. If these prove to be a success, more are sure to follow.

Types

Texas Large Companies Fund (TXF)

The first state-based ETF was introduced in early November 2009 and is focused on publicly traded companies in Texas. The Texas Large Companies ETF follows the Spade Texas Index, which is a market-cap-weighted index of publicly traded companies in Texas. To be eligible for inclusion in the index, companies must have their corporate headquarters in Texas, have exchange-listed shares with a minimum share price of $5, and meet minimum market capitalization and liquidity requirements. No company can make up more than 10% of the index.

On September 30, 2009, the Spade Texas Index had 87 companies with market capitalizations between $2.4 billion and $332 billion.

The ETF may not hold all of the companies in the index and is allowed to invest up to 10% in cash at any time. The fund’s expense ratio is 0.20%.

Oklahoma Exchange-Traded Fund (OOK)

The Oklahoma Exchange-Traded Fund was also introduced in November 2009 and tracks the Spade Oklahoma Index. The Spade Oklahoma Index is a market-cap weighted index that consists of the largest publicly traded companies in Oklahoma.

Index-eligible companies must have their corporate headquarters in Oklahoma, have exchange-listed shares with a minimum share price of $5, and meet minimum market capitalization and liquidity requirements. Again, no company in the index can make up more than 10% of the entire index.

As of September 2009, the index had 29 companies with market capitalizations ranging from $120 million to $28.6 billion.

As with the Texas ETF, the Oklahoma ETF may not include all companies and is allowed to invest up to 10% in cash at any time. It also has an expense ratio of 0.20%.

How to Invest

Both of these ETFs are traded on the NYSE Arca exchange. Any discount broker that allows clients to trade ETFs should also allow trading of these ETFs.

Investor Suitability

Investing in a state-based ETF can be risky from a diversification standpoint. The Texas Large Companies ETF, for example, includes over 50% of its investments in companies within the oil & gas and energy sectors. The Oklahoma Exchange-Traded Fund holds over 60% in energy-related companies. Also, both of these ETFs are investing only in large-cap stocks.

These types of ETFs can work as a small portion of a well-diversified portfolio.

Tax Implications

State-based ETFs are taxed exactly as other ETFs. When you sell an ETF, you will report a capital gain or loss. Whether it is a long-term or short-term gain or loss depends on how long the ETF was held.

Any dividends received while holding the ETF are also taxable at the same rate as qualified dividends received directly from a company.

The Pros

Ease of Exposure to Limited Markets

If you are sure that exposure to a certain geographic location, sector, and market capitalization size is right for your portfolio, then these ETFs are a simple way to invest.

Low Fees

Compared to a mutual fund that invests in the energy and oil & gas sectors, these ETFs offer lower fees.

The Cons

Liquidity

Because these ETFs are new and narrowly focused on a small geographic area, liquidity can be an issue. As of early-December, each ETF had just over 100,000 shares outstanding.

Lack of Diversification

From a diversification standpoint, these ETFs are weighted very heavily in a small number of sectors and include only the largest-capitalization stocks.

Additional Information

The Spade Indexes
www.spadeindexes.com

The Spade Indexes Web site offers information about the indexes that these ETFs follow. Performance data on the indexes is given, along with the methodology of each index and a list of the components that make up the indexes.

AAII’s Guide to ETFs
www.aaii.com/guides

Each year, AAII publishes a Guide to ETFs. The most recent guide was updated in October 2009 and includes over 750 ETFs. The guide discusses the basics of ETFs, the various types, and tax implications for investors. You can also view basic ETF information, performance statistics, expense data and risk information for all of the ETFs tracked.