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  • The Individual Investor’s Guide to Exchange-Traded Funds 2011

    The Individual Investor’s Guide To Exchange Traded Funds 2011 Splash image

    We have expanded this year’s guide, adding nearly 100 new funds to the print version and more than 250 to the online version, to help individual investors navigate the expanding exchange-traded fund (ETF) industry. Also included in this year’s guide are five calendar years of performance data (where applicable, as many ETFs have inception dates after 2006) and five-year annual return (where applicable).

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    There are many superlatives we could use to describe the growth in ETFs, but we’ll let the facts speak for themselves. Our first ETF guide, published in 2003, listed 130 exchange-traded funds. This year’s print guide includes 427 funds, and information on more than 850 additional funds is available on AAII.com.

    A more important statistic is the dollar amount of assets held by exchange-traded funds. Investors, both institutional and individual, show their favoritism for an investment by putting their dollars into it. As of the end of June 2011, the ETF universe held $960 billion in net assets, according to research firm Lipper. This represents more than a 100-fold increase since June 1998, when assets totaled just $9.2 billion.

    While statistics can look large when calculated from a small base, the industry is continuing to grow at a very strong pace. Since 2007, total assets have more than doubled—increasing by nearly $500 billion dollars. The anticipated introduction of new, actively managed ETFs seems likely to propel these numbers even higher.

    This rapid growth has lowered the barriers and costs to many investments. This is particularly the case for foreign markets, currencies, commodities and hedge fund–like strategies. The advantage is that diversification has become easier and cheaper. The disadvantage is that specialized funds have unique risks that may be more difficult to identify before they adversely impact performance. A key rule to consider when evaluating a specialty fund is that just because you can invest in something, does not mean you should.

    Another change in the industry is commission-free ETFs. Discount brokerage firms—including Fidelity, TD Ameritrade, Charles Schwab and Scottrade—allow clients to buy and sell select ETFs without paying commissions. Though there is a transaction cost advantage, the savings should be weighed against the potential performance, diversification and annual expense advantages of a fund that is not commission-free. Put another way, on a $10,000 investment, the waiver of $20 in commissions equates to a one-time savings of just 0.2%. While we welcome lower costs, we don’t view the existence or waiver of a commission as something that should be a significant factor when evaluating a fund.

    The overwhelming majority of ETFs track an index, such as the S&P 500. However, in many cases an index has

    specifically been designed for an ETF to track. This has become particularly evident over the past few years as fund providers seek to differentiate their offerings. The risk is that two similar-sounding funds can have different performance characteristics. This is why it is critical that you understand not only what index the fund follows, but also how its performance may differ from a more widely known index.

    Some ETFs use an enhanced-index strategy. These funds follow a specific type of strategy, such as seeking low valuations or other fundamental criteria. Technically, they are passive funds because they track an index. The index itself, however, is based on a strategy that was designed to take advantage of a market anomaly or historical data that favors a certain style of investing. This makes enhanced-index ETFs close cousins of actively managed ETFs. We have designated such ETFs in this guide with an E to the left of the fund name.

    Total ETF
    Net Assets
    ($ Bil)
    % Change
    Jun-11 959.9 28.8
    Jun-10 745.1 30.1
    Jun-09 572.8 2.0
    Jun-08 561.5 18.6
    Jun-07 473.4 41.3
    Jun-06 335.1 39.5
    Jun-05 240.2 36.7
    Jun-04 175.7 47.7
    Jun-03 118.9 35.6
    Jun-02 87.7 16.4
    Jun-01 75.4 64.1
    Jun-00 45.9 122.0
    Jun-99 20.7 124.4
    Jun-98 9.2 na

    Actively managed funds only account for a small segment of the ETF industry as of press time, but this is expected to change. As Tom Lydon explains, most of the short-term growth in this industry segment will come from new bond funds. PIMCO, already a giant in the mutual fund industry, offers four actively managed ETFs at press time and is working on introducing more. T. Rowe Price could be among other mutual fund companies to introduce actively managed ETFs. Actively managed ETFs in this year’s guide are those not designated as either an index (I) fund or an enhanced-index fund (E) in the columns to the left of the fund name.

    Though all this growth provides more choices and lower overall expenses, the basics of portfolio management do not change. Diversification is important. Consider including exposure to domestic large-cap, mid-cap and small-cap stock funds along with bond, foreign developed-country stock and emerging market stock funds. Once you have your basic allocation properly configured, you can then consider including exposure to other asset classes such as real estate or commodities.

    In terms of choosing between ETFs and mutual funds, go with the fund that best suits your needs. ETFs hold a cost advantage for pure index strategies, such as tracking the performance of the S&P 500 index or the Russell 3000 index. The advantage of mutual funds is that they provide access to professional money managers. You should not feel beholden to either investment vehicle; rather, be open to the possibility of combining ETFs, mutual funds and individual stocks and bonds within your portfolio. When investing in ETFs or mutual funds, pay attention to the funds’ holdings to avoid unanticipated overlap.

    The exchange-traded funds presented in this guide are grouped by category and listed alphabetically within each category; the ticker symbol is indicated after each fund’s name. The listings provide information on a variety of return and risk data, portfolio composition and expenses.

    Exchange-traded notes (ETNs) are also included. ETNs are similar to ETFs in that they trade on exchanges like stocks and are designed to mimic the performance of an index. ETNs, however, are debt securities. Thus, the credit quality of the issuer needs to be considered in addition to other factors (asset class, performance, expense ratios, etc.) when looking at an ETN. Broad references to ETFs in this guide will encompass ETNs, unless otherwise stated.

    Wherever possible, we used the same category names and data (e.g., returns, yield, expense ratio, etc.) presented in our annual Guide to the Top Mutual Funds (published in the February 2011 AAII Journal and also posted in the Investor Guides area on AAII.com). Our rationale is to make comparisons between ETFs and mutual funds as easy as possible.

    Three HOLDRS Removed

    We removed Retail HOLDRS (RTH), Internet HOLDRS (HHH) and Utilities HOLDRS (UTH) from the print version of this year’s guide. Total assets fell significantly for these three trust-issued receipts, sending them below our $200 million requirement. It was not just these trusts that experienced big declines; 15 out of the 17 HOLDRS in our database saw their total assets fall by 23% or more since last August. Assets plunged by more than 50% for 11 of those trusts.

    HOLDRS are often grouped with exchange-traded funds (ETFs), but there are significant differences. HOLDRS allow you to unbundle the portfolio and sell the individual stocks separately. Dividend rights and voting rights are retained by the individual shareholder. Tax losses can be realized on any stocks that decline in value, while gains on the best-performing stocks can be put off indefinitely. HOLDRS can only be bought and sold in round lots of 100 shares.

    Exchange-traded funds are bought and sold as single units. An individual investor cannot sell the individual stocks held within an ETF. The fund, not the ETF owner, maintains all voting and dividend rights for the individual stocks. ETFs can be bought and sold in odd lots, such as a single share or 111 shares.

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    All HOLDRS are identifiable by their name.

    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 ETF Portfolio also provides an idea of how to build and manage a diversified portfolio of exchange-traded funds. (The Model ETF Portfolio is now reviewed, along with our Model Mutual Fund Portfolio, in the March, May, August and November AAII Journal issues; the latest commentary is 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 [SPY] 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 Rydex 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 needs 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 double the size of the minimum requirement used in our 2009 guide and reflects the strong growth the industry has experienced. The rule was relaxed for funds held within the Model ETF Portfolio, which is why you will see First Trust Dow Jones Select MicroCap Index (FDM) listed. An exception was made for CurrencyShares Japanese Yen Trust (FXY), which was included in last year’s guide but has since fallen below the $200 million requirement. 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, as it would have had only a minimal impact on which funds were included in this year’s 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 close to 1,300 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 category contains funds that are designed to move in the opposite direction of 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. All these ETFs are suitable only for speculative trading on 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 have provided us. 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 reports 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 have used 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 the 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 to follow and may have different return characteristics than other indexes with similar names.

    Enhanced: The letter “E” before an ETF’s 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), 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, 2011. 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 April 30, 2011. 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 ETFs. 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, 2011.

    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. This occurs when the ETF’s manager believes he can mimic the returns of the index without holding all of the securities that comprise the index.

    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.

    Inception Date: The date when the ETF was formed and became available for sale to institutional investors. These “creation unit holders” then make the shares available for sale to individual investors.

    Copyright 2011 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

    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 the 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, who writes in this issue about changes in the ETF industry, 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
    ALPS Funds www.alpsfunds.com
    BLDRs www.invescopowershares.com/bldrs
    CurrencyShares www.currencyshares.com
    Direxion www.direxionshares.com
    EGShares www.emergingglobaladvisors.com
    ELEMENTS www.elementsetn.com
    ETF Securities (ETFS) www.etfsecurities.com
    First Trust www.ftportfolios.com
    Global X www.globalxfunds.com
    GreenHaven www.greenhavenfunds.com
    Guggenheim www.guggenheimfunds.com
    HOLDRS www.holdrs.com
    iPath www.ipathetn.com
    IQ www.indexiq.com
    iShares www.ishares.com
    Market Vectors www.vaneck.com
    PIMCO www.pimcoetfs.com
    PowerShares www.invescopowershares.com
    PowerShares DB www.dbfunds.db.com
    ProShares www.proshares.com
    RevenueShares www.revenuesharesetfs.com
    Rydex|SGI www.rydex-sgi.com
    Schwab Funds www.schwab.com/schwabfunds
    SPDRs (State Street Global Advisors) www.spdrs.com
    United States Commodity Funds www.unitedstatescommodityfunds.com
    Vanguard www.vanguard.com
    VelocityShares www.velocityshares.com
    WisdomTree www.wisdomtree.com


    Barbara from FL posted over 5 years ago:

    Excellent explanation of ETFs.
    Very thorough. As a very long time investor in stocks, bonds, mutual funds and options, this is a good basis for a beginner learning the ETF scene.

    Oliver from IL posted over 5 years ago:

    Excellent presentation. I suggest you number the pages to allow for viewers to print copy a specific area of interest;e.g,ETF and ETN Contact Information without havng to copy all pages.

    Vernon from FL posted over 5 years ago:

    Not sure why, but if I click on table/classification links all I get are empty excell tables with no data displayed.

    Vernon from FL posted over 5 years ago:

    My compliments to the staff. The excel downloadable spreadsheet provides an excellent compilation of data for research. Well Done!

    Bruce from MI posted over 5 years ago:

    A very helpful exposition overall.

    Just one of the many useful tips is to watch the expenses of commission-free ETFs, which may not yield the best overall return. I had not thought about that.

    With your tools I can perform the required analysis to drill down to the best approach for my particular situation. Thank's for all the effort that went into making an unwieldy topic manageable.

    Jonathan from TX posted over 5 years ago:

    Excellent articles, clear concise and thorough. I would have liked however, to see more information on ETNs. I have seen cautionary articles about their risks and hidden tax exposure. They are very different from ETFs and are not backed by any assets (e. g. stocks or bonds) just the faith and credit of the issuer. Personally, I would never buy one.

    Tom from FL posted over 5 years ago:

    Why are Blackrock ETFs missing from your listings/tables?

    Charles from IL posted over 5 years ago:

    Blackrock owns iShares and those ETFs are included in the guide. - Charles Rotblut, AAII

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