Before investing in an ETF, investors must understand what makes up the fund. While it is easy to lump all ETFs into one category, the investment risks involved vary dramatically from fund to fund.
ETF strategies continue to multiply, but there are three basic types of ETFs that investors should be able to identify: domestically-traded equity ETFs, international equity ETFs and futures/swap based ETFs.
Domestically-Traded Equity Based ETFs
These ETFs get a complexity rating of beginner.
These ETFs, which trade on U.S. markets and track stocks that also trade on U.S. markets, are the most elemental of the group. These funds tend to closely track their underlying basket of stocks and trade close to net asset value (NAV). This group has lower risk because investments are easily hedgeable. A wide range of strategies are available with this type of fund, including commodity and international.
The ETF itself is traded from 9:30 a.m. EDT to 4 p.m. EDT on a U.S. stock exchange. In addition, all components in the ETF's underlying basket are traded from 9:30 a.m. EDT to 4:00 p.m. EDT on a U.S. stock exchange. And finally, all components are stocks or ADRs.
These ETFs use different strategies to expose investors to different sectors or themes. A passive indexing strategy will rank all the stocks in a certain category by capitalization or another stated combination of criteria, and allocate the fund's assets accordingly. Because some international companies use American Depository Receipts to trade on U.S. stock exchanges, internationally themed funds also appear in this category.
Examples of this kind of ETF include
Financial Select Sector SPDR
PowerShares Golden Dragon Halter USX China Portfolio
Market Vectors Gold Miners ETF
International Equity ETFs
These ETFs get a complexity rating of intermediate to sophisticated.
This group of funds tracks securities that are not listed on U.S. exchanges. While the ETF has trading hours of 9:30 a.m. EDT to 4 p.m. EDT, the stocks in the underlying basket may keep totally different hours on exchanges that are half a world away. Since it is often impossible to immediately hedge your investments in these funds, these ETFs may stray from NAV.
Investors should be awared this ETF contains securities that are traded on a stock exchange outside of the U.S.
While many international equity ETFs are large and liquid, investors need to be more aware of the complexities and limitations placed on foreign investments, currencies, and potential restrictions that could be placed on the fund.
Examples of this kind of ETF include:
iShares MSCI Emerging Markets Index
iShares FTSE/Xinhua China 25 Index
iShares MSCI Germany Index
These ETFs have a complexity rating of sophisticated
These ETFs are comprised of baskets of futures contracts and swaps. The investment objective of these funds is for the NAV of the ETF to reflect the changes in percentage terms of the spot price of the futures and the price of swaps that make up the basket. The futures and swaps markets are complex and involve speculation.
These funds are often much more complex to hedge, and have recently come under regulatory fire. Regulatory intervention can interfere with the pricing of these ETFs, and complicated roll strategies or daily resets can be involved.
The fund is made up of futures contracts and/or swaps.
Examples of this kind of fund are
United States Natural Gas
United States Oil
Direxion Daily Financial Bull 3X Shares
Direxion Daily Financial Bear 3X Shares
These three categories of ETFs are not the only types available, but they are particularly important ones for investors to understand right now. As the ranks of fixed income, actively managed and target date ETFs grow, it will be equally important for investors to understand the particular ways in which these funds differ as well.
Schwab recently announced the launch of a new line of proprietary ETFs, and it is only a matter of time until other large asset managers launch their own funds as well. The next decade will be an exciting one for the industry, as a new kind of ETF issuer and ETF investor enter the marketplace. Investors will be using ETFs in new ways, and substituting them--in some cases--in place of mutual funds.
To compare the dawn of the ETF era to that of mutual funds, however, is an oversimplification. The very things that make ETFs structurally unique from mutual funds are the characteristics that will make them so successful with a broader range of investors. Traditional ETFs are transparent, low cost and liquid. As shell-shocked investors turn back to their 401(k)s and retirement portfolios, these attributes will be more important than ever.
At the time of publication, Dion owned PowerShares Golden Dragon Halter USX China Portfolio and PowerShares QQQ.
Don Dion is the publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.
Dion is also president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.