I'm glad to share the job of helping you make sense of investing in exchange-traded funds, a mission made more necessary by the increasing interest and investment in these products. But I get concerned when I spot articles like the one I read over the long weekend.

I came across " You Might Be Surprised by What's in Your ETF" on SmartMoney.com, and I was negatively surprised by it, to put it mildly. While I do agree with the article's main thrust -- "know what you are holding" -- I believe the bulk of the piece's analysis revealed a fundamental lack of understanding of the product and even of the importance of forward-looking analysis.

Slippage on Oil ETF

The piece starts with a dissection of the United States Oil Fund ( USO) that quickly goes off-point. Pointing out that USO doesn't own oil stocks and instead tracks West Texas intermediate crude, the author does well to emphasize that if you don't know what WTIC is, you shouldn't buy USO. He goes awry when he adds that you probably wouldn't want to buy it because it's down 32%.

Remember that USO is meant to track oil, period. If oil goes down, USO will go down; if oil goes up, well, you see where I'm headed. USO listed on the market in April when oil was much higher. USO is down a lot because WTIC is down a lot. Knowing that oil is down from its high is not enough information to make any decision about USO.

The piece would have done better to point out one problem with USO: The fund is badly lagging WTIC because of the oil market's contango, the cost of rolling to next month's futures contract when this month's expires, if next month's is more expensive, as is often the case.


Considering how big the contango issue has been for USO, you may not want to use it as an oil proxy if and when you believe crude will go higher. Making the decision about buying USO boils down to your opinion about what crude oil will do, whether USO will adequately capture what it will do and whether you even need this kind of exposure in your portfolio -- not just its past returns.

Get What You Pay For

The article then takes on the Claymore Ocean Tomo Patent ETF ( OTP), which I profiled in December when it first listed. In that column, I posited that OTP could turn out to be a better mousetrap for large-cap growth based on its methodology and holdings. The SmartMoney article's author advocates knowing what's under any ETF's hood, but apparently he didn't check this one, because he misses what I believe is a pretty obvious point for an ETF, the difference a methodology can make.


The author's case against OTP is that "most of its portfolio, including firms like General Electric ( GE) and 3M ( MMM), can also be found in cheaper funds." The question is implied: So why not own the cheaper funds?

Well, because despite OTP's expense, it has delivered as advertised in its very short time on the market. While two months is not enough time to make anyone believe that OTP has thoroughly proven itself, it sure shows that investors who paid a little extra for a superior large-cap growth mousetrap have gotten their money's worth so far.

Smart Indexing

Next I've got to counter the article's point that ETFs that own the same 500 stocks -- as in S&P 500-based ETFs -- with different methodologies will deviate by only a percentage point or two, so it doesn't matter which one you choose. Here, Robert Arnott's fundamental index is mentioned but not his fund, the PowerShares FTSE RAFI US 1000 Portfolio ( PRF), and there is specific mention of the Rydex S&P Equal Weight ETF ( RSP): "In the end, regardless of which ETF you pick, you will own the same companies and get the same relative performance within a percentage point or two of each other."

The history of Arnott's fund and RSP vs. the S&P 500 speaks for itself. Anything could happen with returns in the future, but up to this point, methodology has mattered.

Since inception, PRF has beaten the S&P 500 by roughly 6%. In that same time period, RSP has beaten the S&P 500-tracking SPDRs ( SPY) by 3%.

It's too early to know whether PRF can keep up this outperformance. But it is worth noting that since RSP's inception in 2003, it's up a total of 90%, compared with not quite 60% for the S&P 500. This dispersion is clearly attributable to RSP's much smaller market cap, and there will be periods when SPY leads, but the notion put forth in the article that which broad index fund you invest in doesn't matter is completely upside down.


Not Kooky, Complex

The SmartMoney article brings it home with a general condemnation of narrow-based ETFs, saying these new and original ETFs can be so hard to understand, it's almost not worth the effort to decide whether to buy (and that you should wait to judge them on past performance, which I'll get to in a minute). It even says that many unnecessarily slice and dice the market into segments not worth investing in, and uses a pejorative tone (the aforementioned desperation of ETF companies) that implies these instruments are gimmicks.

This conclusion reveals a lack of understanding. The Claymore/Sabrient Stealth ETF ( STH) gets singled out as an example of all of the above faults. But a quick peek under its hood shows STH has a secondary effect (as do most of the "gimmick" funds) that is far from far-fetched.

This ETF is another way for investors to gain small-cap exposure (more specifically, small-cap growth). Since its debut last fall, it has slightly outperformed the iShares Russell 2000 Fund ( IWM) and the iShares Russell 2000 Growth Fund ( IWO). It has been out only a few months, and the lead is slight, but again, this fund has started out doing exactly what it claimed it would.

For investors who are looking for an edge, the extra research is always worth it. I strongly disagree with what seems to be the blanket indictment of these new and original ETFs.

Looking Forward

The SmartMoney author is right: "What you think you see might not always be what you get with an ETF," so "know what you are holding." But I take serious issue with his conclusion from this: a preference for "ETFs based on the well-established indexes at families like Standard & Poor's, Russell and Wilshire" because they "have decades of performance track records so it's easy to see how they'll perform in any market condition."

He also characterizes some of the great innovations in ETFs, which allow investors the flexibility to capture a market segment without the higher risk associated with owning all those individual stocks, as something that desperate "ETF firms ... have resorted to, designing new products around exotic and unproven indexes." That's true for some products, but as always, investors who do their homework will know which products are worth their capital and which are tantamount to desperate ploys.

Buying an index fund, regardless of what type of index it's based on, has to be a forward-looking process. And even "exotic and unproven" indices can go up. Investors are better off sticking with the better half of this article's advice and making sure the ETFs they choose fit the bets they want to make.


Please note that due to factors including low market capitalization and/or insufficient public float, we consider Claymore Ocean Tomo Patent and Claymore/Sabrient Stealth ETF to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
At the time of publication, Nusbaum had no positions in any of the instruments mentioned in this column, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

If you liked this article you might like

Woof! New ETF Applies Dogs of Dow Theory to Emerging Markets

Woof! New ETF Applies Dogs of Dow Theory to Emerging Markets

New ETF Lets You Collect Highway Tolls

New ETF Lets You Collect Highway Tolls

New Guru ETFs Go Global

New Guru ETFs Go Global

New First Trust ETF Combines Two Successful Methodologies

New First Trust ETF Combines Two Successful Methodologies

Is There Room for a Third China A Share ETF?

Is There Room for a Third China A Share ETF?