ETFs: Demystifying the New Generation

Written by Greg Newton

With some 800 exchange-traded funds (ETFs) now listed on U.S. stock exchanges, the days when investors could simply see a product with "Financials" or "Basic Materials" in its name and understand what they were buying are gone.

Now, investors face many of the same challenges as stock and mutual fund purchasers do as they attempt to evaluate products that may represent similar sectors or themes but that can have very different performance drivers.

As with any financial product, successful ETF investing usually comes down to abiding by two of the hoariest cliches in the business: Do your homework, and know what you own. If you're uncertain about a specific product, it might be time for a chat with your financial advisor or an appropriately skeptical gambol through an Internet search engine's results page produced by simply entering the trading symbol. And, if at the end of the quest you still have unresolved questions, it's probably best to just stay away.

The following are just some of the trends in ETF development that potentially offer benefits for investors, but can be landmines for the unwary.

New Weighting Methodologies

Many first-generation ETFs were based on well-known capitalization-weighted indexes, such as the S&P 500 and the Russell 2000. Now, ETFs track indexes based on dividend payouts; more complex amalgams of business indicators, such as book value, cash flow, sales and dividends; and, more commonly still, the so-called “modified equal-weight” methodology, which effectively suppresses the impact of the performance of individual stocks on the ETF.

While each of these methods has its benefits and drawbacks, a look at dividend weighting quickly shows both sides of the story. Academic research arguably proves that dividends are an effective indicator of a company's future prospects and, consequently, its stock performance. However, many broad-market dividend-weighted funds are heavily involved in financial stocks and have suffered with that sector over the last 12 months.

If you’re uncertain about a specific product, it might be time for a chat with your financial advisor or an appropriately skeptical gambol through an Internet search engine’s results page produced by simply entering the trading symbol.

New Indexes

Many ETFs are now based on indexes that were created specifically for that ETF and that often outperform conventional benchmarks over the long term. In those cases, the disclaimer that past performance is not indicative of future results should be taken more seriously than usual, because, in some cases, many of the stocks currently in the ETF were not even listed for much of the index’s stated history.

Currency Exposures

Unquestionably one of the most popular ETF applications in recent years, ETFs with currency exposure have been making it easier for investors to participate in non-U.S. markets. In the recent past, the rising value of the euro against U.S. currency goosed the returns of investors in euro-zone markets; however, as the U.S. dollar rallied strongly against the euro in August, broadly flat European markets translated into a decline in the value of their ETFs in U.S. currency.

Complex or Unfamiliar Investment Objectives

Perhaps the cause of most disappointment among ETF investors, particularly those who own certain early commodity-related ETFs and the more recent leveraged and inverse issues, grew from a simple misunderstanding of the funds' investment objectives. These products, like most ETFs, are intended to track the daily return of the underlying index. But big one-day misses, sometimes driven by supply-demand issues in the stock market, as well as the compounding effects of leverage, mean that performance over time may not meet expectations.

Intellidex: Hidden Gems?

It is a well-known fact in the investment world that many of the best-performing stocks, through all the markets' moods and gyrations, are those of companies that receive little attention from analysts and even less from the media. These companies just plug away, building profits and paying dividends. They are the grunts going quietly about their business amid the glittering brass of market fads and short-lived favorites.

The ETF market has grown to the point where it has its own hidden gems. Among them, especially from the perspective of long-term investors, is the now 40-strong family of market, style and sector ETFs sold by PowerShares under the "Dynamic Portfolio" label.

This family tracks the Intellidex indexes, which are owned by the American Stock Exchange. Instead of using conventional capitalization weighting to select stocks for each portfolio, the Intellidex process uses 25 different factors, consensus analyst estimates, traditional performance measures such as earnings and free cash flow, and technical indicators.

The results speak for themselves. From its inception more than five years ago up until July 31, 2008, the Dynamic Market Portfolio (PWC) outperformed the S&P 500 by more than 2.5% a year, with an annualized return of 10.12%, compared with the market benchmark’s 7.58% return over the same period. In the same time period, the Dynamic OTC Portfolio (PWO) returned just over 8% annualized, while the Nasdaq Composite returned 7.16%.

More impressive, although over a shorter time frame, has been the outperformance of the Dynamic Financials Sector Portfolio (PFI), which was launched in October 2006, compared with the Financial Select Sector SPDR (XLF), the sector's "vanilla" ETF. Both ETFs peaked a year later in October 2007, with the PFI making a total return of 5.88% on the climb, while XLF made 3.22%. But since the sector began its dramatic purge, the performance difference has only increased.

Over the next ten months up to July 31, 2008, PFI was hit hard, dropping 14%. But that was much less than half the nearly 34% loss inflicted on XLF as many of its components suffered greatly in the credit crisis. XLF's ten largest holdings, which accounted for 45% of the portfolio as of June 30, 2008, are dominated by the country's largest commercial and investment banks.

By contrast, PFI's ten largest holdings account for less than 30% of its portfolio, which is dominated by insurance- and investment-management-related names that have so far escaped the worst of the damage. None of XLF's ten largest holdings are currently in the PFI portfolio. Despite its outperformance in the differing market conditions, PFI has assets of just $25 million, compared with $6.5 billion in XLF.

PowerShares Research Chief John Southard, while quick to emphasize that past performance is no guarantee of future results, says that PFI shows the benefits of the Intellidex approach. "We noticed the index started getting signals to reduce weightings in commercial banks about a year ago, and while the tiered weighting approach meant that PFI was as heavily weighted with commercial banks as other ETFs, which are typically based on cap-weighted indexes, we were able to move out of them with relative ease."

The ETF market has grown to the point where it has its own hidden gems.

Now Open: The Commodities Markets

ETFs have played an important role in widening investment opportunities, and perhaps nowhere more so than in providing access to commodities markets. Since State Street issued the first gold ETF (now the SPDR Gold Shares) in late 2004, almost 100 commodity- and currency-related products have launched, with many more expected over the next few months.

Many of these products are structured as exchangetraded notes, or ETNs. While ETNs have the same look and feel as traditional equity-based ETFs in that they trade on stock exchanges and are designed to track underlying benchmarks, the important difference is that they are debt instruments of their issuers, which are affiliates of leading investment banks where the "credit risk" is no longer something to be blithely ignored. In addition, all but a handful of ETNs are based on indexes linked to the unlevered performance of underlying futures contracts, and most do not actually hold physical commodities. By abhorring leverage, the funds generate income by investing assets not required for margin on futures contracts in high-quality, liquid instruments, such as Treasury bills (T-bills).

Among the available commodity instruments:

Broad-based commodity instruments, linked to such well-known indexes as the Dow Jones-AIG and S&P's GSCI commodity indexes. One of the largest funds of this type is the PowerShares DB Commodity Index Tracking Fund (DBC). With assets of more than $2 billion, the DBC tracks just six commodities using crude oil and heating oil as a proxy for energy; aluminum for industrial metals; corn and wheat for the agricultural sector; and gold for precious metals.

Diversified sector instruments, often linked to subindexes of the main commodity indexes. Examples include the $2 billion PowerShares DB Agriculture Fund (DBA), which tracks a basket of corn, wheat, soybeans and sugar; and the PowerShares DB Base Metals Fund (DBB), which follows aluminum, copper and zinc.

Individual commodity instruments, which are now available for exchange-traded commodities from oil to platinum.

While conventional investment counsel is that commodities are dangerous investments because of their volatility and other concerns from the risk bucket, a wide spectrum of research has indicated that some exposure to what is now widely accepted as an asset class in its own right will either reduce overall portfolio volatility or increase returns at a given risk level. Commodities-based ETFs and ETNs offer arguably the most convenient way of adding this exposure.