Thursday, February 8, 2007

The Weird World of ETFs

News Analysis
February 8, 2007

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The Weird World of ETFs

The proliferation of exchange-traded funds has led to the creation of increasingly specialized products. Here are some of the most exotic

Exchange-traded fund launches are quickly becoming as routine as the launches at Cape Canaveral. Fund companies rolled out 155 new ETFs in 2006, according to Boston consultancy Financial Research Corp. As new products hit the market, the nature of the products is changing (see, 5/5/06, "ETFs: Sliced, Diced, and Razor-Thin"). Best known as cheap, tax-efficient portfolio diversifiers, ETFs now provide exposure to even the narrowest—and sometimes most outlandish—investment niches.

Just last week, 22 new ProShares ETFs from Bethesda (Md.)-based ProFunds Group started trading on the American Stock Exchange. Boston's State Street Global Advisors (STT) unveiled its new SPDR FTSE/Macquarie Global Infrastructure 100 ETF (GII). Meanwhile, New York upstart XShares (formerly Ferghana-Wellspring) announced a deal with the Chicago Climate Exchange to build ETFs based on carbon emissions credits.

Investors shouldn't assume something is a smart investment simply because it's an ETF. "The package does not make the product," says Philip Edwards, managing director of Standard & Poor's Investor Services (MHP). "Don't invest in anything you don't understand."

ETFs may be carving the market into thinner and thinner slices, but a well-diversified portfolio remains as important as ever for investing success (see, 6/22/06, "Spread Your Bets in ETFs"). This Five for the Money looks at five of ETF providers' most unusual offerings.

1. PowerShares Lux Nanotech Portfolio (PXN)

Fast-growing Wheaton (Ill.)-based PowerShares has contributed its share of today's vast pool of niche-oriented ETFs. Since being acquired by Amvescap (AVZ) early last year, the company has nearly doubled its ETF lineup, from 36 to about 70. Many of those funds, such as PowerShares Lux Nanotech Portfolio, focus on such narrow slivers of the market that they could be unduly risky for most investors.

Some nanotechnology stocks could certainly thrive in the future, but for most of us the potential volatility may not be worth it. "Focusing on these industries in one fund is a rather perilous course," says Morningstar (MORN) ETF analyst Dan Culloton. "They're going to be very volatile, because not all of these firms are going to survive."

Culloton says industries like nanotech can be so narrow that ETFs tracking them must buy some unlikely stocks to fill out their portfolios. For example, PowerShares Lux Nanotech's holdings include such household names as Toyota Motor (TM), IBM (IBM), Hewlett-Packard (HPQ), Intel (INTC), 3M (MMM), and General Electric (GE). Such blue-chips could decrease the ETF's aforementioned volatility, but they mean investors aren't exactly getting a pure nanotech play.

PowerShares Lux Nanotech Portfolio logged a total market return of –6.3% for the year ended Feb. 6, trailing the Standard & Poor's 500-stock index by 22.95 percentage points. The ETF carries an expense ratio 0.73%. Investors should remember that buying or selling ETF shares also incurs brokerage commissions.

2. HealthShares Enabling Technologies ETF (HHV)

Speaking of ETFs for tiny subsectors: XShares' HealthShares ETFs each target a specific segment of the health-care, life-science, and biotech industries. Launched in late January, the five HealthShares offerings so far include the likes of HealthShares CardioDevices ETF (HHE), HealthShares Diagnostistics ETF (HHD), and HealthShares Emerging Cancer ETF (HHJ). HealthShares Enabling Technologies ETF tracks companies involved in technologies "that enable and support the discovery, clinical development, and manufacturing activities of pharmaceutical and biotechnology companies," according to the prospectus. Top holdings include Sangamo Biosciences (SGMO) and Illumina (ILMN).

The same caveats about potential volatility apply to these narrowly focused ETFs. Furthermore, the stocks such funds invest in might not even be the ones that ultimately profit from new technologies, Morningstar's Culloton notes. In The Future for Investors, Wharton professor Jeremy Siegel writes that companies that benefit from technological advances usually tend to be big, boring ones, not necessarily those laying the wires and expanding the networks. "That's an important thing for investors to remember," Culloton says.

Net annual operating expenses for each HealthShares ETF are capped at 0.95%, not including brokerage commissions. XShares has also filed with the Securities & Exchange Commission to launch a series of ETFs dubbed StateShares, which would home in on geographic subsectors. The funds would track S&P indexes for California, Ohio, Missouri, North Carolina, and 18 other states.

3. Claymore MACROshares Oil Down Tradable Shares (DCR)

While the share price of an ETF changes constantly, its net asset value (NAV) is set only once a day. Because the two don't always match, an investor could buy an ETF at a premium to the NAV and sell at a discount, substantially lowering returns.

Claymore MACROshares Oil Down Tradable Shares has only traded near its NAV 11% of the time, according to Almost 60% of the time, the product has traded at more than a 2.5% discount to its NAV. Technically a trust, not a fund, this exchange-traded security tries to make money from the downward movements of crude futures.

S&P's Edwards has concerns about the product's low trading volume, too. "If an investor wanted to get out, they would need to offer a large discount to attract a buyer," says S&P's Edwards. He advises ETF investors against investing "in anything thinly traded."

Claymore MACROshares Oil Down Tradable Shares has posted year-to-date total market returns of 2.95%, beating the S&P 500 by 0.53 percentage points. The exchange-traded security has come under criticism for its expenses of 1.6%.

4. Internet HOLDRS (HHH)

Not all exotic ETF offerings are thinly traded. In fact, some aren't even new. Merrill Lynch (MER) introduced its first HOLDRS exchange-traded security baskets in 1998, and the HOLDRS' are often among the top-volume traders on the Amex.

Though generally lumped in with ETFs, the various HOLDRS are technically trusts, so they can't rebalance—or even add new stocks. As a result, the HOLDRS' holdings and performance may diverge markedly from those of traditional indexes tracking the same sector. Ron DeLegge, publisher of, observes, "Who in their right mind would want to own an investment product that's not rebalanced or not updated to properly reflect the sector it's supposed to be representing?"

The Internet HOLDRS comprises just 11 stocks, including Yahoo! (YHOO) and eBay (EBAY) but not Internet heavyweights like Google (GOOG), which came out after the HOLDRS debut. By contrast, the First Trust Dow Jones Internet Index Fund (FDN) ETF holds 40 stocks.

Investors may not be quibbling with Internet HOLDRS' performance, however. It has posted total annualized market returns of 14.42% over the past five years, beating the S&P 500 by 5.4%. On a one-year basis, though, Internet HOLDRS trails that benchmark by 23.18 percentage points.

5. iShares MSCI Belgium Index (EWK)

While Kazakhstan does not yet have its own country-specific ETF—sorry, Borat—many other countries, large and small, do. The iShares MSCI Belgium Index is one of the most unusual of them. That's no knock on Belgium, however. Not only are iShares MSCI Belgium Index shareholders investing in only a slim segment of the world market, but the fund's top five holdings make up 60% of the portfolio, creating even more potential volatility.

Still, the iShares MSCI Belgium Index can boast close to blockbuster-caliber performance. The ETF has posted total five-year annualized market returns of 23.91%, besting the MSCI EAFE index by 6.42 percentage points. It has an expense ratio of 0.54%.

This fund may be out of the ordinary, but there are still practical uses for exotic ETFs, says Tom Lydon, president of financial advisory firm Global Trends. "Individual investors and advisers are utilizing ETFs more for specific asset allocation and identifying changing trends in the marketplace," Lydon says. "The only concern is when individual investors get too enthusiastic about a sector or global region after the lion's share of its upside performance is behind."

Either way, investors should make sure they know what they're getting into if they're considering new and unusual ETFs.

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