When doing your research on ETFs, read the prospectus and information found on the issuer’s website. There are many different types of ETFs, depending on what the fund is tracking but also how the securities are weighted, whether there is any additional risk exposure, etc. Make sure you understand what exactly you’re buying before you invest.
Types of ETFs
The most common type of ETF, an index ETF tracks a specific US or foreign stock index (eg. NASDAQ 100, FTSE 100, S&P 500, Russell 2000, etc). There is a large variety of index ETFs for investors to choose from.
These ETFs represent a specific sector (industry group), eg. technology, energy, materials, industrials, healthcare, financials, utilities, consumer staples, etc. They track the collective performance of that industry. As with most other ETF types, there are US as well as foreign and global sector ETFs.
These ETFs are defined by the market capitalization of the individual stocks within. For example large-cap companies (generally over $10 billion in market cap), mid-cap companies ($2 bil to $10 bil), small-caps ($300 mil to $2 bil), micro-caps ($50 mil – $300 mil).
These ETFs track the performance of the markets of an individual country, or, in some cases, an entire region (eg. Eastern Europe, Eurozone, Latin America, Asia, etc). There are numerous international ETFs listed both on US and foreign stock exchanges.
Commodity ETFs track the performance of a commodity (eg. oil, natural gas, gold, silver) or a basket of commodities (such as precious metals, base metals, agricultural commodities, etc).
A currency ETF provides investors the ability to track the performance of various currencies throughout the world, such as the US dollar, Japanese yen, British pound, Euro, etc. (It’s important to note that while FOREX is essentially a 24hr market, currency ETFs have a disadvantage of being available for trading only during stock market trading hours.)
Fixed income ETF
ETFs that track corporate bond or treasury bond indices.
ETFs by weighting model
Most ETFs (and indices) are weighted by market capitalization, meaning that larger companies have much greater representation in the index and greater influence on the price movement. Most of the index’s capitalization is concentrated in the top holdings.
A few providers now offer equal weighted (index and sector) ETFs, which give a broader representation of the companies within the index. Each stock is initially given an equal weight, allowing you to spread your risk equally among all the stocks in the index. It also means you get more exposure to smaller and midsize companies, which often outperform the larger caps.
The other issue with market cap weighting is that stocks that have quickly risen in price and become overvalued will have higher weighting in the index. (The higher a stock’s valuation, the higher is its market cap.) Equal weighed ETFs avoid overweighting stocks that trade above their fair value.
To maintain equal weighting, an equal-weighted ETF needs periodic rebalancing (generally done on a quarterly basis).
This means that such ETFs (compared to traditional index ETFs) usually have higher expense ratios, as well as higher bid-ask spreads (since they tend to be more thinly traded). As rebalancing involves selling stocks that have appreciated most, it results in higher transaction fees but also higher tax liability (due to realization of capital gains).
While equal-weighted ETFs are a great addition to the ETF universe, they tend to be slightly more expensive as well as less tax efficient, all of which can result in a lower compound return. Investors need to examine carefully whether these ETFs will benefit their portfolio.
While traditional indices are market cap weighted, fundamentally weighted ETFs offer an alternative, weighting companies based on fundamental factors (such as book value, earnings, dividends, etc).
Some ETFs are weighted to fit a certain investment style. For instance, there is a range of value ETFs which select companies based on combinations of price/earnings, price/book, price/cash flow ratios, dividend yield, etc.
As we have seen with equal weighting, ETFs that are weighted other than by market cap tend to have a higher portfolio turnover (since they have to buy and sell holdings as prices fluctuate). This results in increased transaction costs and lower tax efficiency; both generally apply to fundamentally weighted ETFs as well.
Actively managed ETFs
Actively managed ETFs have been around since 2008 and have so far not proved very popular with investors. These ETFs, instead of tracking an index, use a manager to select the securities to be included in the fund.
Actively managed ETFs present similar issues as traditional actively managed mutual funds… the expense ratio and transaction costs are higher, and tax liabilities are higher.
Therefore, the manager has to add up enough value to make up for this. Now, as we can see with most mutual funds, that rarely happens. Since most managers don’t do better than market averages, the benefits of actively managed ETFs may be questionable (at least until we start to see some track record of these funds).
While ETFs were first introduced as passive, low-cost, transparent investment vehicles, today there is also a number of highly complex ETFs. Some of them have proved very popular with traders and experienced investors, but it is essential that you fully understand the risks before investing in these more exotic vehicles.