When conducting your survey of ETFs, read the prospectus and information available 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 you are buying exactly before investing.
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 are a variety of index ETFs for investors to choose from.
Sector / Industry ETF
These ETFs represent a specific sector (industry), e.g. technology, energy, materials, industries, healthcare, finance, utilities, consumer staples, etc. They track the collective performance of this industry. As with most other ETF types, there are US as well as foreign and global ETFs.
These ETFs are defined by the market value of the individual shares within. Eg. Large cap companies (generally over $ 10 billion in market size), medium-sized companies ($ 2 car to $ 10 car), small-cap ($ 300 thousand to $ 2 car), microcapsules ($ 50 thousand – $ 300 thousand).
Country Specific ETF
These ETFs track the effectiveness of markets in an individual country or, in some cases, an entire region (eg Eastern Europe, Eurozone, Latin America, Asia, etc.). There are several international ETFs listed on both US and foreign stock exchanges.
Commodity ETFs track the effectiveness of a commodity (e.g., oil, natural gas, gold, silver) or a basket of commodities (such as precious metals, precious metals, agricultural commodities, etc.).
A currency ETF allows investors to track developments in various currencies around the world, such as the US dollar, the Japanese yen, the British pound, the euro, etc. (It is important to note that although FOREX is essentially a 24 hour market , currency exchange funds have a disadvantage of being available only for trading during the trading hours of the stock market.)
ETF with fixed income
ETFs that track corporate or government bonds.
ETFs by weighting model
Most ETFs (and indices) are weighted by market capitalization, which means that larger companies have much greater representation in the index and more influence on price movement. The majority of the index’s capitalization is concentrated in the top holdings.
A few providers now offer equally weighted ETFs (index and sector), which provide a broader representation of the companies within the index. Each stock is initially assigned an equal weight so you can spread your risk equally between all stocks in the index. It also means you get more exposure to smaller and medium-sized companies, which often outperform the larger caps.
The other problem with market weight is that stocks that have quickly risen in price and have been overvalued will carry a higher weight in the index. (The higher a stock’s valuation, the higher its market value.) Equilibrium ETFs avoid the overweight of equities that trade above their fair value.
To maintain equal weighting, an even weighted ETF requires periodic rebalancing (generally performed quarterly).
This means that such ETFs (compared to traditional index ETFs) usually have higher expense ratios as well as higher bid-ask spreads (as they tend to be more thinly traded). As rebalancing involves the sale of shares that have increased most, this results in higher transaction fees but also higher tax liability (due to capital gains realized).
While even 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 should carefully examine whether these ETFs benefit their portfolio.
While traditional indices are market weighted, basic 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 particular investment mode. For example, there are a number of value ETFs that choose companies based on combinations of price / earnings, price / book, price / cash flow ratio, dividend yield, and so on.
As we have seen with the same weighting, ETFs that are weighted apart from market value tend to have higher portfolio turnover (since they have to buy and sell stocks as prices fluctuate). This results in increased transaction costs and lower tax efficiency; both generally apply to basic weighted ETFs.
Actively managed ETFs
Active managed ETFs have been around since 2008 and so far have not proved very popular with investors. These ETFs, instead of tracking an index, use a manager to select the securities to include in the fund.
Actively managed ETFs present similar problems to traditional actively managed mutual funds … the cost ratio and transaction costs are higher and tax liabilities are higher.
Therefore, the manager must add enough value to compensate for this. As we see with most mutual funds, this rarely happens. Since most managers do not outperform market averages, the benefits of actively managed ETFs can be questionable (at least until we start to see some results from these funds).
While ETFs were first introduced as passive, transparent investment vehicles at low cost, today there are also a number of very complex ETFs. Some of them have proven to be very popular with traders and experienced investors, but it is important that you fully understand the risk before investing in these more exotic vehicles.