Whatever your investment interests, you are likely to find ETF types to match them. ETF sponsors, eager to meet investor demand for more ways to diversify their portfolios with passively managed products, have expanded the universe of funds to encompass nearly all asset classes and a range of index categories. The roster includes ETFs linked to:
• Broad-based traditional indexes that track hundreds or even thousands of securities.
• Narrowly focused indexes, such as those that track fewer securities or those in a particular sector.
• Nontraditional indexes, sometimes described as smart beta, strategy, or alternatively weighted indexes.
The equity standard
The original ETF — an equity fund linked to an iconic market-capitalization index—ushered in the new era of index-based investing. Today most ETFs are still equity funds. One reason may be the varied the equity market can be subdivided by size, style, sector, and theme to meet a range of investment objectives. Their popularity may also result from stocks’ being a well-understood asset class, with a long-term track record of providing strong returns despite the risks they pose.
Fixed income ETFs are linked to indexes that track a broad variety of bonds different issuers and with different terms and risk profiles. Mortgage- and asset-backed products, leveraged loans, preferred stock, and credit default swaps, among others, are included in this category. Unlike individual bonds, however, ETFs don’t promise a fixed rate of return or return of principal – two of the primary reasons appeal to buy-and-hold investors.
ETFs linked to commodity indexes offer access to the markets where physical and financial commodities are traded. Most of these funds — with the exception of those that are backed by gold bullion or other precious metals – buy futures contracts on the index they track. This means that the market value of the ETF reflects the changing value of the underlying contracts, not simply the market prices of the commodities.
Investors are attracted to these ETFs, whose returns are not correlated to the return on stocks and bonds, for the risk protection they can provide. However, since the underlying futures contracts expire on a regular schedule, the recurring cost of replacing them can threaten investment principal over time.
Most indexes underlying ETFs continue to be market-capitalization-weighted. In these indexes, the companies with the largest market values — calculated by multiplying the market price of the security by the number of outstanding shares — exert a greater weight on the changing value of the index than companies with lower market values.
The assumption is that market-cap weighting provides the most accurate reflection of the market the index tracks as well as of the overall economy. One limitation of this approach, though, is that, in some market environments, a few big companies can be doing very well while the rest are lagging. A market-cap index would miss that indicator and might provide a misleading view of the state of the economy. In contrast, if the same components had been weighted equally, the index value provided might be more reflective of market reality.
Some ETFs are structured not simply to achieve a market return, sometimes called the market beta, but a return that’s different from beta in some particular way that could strengthen the overall performance of your portfolio. This objective is often described as smart beta.
So, for example, if an ETF sponsor aims to provide a return that features increased dividend income, less volatility, or greater risk control than the market offers, it needs an underlying index that’s been designed specifically to meet that objective. Like traditional indexes, these alternatively weighted indexes follow a set of rules, known as the index methodology, that determines which components to include, how to choose them, and how to calculate the index value.
For example, if the objective is increased dividend income, the ETF would license an index composed of the highest dividend-paying stocks included in a particular market index. When the stock market is strong, companies that pay dividends tend to increase them. And even if the market is flagging, many companies try to maintain dividend levels, at least in part to demonstrate their financial health. As a result, an index tracking these companies, if well designed, can meet its objective.
In contrast, an alternatively weighted index that tracks low-volatility stocks will normally provide a return that reflects the way those stocks behave in different market conditions. During an upturn, the index will rise but probably not as much as a market-cap index. But in a downturn, the low-volatility index will tend to lose less value, providing protection. Of course, an ETF that tracks an alternatively weighted index — and there are many varieties in addition to those described here — may pose greater risks and higher costs than a plain vanilla index. But you may decide that the added diversification more than compensates for the risk and expense.
As you Choose among ETFs, you will want the answers to certain questions, including:
- What’s the ETF’s underlying index? The index is the dominant influence on an ETF’s performance. You need to understand the index’s objective, how it’s weighted, and the securities it includes.
- What does it offer? You’ll want to be clear about What the ETF has the potential to contribute to your portfolio and whether it suits your investment strategy.
- What’s the cost? Price isn’t the only factor, but it is relevant in choosing among ETFs. Look at the expense ratio and transaction costs, which you can estimate using the turnover rate.
- What are the risks? In addition to market risk, which applies to all ETFs, you should understand the types of risks each ETF you’re considering poses. The more complex the strategy, the greater the potential risk.
What ETF Types Should You Buy and Why? Inna Rosputnia
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