Investors should never be fooled into trading an exchange traded fund based solely on its moniker, lest they discover some nasty surprises down the line. While their moniker may give a sense of the what the investment covers, individuals will still need to do some homework on their part before diving in.
If properly understood, misleading ETFs can be effectively utilized like any other fund, writes Vedran Vuk, Senior Analyst at Casey Research, in a special report. Like the saying goes, "don't judge a book by its cover."
With the proper due diligence, any investor can make an informed decision on an ETF and its place in one's investment portfolio.
For instance, Vuk lists a few ETFs that don't appear to act how they initially seem:
- ProShares Hedge Replication ETF (HDG). The fund tries to provide hedge fund strategies to the average retail investor. However, HDG does not actually hold any hedge funds. Instead, it tries to replicate hedge funds by copying what they hold. Consequently, the ETF currently has over 80% of its portfolio in short-term Treasury bonds.
- Market Vectors Junior Gold Miners ETF (GDXJ). Most investors would assume junior to mean "small," but GDXJ's top holdings each have a market capitalization of over $1 billion. This fund is probably better classified as a mid- to small-cap gold miner ETF.
- U.S. Oil Fund ETF (USO). While USO tries to reflect the movement in oil prices, the fund may greatly diverge from crude oil prices, which is largely due to "contango" in the futures market - as an ETF replaces a futures contract that is about to mature, the later-dated contract may be more expensive than the contract about to be rolled, which would cause the ETF to incur a loss.
- U.S. Natural Gas Fund ETF (UNG). Like USO, UNG holds futures contracts to mimic price movements in natural gas. Consequently, the effects of contango are also a major impediment to the fund's performance.
- SPDR Gold Shares ETF (GLD). While an investor does get direct exposure to physical gold bullion, individuals would have to exchange 100,000 shares of GLD to get 10,000 ounces of gold. Additionally, since GLD holds physical bullion, investors may be taxed at the 28% collectible rate come tax season.
- PIMCO Build America Bond Strategy Fund ETF (BABZ). BABZ holdings is better defined as "long maturities and troubled states." The fund only includes bonds from 11 states, with a heavier weighting in California, New York and Illinois, and an average maturity of 27.6 years.
- iShares MSCI Emerging Markets Eastern Europe Index Fund ETF (ESR). By Eastern Europe, the fund weights over 75% in Russia and over 15% in Poland. Additionally, Gazprom accounts for 20% of the overall portfolio.
- iShares MSCI Pacific Ex-Japan Index Fund ETF (EPP), Vanguard Pacific ETF (VPL) and Powershares FTSE RAFI Asia Pacific ex-Japan Portfolio ETF (PAF). Different providers have varying definitions on "Asia Pacific." All three of these funds have large weightings in Australia, Hong Kong and Singapore. Additionally, VPL includes over 50% of its assets in Japan.
- Market Vectors Investment Grade Floating Rate ETF (FLTR). The financial sector makes up 91.4% of the fund's portfolio. Unless you are satisfied with a large financial sector allocation, FLTR may not be the best portfolio diversifier.
Max Chen contributed to this article.
Full disclosure: Tom Lydon's clients own GLD.