Don't Judge an ETF by Its Cover: Five Deceptive Funds

by: IndexUniverse

ETFs are touted for their transparency, but you can't judge an ETF by its cover. Here are five ETFs where looks (and names) may be deceiving.

iShares MSCI Pacific ex-Japan (NYSEARCA:EPP)

Want to invest in the raging "Asian tiger" economy? What better way than with the iShares MSCI Pacific ex-Japan ETF (EPP)? EPP is the world's largest "Pacific ex-Japan" ETF, with over $4.5 billion in assets, and many people use it to gain exposure to the raging Asian economy.

The trouble is, there's not much Asia in the fund.

As of September 30, 65.4% of the fund was in Australian stocks, with a further 1.5% in New Zealand. Only one-third of the fund was in what most of us consider Asia: 20.9% in Hong Kong and 11.3% in Singapore.

It's not BGI's fault; the majority of the developed market cap in the Pacific region ex-Japan is in Australia. But my guess is that many investors looking for "Pacific ex-Japan" exposure are really looking for Asian stocks, and might be better served by something like the SPDR S&P Emerging Asia Pacific ETF (NYSEARCA:GMF).

Which of these two country-weighting schedules better fits your notion of Asia?

click to enlarge

SPDR S&P Emerging Europe (NYSEARCA:GUR)

Is Russia part of the "new Europe?" It's not making any plans to join the European Union, and seems politically committed to remaining independent from Europe.

And yet, more than half of the S&P Emerging Europe (GUR) ETF is focused on Russia. As of September 30, the fund had a 58% weight in Russia, compared with 13.5% in Poland, 12.6% in Turkey, 7% in Hungary and 5% in the Czech Republic. Missing entirely are Poland, the fast-growing Baltic states like Finland and Estonia, and places like Austria, Croatia and Bulgaria.

Those trends are emphasized by the huge weights given two large Russia energy companies: 21.7% of the fund is in Gazprom, the natural gas giant, and 10.5% in Lukoil.

PowerShares Value Line Timeliness Select Portfolio (PIV)

The easy thing to pick on about the PowerShares Value Line Timeliness Select Portfolio (PIV) is the "Timeliness." Since its launch in December 2005, the fund has badly lagged the S&P 500, delivering 9.51% annualized gains vs. 13.04% for the index (although it has done very well over the past year).

But really, it's still too soon to say if the Timeliness strategy works. My quibble, instead, is with Value Line. Maybe it shouldn't bother me that a "Value Line" portfolio actually has a strong growth tilt, but I worry that investors may buy the fund thinking that they are getting a low volatility, value-screened take on the market. Instead, PIV's fund P/E ratio is 23.5, compared with just 16 for the S&P 500. Its book value of 4.3 also ranks high against the S&P 500's 2.8.

Renaming it the Value Line Growth-Oriented Portfolio would solve the confusion.

PowerShares Nasdaq-100 QQQ (QQQQ)

I've pointed this out time and again, but the Nasdaq-100 is a flawed index. First, many people take it as a proxy for "technology," which it is not: only 65% of the fund is devoted to technology, with the rest tied up in healthcare, consumer discretionary and more.

But more importantly, the index's unusual weighting methodology — somewhere between market cap weighting and price weighting — means that the weights assigned different components are entirely out of whack. For instance, Microsoft (NASDAQ:MSFT) is twice as large a company as Apple (NASDAQ:AAPL) ($346 billion vs. $164 billion), but Apple has twice the weight of Microsoft in the index (12.3% vs. 6.5%). The fund is also very concentrated in its largest holdings, with 46% of the fund in the top 10 holdings.

The NYSE Arca Tech 100 (NXT) offers a slightly more diversified fund — its top 10 holdings only account for 25% of the fund — but it too uses a price-weighting mechanism. The First Trust Nasdaq-100 Equal Weight ETF (NASDAQ:QQEW) offers a third and interesting alternative.

The ProShares Funds

I love the ProShares ETFs. The ProShares Short and UltraShort ETFs are the only sensible way to short the market, as they offer both liquidity and interest income, and make a tough task (shorting the market) incredibly easy. Even the Ultra (long) ETFs are useful, providing leverage to the markets.

But despite clear disclosures in the prospectus, I still don't think most investors understand the issue of compounding. The ProShares Ultra funds, for instance, promise to deliver 200% of the daily return of their benchmark indexes. But that does not mean over the long haul that they will deliver 200% of the long-term returns of the benchmarks. Thanks to compounding, the math simply doesn't work out that way.

Look at the 1-year chart for the Ultra QQQ ProShares (NYSEARCA:QLD) against the Nasdaq-100 ETF (QQQQ). Until September, those funds had delivered almost identical returns ... despite QLD's efforts to double the daily return of QQQQ. In fact, during the spring, QQQQ was actually outperforming QLD. Recently, it has made up the gap, but the point remains: you can't count on these funds to deliver 200% of the long-term returns. The ProShares are great funds, and the Short and UltraShort funds are unmatched; but you have to know what you're buying.

Written by Matthew Hougan