The saying “never judge a book by its cover” is certainly applicable to a wide range of situations. That includes the business of investing; for advisors and individuals who use ETFs, the old adage can be very relevant, valuable advice. There are now more than 1,300 exchange-traded products now available to U.S. investors, and that number will only climb higher in coming months and years. For the vast majority of those funds, the product name provides a pretty good description of the underlying assets and investment objectives. The S&P 500 SPDR (NYSEARCA:SPY) invests in the stocks of the S&P 500 Index. The Gold SPDR (NYSEARCA:GLD) invests in gold bars [see also 25 Things Every Financial Advisor Should Know About ETFs].
But in some cases the name of an ETF only tells a part of the story, and a look under the hood can reveal that the actual exposure achieved can vary from what investors might be expecting:
1. Total Bond Market ETFs
Over the last several years investors have become increasingly comfortable with the idea of achieving fixed income exposure through ETFs, embracing the efficiencies of the exchange-traded structure. And the most popular bond ETFs tend to be so-called “aggregate” or “total bond market” ETFs that offer broad-based exposure, such as the iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG) and Vanguard’s Total Bond Market ETF (NYSEARCA:BND). Together, those funds have more than $25 billion in aggregate assets, and are among the largest fixed income ETFs in the world [see also Ten Best ETF Performers Over The Last Five Years (Including A Few Surprises)].
AGG and BND are fine products; they offer cheap, liquid, low maintenance exposure to an asset class that belongs at the core of many long-term, buy-and-hold portfolios. But the idea that these products cover the entire bond market is way off the mark. These funds are dominated by the debt of the U.S. government and bonds issued by agencies such as Fannie Mae and Freddie Mac that are essentially backed by Washington (just take a look at AGG’s top ten holdings). In reality, AGG and BND–as well as other ETFs linked to the same underlying index–offer exposure primarily to Treasuries, with a sprinkling of investment grade corporate bonds.
Missing from many “total bond market” ETFs are junk bonds, floating rate debt, international bonds, and a number of other corners of the global fixed income market. The closest thing to a true total bond market ETF out there is the Madrona Global Bond ETF (NYSEARCA:FWDB), an ETF-of-ETFs that includes high yield debt, emerging markets bonds, TIPS, convertible securities, preferred securities, international Treasuries, and a healthy allocation to corporates.
ETFs can be powerful tools for building a well-rounded, complete bond portfolio. But FWDB is really the only ETF that offers total bond market exposure in a single ticker. AGG and BND are good starts, but they require a number of complementary positions if you want true total bond market exposure.
2. Emerging Markets ETFs
Over the last several years, the emerging economies of the world have been the very clear drivers of global GDP growth; with developed markets in North America and Europe stuck in a prolonged slump, developing economies such as China and Brazil have raced furiously ahead. The widening gap in growth prospects has helped many investors to shed their “home country bias” and make heftier allocations to emerging markets in their portfolios. But judging by the asset bases in some ETFs, a lot of investors probably don’t have nearly as much emerging markets exposure as they might think.
By far the two most popular ETFs in the Emerging Markets ETFdb Category are VWO and EEM, which are linked to the MSCI Emerging Markets Index and have aggregate assets of nearly $80 billion. But by many measures, a healthy portion of these funds is actually invested in developed economies–specifically Taiwan and South Korea, which have been allocated to the “developed” bucket for decades by some agencies such as the IMF. South Korea accounts for about 14% of EEM and VWO, while Taiwan has an allocation of about 11%.
That means that a quarter of the most popular emerging markets ETFs is actually invested in advanced economies–at least according to some sources [see also Forget BRIC ETFs: Look To VISTA Nations For Better Opportunities].
Here’s a quick way to decide for yourself; the following table shows four key metrics, per capita gross domestic product, literacy rate, life expectancy, and Human Development Index (HDI) scores:
|Country||Per Capita GDP||Literacy Rate||Life Expectancy||HDI Score|
Here’s the same table with the country names filled in, revealing that South Korea and Taiwan are in many ways more advanced than one of the world’s largest developed markets:
|Country||Per Capita GDP||Literacy Rate||Life Expectancy||HDI Score|
For investors looking for pure-play emerging markets exposure, the GEMS Composite ETF (AGEM) might be worth a closer look; this fund from EGShares excludes the “quasi-developed” economies, and focuses instead on the BRIC bloc and markets such as South Africa, Mexico, Chile, and Indonesia.
3. Small Cap ETFs
Small cap ETFs have become increasingly popular as tools for establishing exposure to international markets, with many advisors believing that smaller companies offer better “pure play” exposure to the local economy. Whereas large cap ETFs include multi-national companies that generate revenues and earnings from around the globe, smaller stocks tend to be more dependent on local consumption patterns [see also Alternatives To The 20 Most Popular ETFs].
A number of international markets now have dedicated small cap ETFs, including Brazil, Russia, India, China, Japan, Germany, Australia, Canada, Taiwan, and South Korea. But a look under the hood of some of these products reveals that the small cap description may be a bit of a misnomer; many of these ETFs have hefty allocations to mid cap stocks.
That isn’t to say that these products don’t offer a very unique risk / return profile relative to large cap counterparts; the discrepancies in historical returns illustrate that the funds in the adjacent table are very different from those that focus on large cap stocks in the same markets. But investors should recognize that in many cases, “small cap” really means “small / mid cap.”
|Ticker||Name||% Small Caps||% Mid Caps|
|BRF||Market Vectors Brazil Small Cap ETF||51.5%||37.9%|
|ECNS||MSCI China Small Cap Index Fund||39.2%||56.4%|
|SCIF||India Small Cap Index ETF||75.6%||23.9%|
|CNDA||IQ Canada Small Cap ETF||28.3%||71.5%|
|GERJ||Market Vectors Germany Small Cap ETF||54.4%||44.4%|
|KROO||IQ Australia Small Cap ETF||20.6%||76.0%|
|SKOR-OLD||IQ South Korea Small Cap ETF||36.7%||53.8%|
|TWON||IQ Taiwan Small Cap ETF||81.2%||15.6%|
|RSXJ||Market Vectors Russia Small Cap ETF||42.2%||36.1%|
|SCJ||MSCI Japan Small Cap Index Fund||22.9%||73.8%|
|Source: Morningstar data|
Disclosure: No positions at time of writing.
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