Hitchhikers Guide To The ETF Galaxy By Michael Johnston

May 14, 2012 |

At times, it seems as if the number of ETFs available to U.S. investors will soon exceed the number of stars in the sky. That might be overstating things a bit, but the pace of expansion in the ETF industry has truly been impressive over the last several years. With multiple products seemingly debuting every week and very few shutting down (despite countless predictions to the contrary), the size of the ETF lineup has effectively doubled in a relatively short period of time. And there’s no indication that the product development front is going to be slowing down any time soon; issuers continue to file for both innovative and duplicative products, producing a pipeline full of hundreds of funds that could debut at some point in the next several months.

The proliferation of ETFs, ETNs, and other exchange-traded cousins of these vehicles is, in many ways, a very positive development for investors. There are now ETPs for just about every investment objective, ranging from the very broad and very straightforward to the hyper-targeted and rather complex. And many of the more recent additions to the ETF lineup have further “democratized” the business of investing, delivering cheap and easy access to sophisticated strategies that would otherwise be time consuming and expensive to implement.

But the growth spurt for the industry has also made it increasingly difficult to navigate. Moreover, the tremendous variance in level of sophistication and risk tolerance among ETFs can set the stage for confusion and potentially lead to a less-than-ideal experience with ETFs. While ETFs may have initially been designed with long-term buy-and-hold investors in mind, many of the ETFs now on the market are not appropriate for those types of investors–not by a long shot.

In order to get the most out of ETFs, it’s important to acknowledge that the ETF universe is far from homogeneous; the 1,400+ ETPs vary dramatically in terms of risk, complexity, and suitability. Below, we provide an admittedly simplified breakdown of the ETF universe, a framework for determining which ETFs might be appropriate for your investment objectives.

ETF Category #1: Building Blocks

This group includes the types of products that Jack Bogle had in mind when he pioneered index funds decades ago: the broadly-based, cost efficient products that seek to own the market. The members of this group are ETFs that could be at the core of long-term, buy-and-hold portfolios, generally targeting well-known, straightforward stock and bond indexes. Think of the building blocks this way: if you were building a hands-off portfolio for the long-term that included only five funds, you’d focus on the Building Blocks of the ETF universe.

Examples: ETF Building Blocks include broad-based stock and bond funds that cover general asset classes such as mid cap U.S. stocks, investment grade bonds, and emerging markets equities. Many of the largest ETFs fall into this category, offering exposure to a deep, balanced portfolio of individual securities. Specifically, some of the most popular “plain vanilla” ETFs are:

Vanguard Emerging Markets ETF (VWO)
iShares MSCI EAFE Index Fund (EFA)
S&P 500 SPDR (SPY)
Vanguard Total Stock Market ETF (VTI)
Russell 2000 Index Fund (IWM)
Vanguard Total Bond Markets ETF (BND)
Vanguard REIT ETF (VNQ)

There are a number of ETFdb Categories that are dominated by Building Block ETFs, including the All Cap Equities, Total Bond Market, Large Cap Blend, Mid Cap Blend, and Small Cap Blend groupings.

ETF Category #2: Tactical ETF Tools

The second grouping of ETFs, Tactical ETF Tools, can be thought of as products that may be appropriate for slightly more active investors who wish to tilt their portfolios towards or away from certain asset classes on which they maintain strong opinions. Tactical ETF tools are generally more targeted than the broad-based Building Blocks, focusing in on a single sector, country, commodity, or type of fixed income investment [see also 12 High-Yielding Commodities For 2012].

While these Tactical ETF Tools might not make much sense in a long-term, buy-and-hold portfolio, they can be useful for establishing “overweight” positions in segments of the investable universe that might be expected to perform well over the short- to intermediate-term. Think of Tactical ETF Tools as instruments for fine tuning your portfolio based on your interpretation of the current environment. For example, the ETFs in the Financials Equities ETFdb Category can be useful for bulking up your exposure to bank stocks, while ETFs such as the Barclays 20+ Year Treasury Bond Fund (TLT) can be used to extend the duration of a fixed income portfolio.

In the popular “core / satellite” or “core and explore” approach to investing, these Tactical ETF Tools are the more fluid satellite positions that complement larger, more static allocations to the Building Blocks on which a portfolio is built.

Examples: Tactical ETF Tools include products that focus on specific segments of various asset class, such as energy stocks, intermediate term corporate bonds, or natural gas futures.
ETF Category #3: ETF Trading Instruments

There are now hundreds of ETFs and ETNs that are designed for the more active crowd that measures holding periods not in months and years but in days and even hours. Quite simply, many ETPs now on the market are not appropriate for those with long-term objectives and limited ability to monitor and re-balance their holdings. And that’s perfectly fine; this third type of ETF has found a very interested audience among an entirely different type of investor. ETF Trading Instruments have become increasingly popular with more sophisticated, full-time investors who trade very frequently and have high levels of tolerance for risk. The advantages of the exchange-traded structure, it turns out, appeal to a wide range of investors.

Think of these ETF Trading Instruments as very powerful tools–for example, a chainsaw. When used correctly, they can be tremendously effective at amplifying desired risk exposures and capturing returns. But if used incorrectly or by investors who don’t understand exactly how they work, the results can be less-than-ideal. A chainsaw is a great tool for an experienced logger looking to cut down a tree. But when an average Joe uses a chainsaw to cut a loaf of bread, the outcome might not be optimal.

Examples: Most leveraged ETFs can be thought of primarily as trading instruments, though some of the monthly reset products may be useful over a longer time horizon. In addition, ETFs and ETNs focusing on volatility and front-month commodity futures contracts are generally appropriate over a very short time period [see also How The VIX ETN Lost 50% In 48 Hours].
How To Tell The Difference

There’s no surefire way to quickly identify the risk profile of a potential ETF investment, but there are a number of metrics that can deliver insight into which type of fund you might.

But a few tips…

Historical Volatility: It’s useful to consider the historical volatility of an ETF, as this metric often sheds some light on the level of risk involved. The 200-day volatility measure for a leveraged ETF will often be considerably higher than beta products, indicating a significantly higher amount of risk in these products.

    Turnover: The frequency with which a fund trades hands often sheds some light on exactly how investors are using it; generally, a higher frequency of trading accompanies trading instruments while building blocks tend to have considerably lower turnover. For example, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) sees about half of its shares change hands every day–implying an average holding period of about 48 hours. For a fund like the Vanguard Total Stock Market Index (VTI), the turnover is much lower; less than 1% of shares outstanding change hands each session.

Knowing Your Limits

This three pronged framework is by no means perfect; there are certainly a number of ETFs that don’t fall neatly into any of these buckets, and there are exceptions to every rule. But it is hopefully a useful way to approach the rapidly-expanding lineup of exchange-traded products, and understand the very different risk factors that are attributable to different types of ETFs.

The ETF toolkit is filled with a wide range of products, from simple, blunt instruments to sophisticated, turbo-charged mechanisms. It’s important to understand the difference between these products, and acknowledge the limitations that your risk tolerance and knowledge place on your portfolio. For many investors and even financial advisors, it makes sense to stick to the basics and use primarily the Building Blocks of the ETF universe. For others, the Tactical Tools and ETF Trading Instruments will be powerful tools that can unlock new strategies and bring opportunities for significant alpha.

Disclosure: No positions at time of writing.