May 2nd, 2012 by

Misleading ETF’s By Karen DeMasters

April 23, 2012

“Let the buyer beware.” According to Casey Research, that should be the mantra for some exchange-traded funds now on the market that have misleading names that don’t reflect their true makeup.

Casey Research issued a report that names funds it says are particularly misleading or require careful scrutiny before investing in it. The report, written by senior analyst Vedran Vuk, doesn’t necessarily conclude that the funds are bad and aren’t worth investing in; only that investors should read the fine print because a particular fund might not be what they think it is.

Topping the list is the ProShares Hedge Replication (HDG) fund, which seems like it should be geared toward replicating hedge fund strategies and performance. But the ETF actually holds 82% of its assets in three-month U.S. Treasury Bills, which Vuk notes probably isn’t what an investor had in mind when putting money into it.

Similarly misleading are certain ETFs with geographic areas as part of the name, a list that includes the iShares MSCI Emerging Markets Eastern Europe Index Fund (ESR), iShares MSCI Pacific ex-Japan (EPP) fund, Vanguard MSCI Pacific ETF (VPL), and PowerShares FTSE RAFI Asia Pacific ex-Japan Portfolio (PAF).

The ESR fund actually has three-quarters of its assets allocated to Russian companies and little in the rest of Eastern Europe. The Asian funds have a similar problem with too much concentration and not enough diversity among holdings.

EPP, for example, has 65% of its holdings in Australia and a smattering of Hong Kong and Singapore. And PAF has a huge stake in South Korea (36%). Both funds bill themselves as “ex-Japan,” but it can be argued neither one provides broad exposure across the wider region. Meanwhile, VPL has a 62% allocation to Japan and 25% to Australia, which considerably narrows its definition of the Pacific region.

“Though these funds might be good Australia, Hong Kong and Singapore ETFs, they just don’t come close to capturing the whole geographic area,” Doug Casey, chairman of his namesake research outfit.

A similar problem arises with the PIMCO Build America Bond Strategy ETF (BABZ), which seems to represent investments in a wide range of states. Instead, nearly 70% of the assets are invested in bonds from four states––California, New York, Illinois and New Jersey––that have budget problems and issue more bonds than most.

Casey cautions that upon closer examination, most bond funds with a generalized name hold mostly bonds from California and New York.

According to the Casey report, another misleading fund name belongs to the United States Oil Fund (USO), which was designed to follow WTI crude oil prices. Instead, investors can find their assets going in the opposite direction from crude oil prices because the fund does not actually hold any oil. Instead, it maintains positions on the futures markets.

“To really understand how the fund works, one has to understand the shape of the crude-oil forward curve, which defeats the original point of making the ETF a simple commodity investment,” Casey says.

Similarly, the United States Natural Gas Fund (UNG) and some other ETFs that would seem to be commodities are actually holding futures contracts. These examples are the poster boys for a much wider problem with these types of ETFs, Casey warns.

Even funds that hold the actual commodity that is named, such as the SPDR Gold Shares Trust (GLD), can be much more complicated than the average investor wants to deal with. In his report, Vuk notes that even though GLD has a large vault where gold is stored, exchanging one’s paper shares for gold requires special permission that can be transacted only through a broker or market maker.

Furthermore, GLD is structured as a grantor trust, which differs from most other ETFs. In GLD’s case, investors pay taxes on the underlying asset––i.e. gold. But gold is considered a collectible and is taxed at a high long-term rate of 28%, versus the 15% capital gains rate for most long-term ETF holdings.

“Just because these funds are misleading doesn’t necessarily mean that they’re all bad,” Casey says. “The key point is that you have to first understand an investment before you can decide whether to make it part of your portfolio.”

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