Ten ETFs Every Advisor Should Know (But Most Have Never Heard Of): Part II

by on September 16, 2010 | ETFs Mentioned:

As the ETF industry has grown rapidly in recent years, many of the best-known tickers have attracted the majority of new assets. While these “super-tickers” include the building blocks of many buy-and-hold portfolios, some funds receiving considerably less attention present intriguing options as well. Below, we profile five more ETFs that are generally flying under the radar of financial advisors, but could be valuable tools when constructing client portfolios [see Part I of the list]:

5. EG Shares Emerging Markets Consumer ETF (ECON)

This ETF was launched less than a week ago, so it’s completely excusable if you’ve never considered ECON for emerging markets exposure. As mentioned in Part I, the emerging markets ETFs utilized most commonly by advisors for client accounts seek to replicate broad-based, market-cap weighted indexes. While these products (such as EEM and VWO) are by no means flawed, the methodology behind the underlying index does expose them to some biases.

Because the largest companies in emerging markets tend to be oil companies and banks, the emerging markets exposure maintained by most investors is tilted heavily towards the energy and financial sectors, while consumer goods and services firms are underweighted. Given the investment thesis behind an investment in emerging markets–an expanding and increasingly wealthy middle class–that’s a potentially important oversight. Enter ECON, the only ETF that focuses exclusively on the consumer sector of emerging markets. This fund probably shouldn’t replace EEM or VWO in a portfolio, but can serve as a nice complement to those funds in order to provide more well rounded sector exposure.

For advisors looking to establish truly balanced exposure to emerging markets, EEM and VWO are great starting points, but not the final answer. ECON can help to offset the biases those funds introduce to a portfolio [sign up for our free ETF newsletter].

4. WisdomTree Emerging Markets Local Debt Fund (ELD)

The next fund on this list is also relatively new and focuses on emerging markets. But instead of equities, ELD offers exposure to fixed income securities from emerging markets issuers. With interest rates in much of the developed world hovering near record lows, many advisors in the U.S. have been forced to get creative in their search for securities that can deliver a reasonable yield to investors who rely on their portfolios for current income. While junk bonds are a tempting option, the risk profile of those securities may be wholly inappropriate for a large chunk of the investing public. Emerging market debt is another intriguing option, generally offering higher yields than comparable securities issued in the U.S. And as the economic fundamentals in developing economies have continued to strengthen, many investors have become more comfortable with the amount of risk offered by this asset class.

There are several ETFs in the Emerging Markets Bonds ETFdb Category, but the most popular funds focus on dollar-denominated debt. While that feature may be desirable for some investors, the focus on local currencies maintained by ELD has its own advantages. First off, debt issued in local currencies may carry lower risk, since issues don’t face exchange rate risk and don’t have to worry about securing U.S. currency to repay. But perhaps more importantly, ELD offers a way to diversify exposure to the greenback, allowing investors to potentially capitalize on appreciation in emerging market currencies [read Emerging Market ETF Boom Continues].

As such, this fund combines emerging markets interest rates and emerging markets currency exposure, allowing investors to access an asset class that may offer more attractive yields than domestic fixed income securities while also featuring diversification benefits when added to traditional stock-and-bond portfolios.

Van Eck also offers an emerging markets debt fund focusing on securities issued in the local currency; the Market Vectors Emerging Markets Local Currency Bond ETF (EMLC) offers relatively similar exposure as ELD.

3. Claymore Corporate Bond BulletShares

This spot on the list actually represents a suite of seven corporate bond ETFs from Claymore that offer exposure to various segments of the maturity continuum. In some ways, the experience of investing in a bond ETF varies markedly from the experience of investing in a single bond. Funds like AGG or LQD are designed to operate indefinitely, regularly selling debt that no longer meets its investment criteria and using proceeds to purchase new issues. Investors in most fixed income ETFs will never receive a repayment of principal the way an investor in an individual bond would.

As the investment community has become more comfortable with the concept of achieving fixed income exposure through the ETF wrapper, impressive innovation has brought more and more granularity to this space. One important development has come from Claymore, which introduced a line of corporate bond ETFs focusing on debt issues maturing in certain calendar years. Because the BulletShares–which range from 2011 to 2017–have targeted end dates, these funds won’t be around forever. The BulletShares 2015 Corporate Bond ETF (BSCF), for example, invests in corporate debt issues maturing in 2015. As that point approaches, the holdings of BSCF will gradually convert to cash, and a distribution resembling a principal repayment will be made around the end of the year.

The BulletShares products from Claymore offer an experience of holding an individual bond to maturity, while also providing immediate diversification across a basket of holdings. While some investors may prefer to stick with LQD for corporate bond exposure, the BulletShares funds could be tremendously valuable for liability-based investors, whether it be a billion dollar institutional account or a family planning to send a child to college at a specific point in the future. Moreover, these funds have obvious applications for creating fixed income ladders or filling holes in maturity exposure [also read Beyond LQD: Exploring Corporate Bond ETF Options].

2. United States Commodity Index Fund (USCI)

Over the last several years, investors interest in commodities has surged, thanks in part to the introduction of ETFs offering exposure to nearly every corner of this asset class. But in addition to attracting billions of dollars, commodity ETFs have attracted a fair amount of negative press stemming from the manner in which they provide exposure to natural resource prices. Because most exchange-traded commodity products invest in futures contracts, the returns to these funds depend not only on the change in spot price for the relevant commodity, but also on the slope of the futures curve for the underlying commodity.

Because most futures markets are contangoed–reflecting both market expectations and storage costs–most commodity products lag behind the hypothetical return on a spot investment. So while commodity funds may add diversification benefits to traditional stock-and-bond portfolios, the headwinds from contango serve as a substantial hurdle to positive returns over the long haul.

Enter USCI, a new addition to the ETF lineup that features a twist on traditional commodity funds. Each month, USCI selects 14 commodity futures contracts from a pool of 27 potential constituents. The quantitative methodology used to select these contracts includes picking out the seven contracts with the highest percentage price difference between the closest-to-expire contracts and the next-closest-to-expire contracts (in other words, those showing the steepest backwardation or most mild contango). That doesn’t quite make USCI the “contango killer” that some have made it out to be, but it helps the fund to steer clear of markets where the steep slope of the futures curve could eat into returns [see Closer Look At The "Contango Killer"].

For advisors looking to establish a minor position in natural resources as a way to smooth overall portfolio volatility, there are many ways to skin the commodity cat. The strategy implemented by USCI is certainly unique, and has an impressive track record relative to more popular approaches. If it’s commodity exposure you seek, USCI is certainly worth a closer look.

1. Claymore/BNY Mellon Frontier Markets ETF (FRN)

With the developed economies of the world struggling to gain traction and deliver meaningful growth rates, investors have become more comfortable with emerging markets exposure in their portfolios. But few have gone beyond emerging markets to consider equities traded in countries that fall into the third tier of most classification systems. Frontier markets include countries such as Chile, Colombia, Egypt, and Kazakhstan–markets that are significantly less developed than the BRIC bloc or other countries that have reached “emerging” status.

Frontier markets are, of course, very risky investments. The lack of transparency, potentially unstable geopolitical environments, and other risk factors make equities of frontier countries extremely volatile. But there is also significant return potential in this corner of the market, as many of the world’s fastest-growing economies fall into frontier status. An equity portfolio comprised of VTI, EEM, and EFA covers much of the investable universe, but leaves out the markets with perhaps the most meaningful long-term growth potential.

Again, FRN probably isn’t a substitute for emerging markets ETFs, and may not be appropriate for relatively risk averse clients. But for those with a long time horizon and willingness to take on short-term volatility in exchange for long-term return potential, FRN is an interesting option [see A Closer Look At Frontier Market ETFs].

[For more ETF analysis consider trying out a free seven day trial of ETFdb Pro.]

Disclosure: No positions at time of writing.