For ETF Investors, The Details Matter (Part II)

by on January 17, 2011 | ETFs Mentioned:

Last week we highlighted several often-overlooked nuances of popular exchange-traded products, detailing the surprisingly large impact that seemingly minor distinctions can have on a portfolio’s risk/return profile. From the weighting methodology employed by the underlying index to the choice between large caps and small caps for international equity exposure, many details that are often the subject of little consideration can play a big role in determining how an ETF portfolio performs. Below, we highlight five more easy-to-overlook nuances of ETF investing that are often felt in the bottom line [for more ETF insights, sign up for our free ETF newsletter]:

1. Futures-Based vs. Physically-Backed

The introduction of commodity ETFs in recent years serves as an example of the impressive innovation that has become common in the ETF industry. Previously, exposure to natural resource prices was hard to come by for many investors. But the proliferation of exchange-traded commodity products has made achieving exposure to everything from corn to sugar relatively simple [the new and improved ETF Screener features the option to screen commodity ETFs by exposure type].

ETFs may have democratized commodities as an investable asset class, but there have been some growing pains along the way; some investors seemingly expected to achieve exposure to spot prices, while many commodity ETFs employ a futures-based strategy that results in a very different risk/return profile [read Four Strategies For Fighting Contango].

For most commodities, the choice is between futures-based exposure or no exposure at all. But for a handful of precious metals, ETF investors have the option to either gain exposure to spot prices through a physically-backed fund or utilize a futures-based strategy. There are potential advantages and disadvantages to each, and the decision between the two can end up having a material impact on total returns.

The iShares Silver Trust (SLV) was one of the top ETF performers of 2010, adding 82.5% on the year. The PowerShares DB Silver Fund (DBS), which seeks to replicate a futures-based index, lagged behind by about 130 basis points (the 81.2% gain was still pretty impressive). It was a similar story for gold ETFs last year; IAU added 29.5%, while the futures-based UBG and DGL added 28.1% and 27.9%, respectively [see ETFs To Play White Hot Silver].

Physically-backed products avoid any adverse impact of contango, making the better options in many environments. But when markets are backwardated or interest rates are considerably higher than current levels, futures-based options might be expected to deliver a better performance.

2. ETF vs. ETN (More Than Just Credit Risk And Tracking Error)

Most investors are aware of the primary differences between ETFs and ETNs. Exchange-traded notes are debt instruments linked to the performance of an index, meaning that there generally won’t be any tracking error but that investors are exposed to the credit risk of the issuing institution.

But the decision between ETF and ETN can impact a portfolio in other ways, including ramifications for tax liabilities. With the exception of single currency ETNs, exchange-traded notes are treated as prepaid contracts for tax purposes.

Under current IRS regulations, commodity ETNs are taxed as if they were zero-coupon bonds, meaning that investors don’t incur a tax liability until the note is sold or matures. Commodity products that invest in futures contracts, on the other hand, must mark positions to market each year. They’re also required to fill out a Form 1099, a potential administrative headache come tax season [see a good summary of the ETF vs. ETN tax issues].

The distinction between ETNs and ETFs can also be important when investing in MLPs, a sector of the domestic energy market that many have embraced as a source of attractive and relatively stable yields. Distributions are generally treated more favorably under the ETF structure, since payments made by the ETN are subject to taxation at individual income rates (distributions from an ETF may be treated as return of capital). But appreciation of the underlying securities may result in a deferred tax liability within the ETF structure, an adverse development that is avoided within an ETN. As such, the optimal form of exposure depends on both individual tax situations and the breakdown of returns between distributions and capital appreciation [see MLP ETFs: Fact And Fiction].

3. Structure Matters

With more than $90 billion in AUM, the S&P 500 SPDR (SPY) is by far the largest U.S.-listed ETF. And by most accounts, SPY appears to be identical to the iShares S&P 500 Index Fund (IVV); both track the same index and charge an expense ratio of 0.09%. But a closer look shows some subtle differences between the two that can impact the performance of the funds.

SPY is a unit investment trust (UIT), a common structure among the earliest ETFs. UITs must fully replicate their underlying index, and are restricted from lending out securities that make up their portfolio. For investors employing somewhat complex strategies that include options, these restrictions ensure that SPY will replicate the S&P 500 with near-perfect precision, a major advantage for active and sophisticated traders. IVV, on the other hand, is a true ETF that utilizes an open end structure that provides more flexibility. This fund has the capability to lend out stocks to generate additional income, and can use sampling strategies in its portfolio if desired [see A Closer Look At S&P 500 Options].

Another difference relates to the payment of dividends. According to SPY’s prospectus, the ETF pays dividends four times annually, on the last business day of April, July, October, and January. Because SPY is a UIT, the fund cannot reinvest dividends paid by underlying holdings, but rather must hold them in cash until they are scheduled to be distributed to SPY shareholders. So if ExxonMobil, for example, pays a dividend on February 1, SPY would be required to keep that amount in cash until the end of April.

IVV has the ability to reinvest dividends in the interim, which can lead to the iShares ETF performing slightly better than the SPDR in bull markets, and lagging behind slightly in bear markets (in 2010, IVV added 15.1%, while SPY was up 15.0%).

Structural nuances can also impact the risk/return profiles of currency products. The Rydex CurrencyShares are structured as grantor trusts, while the funds from WisdomTree are true actively-managed 1940 Act ETFs. The distinction between the two can impact the tax bill investors ring up, as well as the diversification of the underlying holdings [see Which Euro ETF Is Right For You?].

4. Replication vs. Sampling

Most exchange-traded products are passive in nature, meaning that they seek to replicate the performance of a specified index and don’t try to generate alpha through quantitative analysis or other forms of active management. Many investors assume that replicating an index is an easy task, and that there is a uniform process for accomplishing an investment objective. Theoretically, ETPs that seek to replicate the same index should maintain identical compositions and deliver identical returns.

In reality, however, there is more than one way to skin a cat. Many exchange-traded funds don’t fully replicate the underlying index, holding only a portion of the underlying holdings in an effort to construct a similar investment profile. The following comes from the prospectus for the iShares Barclays Aggregate Bond Fund (AGG):

BFA uses a representative sampling indexing strategy to manage the Fund. “Representative sampling” is an indexing strategy that involves investing in a representative sample of securities that collectively has an investment profile similar to the Underlying Index. The securities selected are expected to have, in aggregate, investment characteristics (based on factors such as market capitalization and industry weightings), fundamental characteristics (such as return variability, duration, maturity or credit ratings and yield) and liquidity measures similar to those of the underlying index.

AGG BND EEM VWO
Number Of Holdings 696 4,746 764 887
2010 Performance 6.3% 5.7% 16.5% 19.4%

AGG and the Vanguard Total Bond Market ETF (BND) both seek to replicate the Barclays Capital U.S. Aggregate Bond Index, a broad-based benchmark of investment grade U.S. bonds. But the funds are clearly not identical; AGG has about 700 individual holdings while BND has more than 4,700. And in 2010, AGG returned about 6.3%–60 basis points or so better than its more broad-based counterpart. It’s a similar story with the two ETFs linked to the MSCI Emerging Markets Index; VWO and EEM. The 2010 performance gap between these products was close to 300 basis points, a surprisingly large delta for two products with identical investment objectives.

There’s no hard and fast rule when it comes to performance; sometimes representative sampling will deliver better results, while others it will be full replication. It’s worth a closer look at the prospectus to see how a potential ETF investment goes about achieving its objective–that detail can have an impact on the risk and return of the fund.

5. Leverage Duration: Daily, Monthly, and Beyond

Most ETF investors understand by now that leveraged products can be extremely risky, subject to big price swings over relatively short periods of time. What some might not consider, however, is that there are actually many different kinds of leveraged ETFs. The most common (and most popular) leveraged products are those that reset on a daily basis, seeking to deliver amplified returns of an underlying index over a single trading session. When held over an extended period of time, the impact of compounding returns can either erode returns to these products, or enhance them–depending on whether markets are trending or oscillating. The leveraged ETFs offered by ProShares and Direxion reset exposure on a daily basis [see Five Facts About Leveraged ETFs Every Investors Should Know].

There are also exchange-traded products go longer between resetting exposure; PowerShares and Deutsche Bank have teamed up on a number of ETPs offering leveraged exposure on a monthly basis, while iPath recently debuted funds that seek to deliver leveraged results over an even longer time period.

Leveraged ETFs that are similar in terms of underlying index and target leverage factor may in fact be very different products. For example, the ProShares Ultra MSCI Emerging Markets (EET) and iPath Long Enhanced MSCI Emerging Markets (EMLB) both offer leveraged exposure to a popular benchmark of emerging market equity performance. But EET resets exposure on a daily basis, whereas EMLB seeks to deliver leveraged results over a much longer timeframe (it’s also worth noting that EMLB is an ETN, which introduces credit risk into the equation).

The frequency with which a leveraged ETF resets exposure may seem like a minor detail, but it can have a huge impact on the risk profile of an exchange-traded product [see Reviewing Three Different Kinds Of Leveraged ETFs].

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Disclosure: No positions at time of writing.