Five Important ETF Lessons (Picture Edition)

by on April 30, 2012 | Updated November 27, 2012 | ETFs Mentioned:

Innovation remains a dominant and exciting theme in the ETF universe, although as with any financial instrument, with growth and evolution also comes increasing complexity and newly discovered nuances. The towering lineup of over 1,400 exchange-traded products is probably intimidating for many investors who are new to industry and aren’t exactly sure where (or how) to start looking for a product that suits their investment objective and risk tolerance [Download 101 ETF Lessons Every Financial Advisor Should Learn].

While there’s certainly no one right way to go about looking for an ETF that fits your needs, it may be helpful to start by considering some of the noteworthy differences across similar products. ETF education is an ongoing process, and as such, there are a number of important lessons to keep in mind, and while some are fairly basic, many of the important ones are often times overlooked.

Below, we highlight five important distinctions to understand when investing in ETFs, complete with visual illustrations of actual performance histories from ETFs:

1. Spot ≠Futures

The Lesson: Some investors assume that ETPs that utilize futures contracts will offer exposure to the underlying asset–for example, that ETFs holding natural gas futures contracts will mimic movements in spot natural gas prices. That simply isn’t true; futures based strategies are often impacted significantly by the slope of the futures curve [see Spot Vs. Futures].

The Proof: The following chart shows performance for the spot VIX, a popular measure of anticipated equity market volatility, compared to VXX, an ETN that replicates the performance of an index comprised of VIX futures:

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2. Currency Impact Matters

The Lesson: Investing in international stocks generally involves a bet on the underlying currency as well. Whether investors realize it or not, an investment in Japanese stocks effectively includes a long position in the yen and a short position in the U.S. dollar. Often times, the impact of currency fluctuations on bottom line returns realized by U.S. investors is significant [see King Dollar ETFdb Portfolio].

The Proof: The chart below shows the performance of two ETFs holding Japanese stocks. While the portfolios are substantially similar, there is one key difference: the WisdomTree Japan Hedged Equity Fund (DXJ) strips out exposure to the Japanese yen, while the iShares MSCI Japan Index Fund (EWJ) leaves that exchange rate risk in. When the yen is climbing versus the greenback, EWJ gets a boost. When the yen is sliding, however, DXJ will tend to outperform EWJ.

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3. Small Cap Difference

The Lesson: When using ETFs to achieve international equity exposure, investors now often have a choice between large cap and small cap stocks. While these two choices may seem very similar–they target the same country–there can be some significant differences in the risk and return profiles realized [see Small Cap ETFdb Portfolio].

The Proof: The following table shows two India ETFs; SCIN holds small cap stocks, while INP is linked to an index comprised of larger companies. Small cap stocks tend to exhibit more volatility on both the up side and down side; though the losses have been more significant over the period shown below, small cap Indian stocks did very well in early 2012 as this market rallied, pulling ahead of their larger counterparts.

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4. Tracking Error, Expenses Matter

The Lesson: Even among ETFs that should be identical–those that track the same index–differences in performance often arise. Expense ratios are one source of these deltas, and tracking error can also contribute to gaps in performance [try our Free ETF Head-To-Head Comparison Tool].

The Proof: Below is a chart comparing Vanguard’s VWO and iShares’ EEM, two ETFs that both seek to replicate the MSCI Emerging Markets Index. The difference in performance since VWO debuted isn’t massive, but it is certainly material: VWO has outperformed by about 500 basis points since March 2005. The explanation lies in large part in the expense ratio difference: VWO charges just 0.20%, while EEM costs 0.67% annually.

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5. Style vs. Pure Style

The Lesson: For investors looking to target value or growth stocks, there are different options available in the ETF universe. Some products cast relatively wide nets, including significant portions of the broader universe. Others are more targeted in nature, selecting only the individual securities that exhibit the strongest value and growth characteristics [see our Pure Value and Pure Growth ETFdb Portfolio].

The Proof: The table below compares two ETFs that offer exposure to very similar baskets of stocks: the iShares S&P MidCap 400 Value Index Fund (IJJ) and the Guggenheim S&P MidCap 400 Pure Value ETF (RFV). The historical performance is pretty interesting; RFV, which holds a much more targeted portfolio, has delivered huge returns in certain environments:

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Disclosure: No positions at time of writing.