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LIMITED-TIME ONLY - May 2015 ETF Edge Newsletter | ACCESS NOW

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In the world of finance, with innovation comes complexity, and ETFs are no exception to this rule even in light of their unparalleled ease-of-use and cost-efficiency. Given the sheer variety of options available, it’s no wonder that ETFs have found their way into countless portfolios and onto traders’ radar screens. While simplicity has proven to be at the heart of the exchange-traded product structure, there are still a number of nuances that must be taken into consideration before jumping into a position—many are often overlooked, even by experienced investors.

At ETFdb.com, we’ve long been proponents of “Looking Under the Hood,” that is to say, doing your research and making sure that you thoroughly understand the objective, risks, and quirks associated with an ETF before logging into your brokerage account to place a limit order. Some of our most popular educational pieces that dive deeper into examples covering the often overlooked nuances associated with certain funds include:

Below, we’re expanding upon the theme of “digging deeper” and uncovering three peculiar cases where the so-called fine print reveals some surprising quirks about ETFs that you may be considering or already holding in your own portfolio.

What Is My ETF’s P/E Ratio?

Analyzing Data on a computer

The price-to-earnings ratio is among the most popular valuation metrics out there. If you’re an ETF investor, it’s safe to say that you’ve at least referenced the P/E ratio when researching and comparing funds, but have you considered the calculations behind an ETF’s pricing multiple? Let’s consider the iShares lineup for this example. Suppose you’re thinking about making an investment in the well-known Nasdaq Biotechnology ETF (IBB B+), but you’re worried about buying in at a time when valuations might be too high. Naturally, you’re going to reference the fund’s P/E ratio, compare it to the broader market, and perhaps compare it to that of industry leaders.

In the case of IBB, its P/E ratio stands at a little over 30 at the time of writing (4/22/2015). However, a closer look at the fine print on the iShares website regarding how this valuation metric is calculated serves as an excellent reminder of why it’s important to pay attention to the details. The fine print reads, “Negative earnings are excluded, extraordinary items are excluded, and P/E ratios over 60 are set to 60.” Being aware of this may seem trivial to some, but if you rely on the P/E ratio in your decision making then knowing this nuance is tremendously important. The lesson here is to read the fine print about how certain metrics are calculated, whether it’s P/E ratios or dividend yields, because every issuer has their own way of running the numbers so to say.

A Little Known Fact About UITs

If you don’t know what a UIT is, you might be surprised to learn that some of the most popular ETFs out there are actually structured as UITs. Popular funds like the SPDR S&P 500 (SPY A), QQQ (QQQ B+), and even the Dow Jones Industrial Average ETF (DIA A), are all structured as united investment trusts, UITs for short; for the most part, these instruments are structured and behave like ETFs, except when it comes to certain specifics like creation of units [see also Ten Commandments Of ETF Investing].

There is another quirk that may surprise even those familiar with UITs; all UITs have a mandatory termination date. That is to say, outlined in each of the fund’s prospectus is a termination clause. There is no reason to panic, seeing as how this mandatory closing date is set out over a century from now, 2118 and 2124 for SPY and QQQ, respectively.

While in this instance overlooking the fine print may not lead to severe, or even any, consequences, the lesson remains the same: you should always be aware of the quirks and nuances associated with a product before investing, because there will come a time when the details will matter, and you don’t want to be caught off guard.

Weighting Methodologies

Many ETF investors pay a great deal of attention to certain attributes of their equity exposure, such as the size and location of the underlying firms. Some details, such as the weighting methodology used to determine the weights assigned to the underlying holdings of a fund, can be easy to overlook. But the manner in which weightings are computed by an underlying index can actually have a major impact on the returns of an ETF, suggesting that perhaps more consideration should be afforded to selection of an appropriate methodology.

Consider the following six ETFs that offer exposure to large cap U.S. equities. While the composition of all ETFs isn’t identical, the overlap between these funds is considerable (in some cases, such as RSP / SPY / RWL, the underlying holdings are identical). But the returns generated by these funds in 2010 were very, very different:

ETFWeighting2014 Gain
S&P Equal Weight ETF (RSP A-)Equal14.06%
FTSE RAFI U.S. 1000 (PRF A-)RAFI12.20%
RevenueShares Large Cap ETF (RWL A-)Revenue13.32%
WisdomTree Large Cap Dividend (DLN A)Dividend14.24%
S&P 500 SPDR (SPY A)Market Cap13.46%
WisdomTree Earnings 500 Fund (EPS B+)Earnings13.59%

The delta between RSP and SPY– 60 basis points–demonstrates the importance of weighting methodologies. Both funds invest in the stocks that make up the S&P 500; SPY weights according to market capitalization, while RSP gives an equal weighting to each component. That may seem like a relatively minor distinction, but it translates into a considerable difference in return [see More Thoughts On Equal Weighting].

It should be noted that the above table reflects results for a relatively short period of time. While it isn’t safe to assume that equal weighting will always outperform cap weighting or that earnings-weighting will always be a laggard, it is fair to conclude that the weighting methodology employed can have a significant impact on return.

Style vs. Pure Style

One of the simplest and most common ways to bifurcate stocks involves breaking up the universe of equities into growth companies and value companies. Value companies are those that feature low price-to-earnings and price-to-book ratios and high dividend yields. Growth companies are those that feature higher valuation multiples and lower dividend yields (which are often accompanied by greater prospects for future earnings growth).

This classification system logically leads to investment strategies; some investors believe that value companies perform better in certain environments while growth companies will outperform in others. And of course there are a number of ETFs offering exposure to both value and growth subsets of various market capitalization tiers. Generally, the makeup of these funds will be similar. But the following table might be a bit surprising:

ETFIndex2014 Gain
Rydex S&P 500 Pure Growth ETF (RPG B)S&P 500/Citigroup Pure Growth Index13.89%
iShares S&P 500 Growth Index Fund (IVW A-)S&P 500/Citigroup Growth Index14.64%

This one might leave you scratching your head as well:

ETFIndex2014 Gain
Rydex S&P SmallCap 600 Pure Value ETF (RZV C)S&P SmallCap 600/Citigroup Pure Value Index2.72%
iShares S&P SmallCap 600 Value Index Fund (IJS A) S&P SmallCap 600/Citigroup Value Index7.56%

The funds appear to be quite similar, but the performances for 2014 indicate otherwise. A closer look reveals the discrepancies between a value ETF from iShares and a pure value ETF from Rydex.

IVW has 328 individual holdings. The value counterpart–the S&P SmallCap 600 Value Index Fund (IJS)–has 460. Since both funds offer exposure to subsets of the S&P 600, it doesn’t take a mathematician to conclude that there must be some overlap between the two; some S&P 600 constituents are included in both the growth and value funds.

RPG, on the other hand, has about 107 holdings. The value counterpart (RZV) has about 160. These funds focus on the companies that exhibit strong growth or value characteristics, leaving out those that don’t fall clearly into one category or the other. Again, it seems like a relatively minor distinction. But the impact on returns can clearly be significant.

Of course, it shouldn’t be assumed that the pure style strategies will always outperform the more inclusive style funds. And there are of course diversification benefits to maintaining a larger base of holdings for certain investors. But the point is quite clear; not all growth or value funds are created equal [see Under The Hood Of Value And Growth ETFs].

Small Caps vs. Large Caps

A domestic equity portfolio consisting entirely of the stocks that make up the S&P 500 would likely flunk the “diversification test” of many investors; including mid cap and small cap stocks to your portfolio has the potential to add both diversification and return enhancement benefits. Yet when it comes to international exposure, some investors are content to limit their exposure to the largest of the large companies listed on non-U.S. exchanges.

The most popular international equity ETFs tend to be tilted towards large cap stocks, since the underlying indexes are often cap-weighted benchmarks that consist of the biggest companies in that market. Large cap equity ETFs may be susceptible to a couple of biases. Because the underlying holdings tend to be multi-national companies that generate revenues around the world, the link between the local economy and the performance may be weakened (Coca-Cola, for example, generates the majority of its revenue from outside the U.S.). Second, large cap equity ETFs tend to be tilted towards certain sectors and away from others. Because the largest companies in many economies are banks and oil firms, many large cap international ETFs have considerable exposure to the energy and financial sectors.

In recent years, a number of small cap international ETFs have popped up, and many have drawn significant interest from investors. And, as 2014′s performance shows, the risk/return profile between large caps and small caps can be considerable:

RegionLarge CapSmall Cap
Emerging Markets (EEM A-), (EWX A-)-3.92%-1.87%
Developed Markets (VEA A), (SCZ A)-5.98%-6.07%
China (FXI B-), (HAO B+)11.45%-0.03%
Brazil (EWZ A-), (BRF A-)-15.52%-25.79%
Japan (EWJ A), (SCJ A)-6.22%-2.66%

As the table above indicates, 2014 was a mixed year for both small caps and large caps. Again, this won’t necessarily be the case every year—large caps will outperform small caps in certain environments and vice versa—but the massive return gaps is clear evidence that exposure to international equities is not binary. There are a number of different options, and the difference in return (and risk) between large caps and small caps is significant [use the free ETF screener to find all the small cap options for international exposure].

Hedged vs. Not-Hedged

When considering the primary performance drivers of international equity ETFs, most U.S. investors would focus on the health of the local economy, consumer confidence, unemployment, etc. But for the vast majority of international stock funds, the performance of the relevant country’s currency can also have a big impact on bottom line returns. A declining euro, for example, will erode the value of the stocks that make up many of the funds in the European Equities ETFdb Category, just as a strong yen would give a boost to the members of the Japan Equities ETFdb Category.

Most portfolios maintain considerable exposure to exchange rate movements, whether investors know it or not. And while the impact of currency valuations on stock returns will often be minor, it can be material in certain environments.

Currently, there are a couple ETFs out there that hedge out currency exposure. WisdomTree’s Japan Hedged Equity Fund (DXJ), for example, seeks to provide exposure to equity securities in Japan, while at the same time hedging exposure to fluctuations between the value of the U.S. dollar and and the Japanese yen. Here’s a look at the difference between DXJ and the broad Japanese equity market (as represented by EWJ):

Dxj%20vs%20ewj

The currency hedging isn’t the only difference between EWJ and DXJ, but the stocks that make up these ETFs are generally similar. As shown by the big performance delta last year, the “currency effect” on international equity ETFs can be significant. WisdomTree also offers HEDJ, essentially a currency hedged EAFE ETF that makes an interesting option for investors looking to invest in European stocks but concerned about the potential impact of a troubled euro [see Do You Need A Hedged Equity ETF?].

Front Month vs. Balanced

By now, most investors are well aware that the returns generated by futures-based commodity ETFs aren’t likely to be identical to the change in the spot price of the underlying resource, especially over an extended period of time. The slope of the futures curve can have a major impact on the performance of commodity ETPs; when markets are contangoed these products can lag behind the hypothetical spot return, while a backwardated futures markets can give an extra boost to a futures-based strategy [see Options For Contango Free Commodity ETF Investing].

But for certain commodities, there are differences among the way in which various futures-based products achieve and maintain exposure. Many of the most popular products invest in front-month futures contracts, as these securities tend to exhibit the strongest correlation to spot prices. This strategy will also require the fund to “roll” its holdings regularly in order to avoid taking possession of the underlying assets (which can be a good or a bad thing, depending on the slope of the futures curve). The United States Oil Fund (USO A) is one such product; it invests in front month NYMEX crude oil contracts.

There are options for futures-based commodity exposure that don’t involve investing exclusively in closest-to-expiration contracts. The holdings of the United States 12 Month Oil Fund (USL A+), for example, generally consist of the near month contract to expire and the contracts for the following eleven months, for a total of 12 consecutive months’ contracts. Such a strategy will generally result in a weaker response to changes in spot prices as well as less vulnerability to the impact of the slope of the futures curve.

Both products invest in NYMEX crude oil futures contracts, but the risk/return profiles are far from identical. In 2010, USL added about 6.5% as crude prices spikes. USO actually lost ground in 2010 (less than 1%), as the adverse impact of a contangoed futures markets canceled out the run-up in crude prices. For an investor who maintained exposure to crude oil in 2010, the decision of how to weight futures contract maturities was worth about 700 basis points.

Futures-Based vs. Physically-Backed

The introduction of commodity ETFs 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].

silver dollar coin

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 C+) lost 19.51%. The PowerShares DB Silver Fund (DBS C), which seeks to replicate a futures-based index, lagged behind by more than 200 basis points (losing 21.74%), displaying the difference in return between these two strategies.

Physically-backed products avoid any adverse impact of contango, making them 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.

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 IRS regulations in 2011, 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].

Structure Matters

By most accounts, SPY appears to be identical to the iShares S&P 500 Index Fund (IVV A-); 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?].

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 A+):

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.

ETFNumber of Holdings
AGG3611
BND16452
EEM862
VWO1007

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; BND has nearly five times the holdings of AGG. This often creates a performance delta. It’s a similar story with the two ETFs linked to the MSCI Emerging Markets Index; (VWO A) and (EEM A-).

There’s no hard and fast rule when it comes to performance; sometimes representative sampling will deliver better results, while others 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.

Leverage Duration: Daily, Monthly, and Beyond

wall street physical sign

Most ETF investors understand by now that leveraged products can be extremely risky, as they’re 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 Investor Should Know].

There are also exchange-traded products that 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 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 B) and iPath Long Enhanced MSCI Emerging Markets (EMLB B-) 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].

The Bottom Line

The ETF world offers investors everything from plain-vanilla equity exposure to unique weighting methodologies to put a new spin on an old investment. Be sure to always look under the hood of a fund prior to investing and do not be afraid to explore some of the competing products in the space.

Follow me on Twitter @Sbojinov

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Disclosure: No positions at time of writing.

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