Ten ETFs Every Advisor Should Know (But Most Have Never Heard Of)
As the ETF industry has expanded at a breakneck pace in recent years, keeping track of all the products out there has become no easy task. There are now well more than 1,000 exchange-traded products included in the ETF Screener, and many of those have hit the market in the last two to three years.
As ETFs have attracted billions of dollars in cash inflows, it has primarily been the well-established, plain vanilla products that have demonstrated the most impressive growth. Part of that is no doubt because many of the new funds launched in recent years have been targeted in on very specific corners of the investable universe or utilized advanced screening methodologies to select individual holdings, making them useless to investors with a long-term focus. But some of the more recent additions to the ETF lineup include products that should be considered as “building blocks” of long-term, buy-and-hold portfolios [see The Complete List Of The Cheapest ETFs].
Below, we profile ten ETFs that should be on the radar screen of every financial advisor out there, but that most money managers have probably never heard of. These ETFs aren’t necessarily “buys” in the current environment, and some of them may be completely inappropriate for certain clients and return objectives. But the unique exposure offered by these funds can’t be found anywhere else, and could be valuable additions to any advisor’s toolkit:
10. SPDR Barclays Aggregate Bond ETF (LAG)
Most investors looking for one-stop exposure to U.S. bond markets gravitate towards either the iShares Barclays Aggregate Bond Fund (AGG) or Vanguard’s Total Bond Market ETF (BND). Both of these funds track the Barclays Capital U.S. Aggregate Bond Index, a broad-based benchmark that includes Treasuries, investment grade corporate debt, and mortgage-backed securities.
LAG tracks that same benchmark, and does so at a cost (0.1345%) that is less than both of the more popular products from iShares (0.24%) and Vanguard (0.14%). LAG has total assets of about $225 million–or about 1% of the aggregate assets in AGG and BND–indicating that a lot of investors are perhaps paying more than they should for the fixed income portion of their portfolios.
Until recently, SCHB held the title of cheapest ETF on the market (it now shares that distinction with VOO), but hasn’t exactly been overwhelmed by cost-conscious advisors looking to minimize their clients’ expenses. SCHB, which tracks the broad-based Dow Jones U.S. Broad Stock Market Index, includes about 1,600 individual securities, making it an extremely cost-efficient tool for gaining exposure to domestic equities of all size.
Consider the effective expense ratios of some hypothetical alternatives for diversified domestic equity exposure:
- Equal weightings to the S&P 500 SPDR (SPY, expense ratio of 0.09%), S&P MidCap SPDR (MDY, 0.25%) and S&P SmallCap 600 Index Fund (0.20%).
- Russell 3000 Index Fund (IWV, 0.21%)
These two strategies feature expense ratios of 18 basis points and 21 basis points, respectively, or more than three times the fees charged by SCHB. On a $1 million position, that translates into only about $1,500 annually, but over a long time horizon the horrors of compounding costs can really add up. Assuming that all three positions (SCHB, and the two alternatives highlighted) returned 10% pre-expenses annually over 30 years, the difference in growth of a $1 million position would be more than $500,000.
SCHB has assets of less than $300 million, again indicating that far too few advisors out there are taking advantage of the low cost ETF options out there–with the end result that their clients are paying too much.
8. PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB)
With interest rates near record lows and no sign of an increase insight, many advisors have begun to seek out non-traditional sources of yield for client portfolios. For many, this search has led to junk bonds ETFs, some of which offer yields that are pushing double digits. Of the three ETFs in the High Yield Bonds ETFdb Category, JNK and HYG receive the majority of the attention and assets, while PHB is generally overlooked.
But a closer look at the methodologies behind some popular junk bond ETFs uncovers some potential concerns. Market value weighted indexes tend to give the largest allocations to the biggest debt issues, meaning that investors maintain more exposure to those companies with the most significant debt burdens. While that can translate into attractive yields, it also translates into considerable risk.
Enter PHB, a junk bond ETF linked to a fundamental index that determines components and allocations based on four fundamental factors: book value of assets, gross sales, gross dividends, and cash flow. As such, the underlying index is likely to exhibit a bias towards companies that have strong cash flows (read: greater ability to repay debt).
Along with this reduced risk comes lower expected yields, meaning that on the risk/return spectrum PHB falls somewhere in between LQD and JNK. For those advisors out there looking to fill in the gaps in the fixed income spectrum, PHB can be a valuable addition to a portfolio [see PHB: A Different Kind Of Junk Bond ETF].
7. IQ CPI Inflation Hedged ETF (CPI)
Although recent CPI reports seem to indicate that deflation is a more immediate concern for the U.S. economy, the consensus opinion is that somewhere down the road the massive capital injections used to fight off a recession in recent years will result in significant inflationary pressures.
To combat inflation, most advisors have stocked up on TIPS; the seven ETFs in the Inflation-Protected Bonds ETFdb Category have aggregate assets north of $22 billion–with the vast majority of that attributable to the ultra-popular TIP. While TIPS have certain obvious appeal in inflationary environments, there are also some major, overlooked risk factors. For starters, TIPS are, after all, bonds, which means that they would likely be impacted adversely by interest rate hikes, a traditional companion to rising inflation.
CPI takes a unique approach to inflation protection, seeking to replicate the performance of an index that provides a real return above the rate of inflation represented by the Consumer Price Index. To do this, CPI forms a core holding around short-term bonds (achieved through ETFs) with satellite holdings changing based on macroeconomic conditions. For advisors looking to protect against inflation but wary of the potential pitfalls of TIPS, CPI is worth a closer look [see TIP: Silver Bullet Or Steel Trap?].
6. SPDR S&P Emerging Markets Small Cap ETF (EWX)
Frustrated by the lack of meaningful growth prospects in much of the developed world, many advisors have begun to ease back their home country bias and become more comfortable making larger allocations to rapidly-expanding emerging markets. Those looking to establish emerging markets exposure through ETFs gravitate to EEM and VWO, which seek to replicate the MSCI Emerging Markets Index and have aggregate assets of about $60 billion.
While both of those are fine places start, these ultra-popular funds feature some biases that prevent them from providing complete emerging markets exposure. Because the underlying index is cap-weighted, EEM and VWO consist almost exclusively of mega cap and large cap stocks–a group that generally includes multi-national firms that generate revenue from markets around the world, including developed and developing economies. Moreover, this methodology introduces a sector bias; because the largest market capitalizations tend to belong to banks and oil companies, cap-weighted international ETFs tend to maintain heavy biases towards the financial and energy sectors.
EWX offers exposure to small cap emerging market stocks, an asset class that may be more of a “pure play” on local markets and include more balanced exposure to sectors under-represented in EEM and VWO–such as consumer goods and services and technology. Advisors looking to establish balanced emerging market exposure should consider complementing large caps with EWX [also read Playing The Emerging Markets Though Small Cap ETFs].
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. 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].
Disclosure: No positions at time of writing.