Five ETFs Most Investors Don’t Understand

by on May 11, 2009 | Updated May 14, 2009 | ETFs Mentioned:

The majority of ETFs on the market follow the traditional ETF model – tracking an underlying equity or bond index. But as the benefits of the ETF structure become more widely accepted, inflows from increasingly sophisticated  have created a demand for increasingly complex funds. Here are five of the more complex ETFs available to investors today, along with explanations of their objectives and strategies.

  1. PowerShares S&P 500 BuyWrite Portfolio (PBP):  This ETF is based on the CBOE S&P 500 BuyWrite Index, which measures the rate of return of an S&P 500 covered call strategy. This strategy consists of holding a portfolio indexed to the S&P 500, and selling a series of call options, each with an exercise price at or above the current level of the S&P 500. Selling options hedges downside risk if the market falls (since the ETF receives premiums from options that are out-of-the-money), but limits upside returns if the market rise (since the ETF options sold by the ETF are in the money).
  2. ELEMENTS S&P Commodity Trends Indicator Total Return ETN (LSC):  LSC is linked to the S&P Commodity Trends Indicator, which applies a long/short strategy to 6 commodity sectors (livestock, grains, softs, energy, precious metals, and industrial metals) comprising 16 physical commodity futures contracts. This index takes long, short, or flat positions in each commodity based on the exponential average of the prices over the past seven months. Since it takes both long and short positions, this fund sometimes moves in the opposite direction of overall commodity prices.
  3. SPDR Barclays Capital Mortgage Backed Bond ETF (MBG): This ETF provides a return that corresponds to the performance of an index that tracks the U.S. agency mortgage pass-through sector of the U.S. investment grade bond market. In other words, MBG invests in pass-through securities backed by pools of mortgages issued by Ginnie Mae and Fannie Mae. Surprisingly, as of the date of this post, this ETF has a positive return since inception (it was launched in January 2009).
  4. iPath Optimized Currency Carry ETN (ICI): ICI attempts to track the Barclays Intelligent Carry Index, which is designed to reflect the total return of an “intelligent carry strategy.” This strategy uses objective and systematic methodologies to capture returns available by investing in high-yielding currencies with the exposure financed by borrowings in low-yielding currencies. ICI is able to invest in currencies of the G10 countries, which include the U.S. dollar, euro, Japanese yen, Canadian dollar, Swiss franc, British pound sterling, Australian dollar, New Zealand dollar, Norwegian krone, and Swedish krona.
  5. MacroShares $100 Oil Up (UOY) and $100 Oil Down (DOY): These ETFs, which are issued in pairs, allow investors exposure to either upward or downward movements in light sweet crude oil futures contracts. Funds are placed in separate trusts and invested in short-term T-Bills. The trusts pledge assets over time according to a predetermined formula driven by changes in the underlying index (i.e., oil prices). If oil prices increase, money is moved from DOY to UOY, and vice versa.

These funds are yet another indicator of the extent to which the ETF industry has expanded in recent years. As cash continues to pour in to the industry, don’t be surprised if we see launches of more and more non-traditional, increasingly complex ETFs in the future.