Ten ETFs Every Advisor Should Know (But Most Have Never Heard Of): Part I

by on September 16, 2010 | ETFs Mentioned:

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 [for more ETF ideas, sign up for our free ETF newsletter]:

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.

9. Schwab U.S. Broad Market ETF (SCHB)

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].

[see Part II of Ten ETFs Every Advisor Should Know]

Disclosure: No positions at time of writing.