Understanding Some Misunderstood ETFs

by on March 8, 2012 | Updated July 9, 2014

The vast majority of the more than 1,600 ETFs now available are pretty straightforward; most investors can pretty quickly grasp the investment objectives based on a quick glance at the name and holdings. There are, however, some ETFs that investors do not understand well at all–products that are actually quite different from the perceptions that many have about them. 

Below, we highlight a couple classes of ETF that are commonly misunderstood–and set the record straight [for more ETF insights, sign up for the free ETFdb newsletter].

Hedge Fund ETFs

One of the most significant of the countless innovations in the ETF industry has been the launch of products that offer exposure to hedge fund strategies, but at a fraction of the price and with significantly better liquidity and transparency. But there is some misunderstanding about what exactly hedge fund ETFs are and what they seek to achieve.

Many investors view hedge funds as extremely risky vehicles that aim for massive returns through the use of complex securities and strategies that are out of the reach of most investors. Some certainly fit that description, but hedge fund ETFs generally operate towards the other end of the risk spectrum. The original idea behind hedge funds was a security that offers low correlations to traditional asset classes such as stocks and bonds that is capable of delivering positive returns in any environment. And indeed, the hedge fund ETFs now available to investors are not the “shoot the lights out through massive risk” vehicles. They generally exhibit very low volatility, using various strategies to deliver steady returns.

The IQ Hedge Multi-Strategy Tracker ETF (QAI) has returned about 4% over the second half of 2013 and the first half of 2014–a figure that is on the right side of zero but probably won’t blow anyone away. But it’s done that with a 200 day volatility of only about 5.5% and a beta of just 0.44. By comparison, SPY has a 200 day volatility of over 9%.

Looking under the hood of QAI may also help to correct some misconceptions about hedge fund ETFs. The holdings of this ETF are not exotic, risky securities, but other ETFs that tap into traditional asset classes. QAI’s top holdings recently included funds such as LQD, VTI, and AGG–hardly a roster of exotic, super-risky positions. 

Hedge fund ETFs can be very useful tools, but not in the way that many investors imagine. Most are unlikely to double in value over the next month, but many of them can bring valuable diversification benefits to traditional stock-and-bond portfolios. That might not be quite as sexy as a double digit gain overnight, but it can be pretty important for many investors. 

Socially Responsible ETFs

There is perhaps a bit of confusion about what socially responsible ETFs include; some might expect these products to focus exclusively on organic food providers and religious bookstores. But in reality, ETFs such as the iShares KLD Select Social Index Fund (KLD) and North America Sustainability Index ETF (NASI) are substantially similar to broad-based equity ETFs covering the same regions of the world. The overlap is significant; it is really the excluded companies that make these socially responsible ETFs unique. For example, the largest individual holdings of KLD include IBM, Starbucks, and Nike.

Incidentally, there may also be some confusion over the investment thesis behind these products. Though some investors no doubt buy these funds because of the utility derived from avoiding “bad” companies, there is a case to be made for these methodologies producing above-average returns over the long run. Companies that stay on the right side of the law and act as responsible corporate citizens are more likely to avoid costly lawsuits and build loyal customer bases–two factors that can boost profitability over the long run.

Commodity ETFs

This is a topic that has been covered quite a bit, but the potential for confusion is significant so it’s worth reviewing. A lot of investors are under the impression that commodity ETFs offer exposure to spot commodity prices. While some funds such as GLD and IAU do hold physical commodities, the majority of commodity ETPs achieve their investment objectives by holding futures contracts. That introduces additional factors into the equation, and means that the returns realized by commodity ETPs often depend more on the slope of the futures curves than they do on the changes in spot prices of the relevant natural resources [see Commodity ETFs: Factors To Consider]. 

Disclosure: No positions at time of writing.