ETFs: Exploring New Territory

The latest income-generating exchange-traded funds (ETFs) are still more or less off the radar, while the effectiveness of new weighting strategies remains to be seen. But these innovations might be exactly what investors need now.

By Greg Newton

The Changing Face of ETFs

For much of the 15-year history of the ETFs business, developers have focused intently on the stock market with barely a thought for income-oriented investors. But that has changed dramatically. Among the more than 800 ETFs available to U.S. investors today are some 50 "pure" fixed-income instruments; treasury and corporate high-yield indexes; junk-bond ETFs; and another 50 or so stock-based ETFs for which dividend income is an important, if not the only, factor in component selection.

The iShares ETFs family from Barclays opened the first four bond ETFs in 2003, tracking the Lehman 1-3 Year (SHY), Lehman 7-10 Year (IEF) and Lehman 20+ Year (TLT) Treasury indexes, and the Goldman Sachs Investop (since changed to the iBoxx $ Investment Grade) corporate bond index (LQD) in July 2002. Those ETFs, together with the Lehman Aggregate Bond Fund (AGG) and the TIPs Bond Fund, which iShares added in the second half of 2003, accumulated total assets of well over $30 billion by September 30, 2008, demonstrating the clear first-mover advantage in the ETF world.

By contrast, the latecomers, which include StatevStreet's SPDR family and PowerShares' ETFs, along with another nine offerings from the iShares family, have accumulated just $1.5 billion among them, according to IndexUniverse figures. State Street, however, did make a play for the recognizable-tickers prize by nabbing the apropos trading symbols BIL and JNK for its 3-Month Treasury bill and high-yield corporate-bond ETFs, respectively.

The relatively slow uptake of the new products can be attributed to three possible causes:

• Many are focused on the same areas and durations as the existing core iShares products.
• The introductions have been submerged in the continuing avalanche of equity-based ETF issues.
• Most of the new products in new areas — including municipal bonds, mortgages and lower-rated corporate bonds — have been introduced into the most turbulent credit markets in at least a generation.

iShares' Lehman Mortgage Bond ETF (MBB), for example, invests only in Ginnie Maes, which carry an explicit government guarantee, along with "investment- grade, fixed-rate" securities issued by Fannie Mae and Freddie Mac with a maturity of at least one year and an outstanding face value of more than $250 million. Despite that solid backing, the ETF mostly traded by appointment after its launch in March 2007 until the Treasury stepped into the game in September 2008 and made the formerly implicit guarantee of the agencies' $5 trillion-plus debt perfectly explicit.

New Bond Options

Among the newcomers to the pure fixed-income ETF market, Invesco PowerShares Capital Magagement LLC has made an impressive debut, raising almost $650 million by mid-September for eight products, all introduced since October 2007.

The key word that explains the ETF's competitive advantage over other investment vehicles,
despite the impact of credit-market turmoil, is "insured."

Its family of three municipal ETFs — the Insured National Municipal Bond Portfolio (PZA), Insured California Municipal Bond Portfolio (PWZ) and Insured New York Municipal Bond Portfolio (PZT) — held assets of more than $180 million, despite competition from both iShares and State Street. All three funds track Merrill Lynch indexes focused on AAA-rated, insured, tax-exempt, long-term debt publicly issued by U.S. states or their political subdivisions, with the California and New York offerings concentrated in those states and in Puerto Rico.

The key word that explains the ETF's competitive advantage over other investment vehicles, despite the impact of credit-market turmoil, is "insured." According to the funds’ prospectuses, the qualifying securities must have “an unconditional contractual guaranty by an insurance company for any unpaid interest and principal.”

The funds are designed for investors who seek a relatively low-cost approach to investing in a portfolio of municipal securities in a specified index. The funds may be suitable for long-term investment in the market represented in the relevant index, and may also be used as an asset-allocation tool or as a speculative trading instrument. The funds intend to pay income exempt from federal income taxes, including the alternative minimum tax.

Investors, especially those considering using an ETF as a speculative trading instrument, should remember that profits made on buying or selling the ETF, as opposed to the income it generates, will be subject to the same tax treatment as ordinary shares. But compared with conventional municipalbond funds, which can incur taxable gains when one is forced to sell portfolio securities to meet redemptions, the ETFs' "in-kind" redemption process protects continuing shareholders from potentially adverse effects of frequent cash redemptions. This restriction applies only to dealings in the 100,000-share "creation units;" regular investors buy and sell shares in the ETFs through brokers, in normal cash or margin transactions, as they do with any other ETF.

Another fast starter from the PowerShares' armory is the Emerging Markets Sovereign Debt Portfolio (PCY), which, by mid-September, had raised $120 million since its launch in October 2007, despite the challenge from the iShares Emerging Markets Bond Fund (EMB), which was launched in December 2007.

The PowerShares PCY ETF is designed to track the Deutsche Bank Emerging Market U.S. Dollar Liquid Index, which measures potential returns from a theoretical portfolio of liquid emerging markets U.S. dollar-denominated bonds with at least three years to maturity and an outstanding float of more than $500 million. The ETF's ten largest holdings in mid-September included bonds from the Philippines, Chile, Colombia, Poland, South Korea, Hungary, Panama, South Africa and Uruguay.

While the fund’s short performance history needs to be treated with caution, it was flat after its first 11 months of trading, including almost $1.25 in dividends. By comparison, the largest emerging markets equity ETF, iShares MSCI Emerging Markets Index Fund (EEM), was down more than 30% over the same period after paying a split-adjusted 21.6-cent dividend.

Perhaps more intriguingly, PCY's underlying index had produced an annualized five-year return of 9.56% ending Sept. 30, 2008, compared with the 18.67% total return in the MSCI Emerging Markets index over the same period, which was dominated by a combination of the unremitting rise in emerging stock markets and the decline of the U.S. dollar. But the index underlying PCY achieved its return with a volatility (a measure of risk) of just 8.18%, compared with the 21.5% of the stock index.

Understanding Weights

One of the most confusing aspects of ETFs for investors new to the field — and one that plays an important role in determining performance — is the weighting of the individual components in both the underlying index and, consequently, the ETF itself. Most early ETFs, including the now 15-year-old S&P 500 tracker (SPY) and the MSCI country "baskets," were based on familiar market capitalization- based indexes, in which the weighting of the index components is determined by their market capitalization.

But that approach has, over the years, become more of the exception than the rule. The following outlines some of the most widely used ETF weighting strategies and how they impact performance:

Capitalization and/or modified capitalization weighting: In this method, component selection is proportional to the capitalization of the underlying stocks, and performance tends to be driven by the more heavily weighted stocks. For example, Exxon-Mobil (XOM) accounts for more than 4% of SPY; it can, by itself, move the ETF by as much as the combined effect of Apple (AAPL), Google (GOOG), Schlumberger (SLB) and Verizon (VZ).

Modified cap weighting is often used in ETFs representing a "subsector" of a broader cap-weighted index. It prevents a few large-cap holdings from overwhelming an index’s mostly mid- and small-cap names. In the S&P Homebuilders ETF (XHB), retailers The Home Depot (HD) and Lowes (L) would, were it not for the weighting cap, account for about 70% of the ETF.

Equal and/or modified equal weighting: As the name implies, equally weighted ETFs divide holdings equally, by percentage of NAV, among its holdings. The Rydex S&P 500 Equal Weight ETF (RSP) has just .25% of its assets invested in Exxon-Mobil, meaning that moves in that individual stock have no discernable impact on the ETF's movement.

Modified equal weighting, used especially in ETFs with fewer than 50 holdings, is a concept that gives indexers a degree of freedom in meeting a focused investment objective, while meeting regulatory demands for diversification and, in some cases, addressing such questions as the market liquidity of individual components. The impact of this weighting methodology can significantly affect the performance of the ETF, and investors need to understand this on a product-by-product basis.

Factor weighting: One of the most significant recent developments in ETFs is the creation of funds that weight their components based on specific financial attributes to deliver proper market exposure rather than use cap weighting. For example, the PowerShares FTSE-RAFI series of broad-market and sector ETFs are designed to track indexes that select and weight components based on book value, cash flow, sales and dividends.

The latest ETF weighting approaches are too new to have been tested through a complete market cycle and remain controversial. While they are supported by some academic and quasi-academic studies and show impressive hypothetical performance, supporters of traditional cap weighting dismiss them as fads. Unfortunately for prospective investors, it's an intensely partisan debate whose resolution lies far in the future. Stay tuned.

Investing in ETFs and ETNs involves risks similar to those with any other exchange-listed investment, including possible losses. Shares are not FDIC insured, may lose value and have no bank guarantee. Before investing in ETFs or ETNs, investors should carefully review available documents, including risk disclosures and other disclaimers included in the products’ prospectuses, and assess their suitability for their own financial circumstances.