You've probably heard ETF.com say numerous times, "Not all ETFs are created equal." As an investor, it's imperative to understand how the ETF's underlying index works, since the name of an ETF can be deceiving … or, at least, not fully representative of the exposure you think you're getting.
In selecting the right ETF, investors have an array of factors to consider. Costs, tracking, structure and the liquidity of ETFs are crucial. Still, even if all those things align the way they’re supposed to, at the end of the day, an ETF’s returns are primarily driven by its underlying holdings.
For example, frontier markets made quite a splash in 2013, with many of them massively outperforming the BRICs and other emerging markets. There are currently two broad frontier market ETFs available: the iShares Frontier 100 ETF (FM | D-93) and the Guggenheim Frontier Markets ETF (FRN | D-18).
Both of them claim to provide broad exposure to frontier markets, so you’d think they’re similar funds. But if you were invested in the wrong one, you probably would have never known frontier markets even performed well in 2013.
In 2013, FM returned more than 25 percent, while FRN returned -13 percent. That’s a total difference in returns of 38 percent between the two funds!
So, what gives?
FRN follows BNY Mellon’s classification framework and is only eligible to hold depositary receipts. Therefore, the resulting basket gives you exposure to countries like Chile, Colombia, Egypt and Peru—those countries make up more than 70 percent of FRN’s weighting—even though MSCI, FTSE and S&P have them all classified as emerging.
Meanwhile, FM follows MSCI’s classification framework and is capable of holding local shares. This gives FM a tilt toward Gulf States like Kuwait, Qatar and UAE, as well as African countries like Nigeria and Kenya.
Some would argue that FM is the first “pure” frontier markets ETF, consisting solely of countries classified as frontier by the major index providers. Others would say that its focus on Kuwait and Qatar misses the dynamic growth people are looking for. Regardless of which provider’s classification you want to follow, one thing is clear: You have to be careful when choosing a frontier market ETF!
That’s not the only example, of course. In almost every area of the market, from biotech to bonds, there are massive differences between different products. And when you get into areas like commodities, volatility or leverage funds, watch out:
- Crude oil ETFs do not track the price of crude oil
- Volatility ETFs do not track the CBOE VIX Volatility Index
- Leveraged and inverse ETFs that promise 2x or -2x (or 3x and -3x) the return of an index won’t deliver that return over more than one day.
The takeaway here is to not just assume a fund covers the country, sector, region or theme precisely the way you expect, simply based on its name. Do the extra homework.
Even if you get your investment outlook wrong, at least you’ll get the exposure you want correct, and you won’t have to be invested in the wrong product by accident.
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