Getting Started With ETFs

February 24, 2022

Beyond Broad Equity: ETFs You May Encounter

ESG ETFs
Environmental, social and governance strategies have exploded since the pandemic. Currently, the category (found under the Socially Responsible channel on ETF.com), has roughly $109 billion in assets under management spread across more than 180 ETFs.

The category, however, includes far more than funds that simply rely on metrics around the three pillars of the ESG rubric. It encompasses funds that: screen companies based on the values of different religions; specifically home in on concerns like climate change or clean energy; or promote causes such as racial and gender equality.

Although ESG is the most widely recognized term, other terms for funds that screen based on values or other nonfinancial criteria can include “socially responsible,” “impact investing” and “sustainable investing.”

With traditional ESG investing, companies with significant business activities in areas such as fossil fuels, weapons, alcohol or gambling are often excluded. One of the largest historical criticisms of ESG investing has been that investors give up performance by limiting where they invest.

However, during the pandemic, ESG strategies have tended to outperform. And during 2020 and 2021, the category exploded, with more than 80 ESG ETFs added to the marketplace. That’s roughly 45% of the entire ESG universe, and leading issuers have pledged to roll out even more funds that fit ESG criteria to meet increasing demand.

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Defined Outcome ETFs
The first defined outcome ETF launched on the market in 2018. Since then, the field has grown to encompass roughly 145 ETFs, with more than $11 billion in assets under management.

All of these funds are actively managed and generally use flexible exchange (FLEX) options tied to indexes or passively managed ETFs to achieve their stated goals. Although there are some differences in how they operate and variation in goals, generally, the funds provide a limited amount of upside tied to the performance of their target index/ETF while protecting against downside performance up to a certain percentage.

For example, the $536 million Innovator U.S. Equity Power Buffer ETF – January (PJAN) resets every Jan. 1. On that date, the fund resets its static buffer against a 15% decline and its upside cap.

As of Jan. 1, 2022, the upside cap, determined by the pricing of the options at that time, is 8.99% before expenses. That means over the one-year period until its next reset, the fund could go up as much as 8.20% (once you take into account its 0.79% expense ratio), or that its reference benchmark could decline as much as 14.21% after expenses before the fund sees any downside loss.

Other funds have different reset dates, different buffers and use different types of FLEX options to achieve their goals, but the concept is the same across funds. Many view these funds as potential substitutes for fixed income at a time where interest rates are extremely low, or believe they can be used to manage retirement assets.

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Commodity ETFs
Commodities are generally raw materials falling under the designation of metals, agricultural products or energy sources. It’s a category that has undergone a significant evolution over the years, and it’s currently represented by 107 ETFs and ETNs holding roughly $150 billion in assets under management.

Many investors see them as a great diversifier for equity and fixed income portfolios, especially after the commodity boom that characterized the early years of the 21st century.

From an ETF perspective, there are two types: futures-based or physical. Physical ETFs tend to involve precious metals, which are relatively easy to store, unlike natural gas or wheat. They allow investors to access the coveted “spot price,” which is the current price of the commodity as it trades in the market.

Other commodity ETFs or ETNs hold futures contracts that represent ownership of a particular commodity at a future price; however, the funds never take delivery of those commodities. Instead, they roll the assets directly into contracts that expire later.

Most futures-based commodity ETFs roll into front-month contracts, but some have methodologies that allow them to roll into others at different locations along the futures curve. It should be noted that the costs of rolling to new contracts are a significant drawback of futures-based funds.

There are two terms to understand when it comes to futures-based commodity ETFs: contango and backwardation.

When a futures market is in contango, the price of the commodity for future delivery is higher than the spot price (longer-dated futures prices are higher than near-dated futures). A chart plotting the price of futures contracts over time is upward-sloping. When a futures market is in backwardation, the opposite occurs (far-dated futures are lower than the spot or near-term futures price). A chart plotting the price of futures contracts over time is downward-sloping. Backwardation is the more desirable trend for an investor in futures-based ETFs or ETNs.

While most commodity ETFs are index-based, there are quite a few that are actively managed.

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Thematic ETFs
“Thematic” can refer to a fund that represents a small slice of a broad sector (just as cybersecurity is a subset of technology) or it can refer to a wide-ranging fund that crosses sectors to select securities fitting the targeted theme (such as an ETF focused on a concept like innovation or infrastructure).

These ETFs have taken off, as the low-hanging fruit of core asset classes have been covered by established ETF issuers. The rise of the internet has also been a driver, as it has created a host of burgeoning categories, such as online commerce, streaming, online betting and gaming, which don’t necessarily fit neatly into a traditional sector structure.

Currently, ETF.com classifies 267 ETFs as falling under the “theme investing” category. A quick look at the largest members of the category includes funds that home in on cybersecurity, clean energy, infrastructure and internet firms, among other areas of focus.

The drawbacks of these funds tend to be that they can be narrow in scope, with small and illiquid holdings, which can contribute to volatility. However, for someone with a strong conviction about a particular theme, the potential for diversification and alpha can be very attractive.

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Bitcoin Futures ETFs
Cryptocurrency is all the rage these days, and bitcoin is the best known and largest of the cryptos available. It’s no surprise that there’s a significant amount of demand for an ETF that holds bitcoin.

In fact, the first filing for a physical bitcoin ETF was made in 2013, but there was little to no movement until several years later. Physical bitcoin ETFs were consistently rejected by the SEC, but after a lot of iterations and consultation, a bitcoin futures ETF was approved to launch.

The ProShares Bitcoin Strategy ETF (BITO) hit the market in October 2021 to much fanfare, and surpassed the $1 billion in assets mark after just two days of trading (with the drop in bitcoin price, it’s less than that currently). It was rapidly followed by the Valkyrie Bitcoin Strategy ETF (BTF), which has seen less success and currently holds about $39 million in assets.

As of mid-February 2022, the SEC has not approved a physical bitcoin ETF.

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