3 ETFs, That, Like Hello Kitty, Are Lies

August 28, 2014

The investment world was rocked by the news today that Hello Kitty is not actually a cat. But the pernicious mislabeling of some ETFs is even worse.

ETFs are awesome, because most of the time, what you get is exactly what the label on the tin says. You want exposure to Treasury bonds with maturities longer than 20 years? The iShares 20+ Year Treasury Bond ETF (TLT | A-85) is going to give you just that. Done and dusted.

But just like many of us were shocked to learn today that Hello Kitty, that annoying/adorable Sanrio creation that’s sold countless pencil cases over 40 years, is actually a 1970s era British schoolgirl, many investors are shocked to find out that once in a while, the label on an ETF can be just as off. (And think about it, Hello Kitty owns a pet cat, so if she were a cat, Sanrio would be condoning actual slavery. And yes, it’s is the summer doldrums.)

So, who are the worst offenders of not being a cat in ETF land? Here are my top three picks:

1. Every Volatility ETF

Frequent readers will recognize my particular angst over all of the ETFs and ETNs purporting to provide exposure to volatility as a stand-alone asset class. This collection of 17 ETFs generally tracks some version of VIX futures. What’s wrong with that? It’s not really capturing volatility, except by a narrow definition (implied future volatility as traded on a single day).

They require perfect timing to work. And the persistent contango in the VIX futures market has made any buy-and-hold investor the proud owner of one of the worst investments in recorded history.

VXX

Sure, it does what it says on the tin. Most folks, however, don’t get past the whiskers.

 

2. ‘Natural Resources’ ETFs

ETFs that track any version of the various natural resources indexes all have one thing in common—they’re not actually giving you exposure to natural resources. I’ve talked to countless advisors who think that buying a collection of “natural resources” stocks is just investing in actual oil, gold or timber with a twist. Unfortunately, that’s rarely the case.

Consider how investors in the largest natural resources ETF, the SPDR Global Natural Resources ETF (GNR | A-80) have done this year:

GNR

In this case, they should be happy they’re not really buying commodities—the Goldman Sachs Commodity Index is down almost 8 percent this year, while GNR is up 14 percent. Still, it’s pretty obvious that what you’re buying here is equities, not natural resources.

There’s nothing wrong with GNR—it’s a good fund, delivering what it promises when you dig into the actual mandate, which is to buy stocks of companies related to the space. But companies like Exxon, Mobile and Monsanto are far from perfect proxies for oil and agriculture, and in many cases, the huge, integrated nature of their businesses both dilute their real exposure to the natural resources markets and introduce business cycle risks all their own.

 

3. Real Estate ETFs

Much like natural resources, investors turn to real estate ETFs hoping to get exposure to, well, you know, real estate. The problem is that the vast majority of real estate in the world is privately held, and not just homes—commercial real estate, farm land, timber—the majority of it is off limits to any fund trying to invest. Still, the convenience of the ETF package has rocketed the assets of funds like the Vanguard REIT ETF (VNQ | A-88), which has nearly $25 billion in assets.

On the one hand, funds like VNQ do what they say they’re going to do—they buy REITs. But on the other, they’re not really providing exposure to the core premise of real estate. There are real issues with using REITs as the path to your real estate exposure.

REITs invest in income-producing rental properties, and are required to distribute 90 percent of their profits to shareholders. That means no reinvestment, so, in order to grow, REITs are constantly on the prowl for new debt and equity investment to build the next mall or hospital.

Worse, the nature of accounting is that the value of the actual property held by REITs is depreciated heavily, which is fine from a business operations perspective, but the opposite of what many investors think they’re doing—investing in an appreciating asset.

It’s good for reported earnings, but not really the point of, say, buying a plot of land and sitting on it for a generation. In other words, investing in REITs gives you exposure to one very, very narrow definition of what it means to “invest in real estate”—the version where you try and maximize your current income. Many investors I’ve talked to, however, think they’re buying property to sit on for decades, believing that, like their houses, it will just slowly appreciate without having to incur taxes.

So what you end up with is REITs that look almost like bonds, versus the very real and topsy-turvy real estate market:

VNQ

Conclusion: Look Past The Whiskers
None of these classes of ETFs—volatility, natural resources or real estate—is actually doing anything wrong. At a prospectus level, each is doing exactly what it says it’s going to do. In the same way, Hello Kitty has been wandering around for 40 years playing dress-up, walking on four legs, speaking Japanese or English and carrying a purse. Nobody should really be surprised she’s not a cat. Just like you shouldn’t be surprised when your REIT isn’t sitting on fallow farmland.

You just have to look past the pointy ears and the whiskers.


 

At the time of this writing, the author held no positions in the securities mentioned. His children may, however, own Hello Kitty pencil cases. Reach Dave Nadig at [email protected], or follow him on Twitter @DaveNadig.


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