Five Game-Changing ETFs

September 04, 2007

I loved your list of "5 ETFs," Jim. And for the most part, I agreed with your selections. I thought I'd take a crack at my own "5 ETFs" list.

My list, however, comes with a slightly different focus: I thought I'd choose five recently launched ETFs that I think have the potential to "change the game" in the ETF industry. I'm going to limit myself to funds you failed to mention, with the caveat that I think ETNs are potentially the single most important development in this industry in the past two years.

Still, there are a lot of other interesting funds, and here are five recently launched funds that top my list.

1) PowerShares DB G10 Currency Harvest ETF (DBV): This is an unpopular time to highlight this fund, because it sold off sharply during the recent market turmoil, falling nearly 10% from late-July to mid-August. But one of the great things about the ETF industry is that it has brought institutional strategies to the retail investor at low costs, and no fund has done that more successfully than DBC.

DBV is essentially a "carry trade" ETF. It buys currencies with high interest rates and shorts currencies with low interest rates. For the past few decades, that's been a bombproof strategy ... about as close as you can get to printing money. And the backtested data on this fund is some of the best I've seen, with the fund steadily marching up 10% a year with almost no hiccups. Even with the recent downturn, the fund is up ... you guessed it ... about 10% over its first (almost) year on the market.

For putting the carry trade within my reach for 0.75% in annual expenses, DBV is a game-changing ETF.

2) PowerShares DB Commodity Index Tracking Fund (DBC): You recently copped to being a less-than-pure indexer, Jim, with your value and international tilts and your continued faith in gold. Now, here's where I break with the indexers: I don't think pure indexing works in commodities.

I have two reasons for this. First, there is no market capitalization of wheat or oil. No one agrees what the "right" way to index in the commodities space is, and different mainline indexes have vastly different structures and returns. And when there's that much disagreement, you can't assume that the "mainline" methodologies are the best.

More importantly, however, there are structural issues in the commodities market - contango and backwardation - that make "buy and hold" a less-than-perfect strategy for these assets. I mean, imagine if there were times when stock yields were negative ... when you had to pay dividends to companies, rather than the other way around ... would you want to buy an index that held those stocks?  That's essentially what you do when you hold a commodities index when the market is in contango.

Although we're currently back in backwardation for most commodities, that won't always be the case. And therefore, I think DBC is a game-changing ETF, not just because it was the first broad-based commodity futures ETF, but because its "optimum yield" strategy makes for smarter investing in the space. Ultimately, I think this and other smart strategies will have a significant edge over their "traditional" peers in the commodities market.

3) Vanguard Europe Pacific ETF (VEA) and Vanguard Emerging Markets ETF (VWO): This one comes down to costs. VEA and VWO are direct challenges to Barclays Global Investors (BGI). These two funds offer exposure to the exact same index as BGI's EFA and EEM ETFs, respectively, but the Vanguard funds charge a fraction of the fees: VEA costs 0.15% vs. 0.35% for EFA, and VWO costs 0.30% vs. 0.75% for EEM. Will investors switch? Will BGI lower its fees? And how large will Vanguard's ETF business get? Those are huge questions in the industry right now. EFA and EEM have a combined $60+ billion in assets, and Vanguard has them in its sights.

4) ProShares UltraShort QQQ (QID): The leveraged ETFs have flaws ... big flaws. Most people assume, despite clear language in the prospectus, that these ETFs deliver twice the returns of their benchmark indexes, when in fact they deliver twice the daily return, which is entirely different. The QQQQs, for instance, are up about 23% over the past year; you might think that QID, which promises to deliver 200% of the inverse return of the QQQs, would be down 46%. In fact, it's down about 33% ... not even close.

Still, for an investor looking for easy shorts and easy leverage, these are your best shot. And the ProShares ETFs have been huge hits, attracting over $7 billion in assets and trading in unbelievable size. For the hedge fund/day trader types that probably dominate flows in these products, the double-daily returns is probably just fine.

I suspect these products will continue to grow and occupy an ever-larger space in the trading environment. 200% short leverage for 0.95% expenses, tradable like a stock? When you think about it, it's pretty impressive.

5) WisdomTree Emerging Markets High Yield ETF (DEM): Why? In short? A 6.5% yield.

To answer more completely ... the huge rush of assets into the emerging markets space has me worried. That area blows up with far too much regularity for investors to be sinking SO much money into the space. Are China and India a good bet over the next 40 years? I think so. Over the next five or 10? Who knows...

So while I'm not yet convinced by the various alternative weighting strategies in most markets, weighting by dividends in the emerging markets space makes sense to me. The global financial markets have gotten more transparent recently, but I'm still not sure I'd trust the accounting of all the firms listed in China, or Brazil or Russia, etc. DEM screens for companies that are paying out cold, hard cash, which provides a nice check on reality.

Paranoid? A little. But I also think it could appeal to a lot of investors interested in emerging markets but worried about buying in at the top.


There you have it: five recently launched game-changing ETFs. There are plenty more I could have mentioned, too.  Honorable mentions go to the Rydex Pure Style ETFs, the SSgA International Regional ETFs and the various theme ETFs, such as alternative energy and water. And the word's still out on the various "beat-the-market" ETFs ... if they can succeed in delivering outperformance, they will turn out to be important funds too.

Later this week, I'll take a look at the new ETF Watch and choose five funds in registration that I think could reshape the landscape in the future...

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