Just a few years ago, exchange-traded funds were primarily a low-cost way to invest in broad stock and bond market indexes. Not anymore. Today fund managers are rolling out a diverse array of new products, hitting niches, such as commodities and currencies, or stock market sectors that the major indexes miss. Investment strategists and financial advisers say the right dose of these specialized ETFs can improve portfolio performance.
The most straightforward way to use the new funds is to diversify a portfolio of stocks and bonds. The key is to find investments that don't move in sync with what's already in the portfolio -- or better yet, zig when the other parts zag.
Sure, a few conventional mutual funds can do the job. But they often have higher expenses and make more taxable distributions than ETFs, which are basically index funds created on demand by marketmakers. That's why John Gay, an adviser at Frisco Financial Planning in Frisco, Tex., is using ETFs to invest 5% to 10% of his clients' cash in real estate and commodities. "I need something that's going to be cost-effective and tax efficient," he says.
GOING FOR GOLD
Investors seeking diversification with commodities are just beginning to seek ETFs for the job. Deutsche Bank's (DB) DB Commodity Index Tracking Fund (DBC), which came out in February, invests directly in futures contracts on six commodities: crude oil, heating oil, gold, aluminum, corn, and wheat. The one drawback is the 1.30% expense ratio, fairly high for an ETF. For that reason, Gay says he'll wait and likely invest in a similar Barclays Global Investors (BCS) fund that's in registration at the Securities & Exchange Commission. It's expected to have expenses of just 0.75%.
Far and away the most popular of the new niche funds, measured by assets or trading volume, is State Street's (STT) streetTRACKS Gold Trust (GLD), with more than $6 billion in assets. With gold up 22% over the last year, that's not a surprise. At first blush, this fund does not look like much of a diversifier. Over the past year gold has tracked the S&P closely with a correlation of 0.81. (Perfect correlation would be 1.0.) Over longer periods, though, the correlation is much lower, just 0.38 over the past three years. In fact, it was slightly negative during the Internet bubble and the bear market.
The new niche funds can also be useful for investors seeking a play on an industry or economic trends. State Street's new SPDR Homebuilders (XHB) ETF lets investors buy a basket of 21 companies. Builders' shares have more than tripled over the past five years but have fallen 7% this year as the Federal Reserve's efforts to raise rates finally slowed the housing market. Think housing prices will collapse? Sell this ETF short. But if you believe higher rates have done all their damage, the ETF is a buy. "Over the long term, homebuilding is a tremendous industry," says Stephen East, an analyst at Susquehanna Financial Group, an institutional research firm in Bala Cynwyd, Pa.
State Street's streetTRACKS KBW Bank Fund, which launched in November, offers another way to play the Fed's moves. The ETF holds stocks of 24 of the nation's largest banks, and it has bounced from around $50 to $55 a share this year. If the Fed ends its rate hikes soon, the ETF could start moving higher.
The latest ETFs also provide investors an opportunity to add overlooked corners of the market to their portfolios, such as water stocks. The index of water utilities and companies that make filtration and pumping equipment behind the PowerShares Water Resources Portfolio (PHO) has risen 15% a year over the past five years. Debra Coy, an analyst who follows the sector for Stanford Washington Research Group, says these stocks may be a little pricey now but over the long haul have "great fundamentals due to rising demand for both water supply and water infrastructure around the world."
Microcap stocks, typically companies with capitalizations under $500 million, have been top performers over the past few years, but the sector isn't well covered by regular mutual funds. So Barclays now offers a microcap fund based on the 2,000-stock Russell Microcap Index that sports a 0.60% expense ratio, a full percentage point less costly than the average microcap mutual fund. First Trust Portfolios, a fund manager in Lisle, Ill., also has a microcap ETF, but with a slightly different twist. The fund includes only microcap stocks that pass five Dow Jones (DJ) screens that look at fundamentals such as price-to-earnings ratios and profit margins. So far this year, the Dow Jones ETF is lagging behind the Russell-based fund by almost three percentage points.
PowerShares has two new small and microcap offerings that use quantitative investment methods developed by Zacks Investment Research in Chicago. The PowerShares Zacks Small Cap Portfolio (PZJ) and similarly named microcap fund are based on research showing that companies that beat analyst earnings estimates are likely to outperform the market. Zacks' system also looks for stocks with few analysts covering them.
If this new round of ETFs doesn't offer what you want, keep your eyes open. Some three dozen are in registration.
By Aaron Pressman