Types of Exchange Traded Funds (ETFs)
Given the surge of popularity of exchange traded funds, it's vital to track these funds as they come to market. The following list of ETF styles will help you make the most informed decisions possible, in order to determine which style makes the most sense for your investment goals:
United States Market Index ETFs
Market ETFs usually track a major market index and are some of the most active ETFs on an exchange floor. But some market ETFs track low-volume indexes as well. Keep in mind the goal of a market ETF is to emulate an underlying index--not outperform it.
Example: the QQQQ’s which tracks the Nasdaq-100 index.
Foreign Market Index ETFs
The U.S. isn't the only country to boast market index ETFs. There are many foreign ETFs to choose from as well. So if you seek international exposure or you wish to hedge against foreign investment risk, country or region ETFs may be a good option.
Examples: EWJ, which tracks Japan’s Nikkei Index; EWG which tracks the MSCI Germany Index.
Foreign Currency ETFs
Foreign currency ETFs help investors gain exposure to foreign currencies without completing complex transactions. Currency ETFs are seemingly simple investment vehicles that track foreign currency, similar to the way market ETFs tracks its underlying index. In some cases, this type of ETF tracks a basket of currencies, giving investors access to multiple foreign currencies.
Sector and Industry ETFs
Industry ETFs generally track a sector index representing a certain industry. These vehicles help investors gain exposure to a certain market sector like pharmaceuticals or homebuilders--without purchasing shares in multiple individual companies.
Commodity ETFs are similar to industry ETFs in that they target certain areas of the market. However, when you purchase a commodity ETF, like gold or energy, you don't actually buy the commodity. Rather, these ETFs consist of derivative contracts to emulate the price of the underlying commodity. In short: when you buy an oil ETF, you are investing in oil without setting up a mining drill in your backyard!
Some ETFs do not comprise equities at all. Case in point: Commodity ETFs are made up of derivative contracts like futures, forwards, and options. While the goal is to emulate an investment product, there are different ways to accomplish this within the construction of ETFs.
Some ETFs track a certain investment style or market capitalization. Style ETFs are most actively traded in the United States and exist on growth and value indexes developed by S&P/BARRA and Russell. If you have a certain investment goal based on a market-cap style, you may be able to reach your target with a style ETF like the SPDR Dow Jones Large-Cap Value ETF (ELV) which tracks the Dow Jones U.S. Large-Cap Value Index.
The many available bond ETFs runs the gamut, from international to government to corporate, to name a few. Bond ETFs have a difficult task when it comes to construction because they track low-liquidity investment products. Bonds are not active in secondary markets because they're normally held to maturity. However, ETFs are actively traded products on exchange floors. ETF providers, like Barclays, have rolled out debt-based ETFs and created successful bond funds like the SPDR Capital Long Credit Bond ETF (LWC). This offering gives investors opportunities in the bond market while still maintaining the benefits of ETFs.
ETNs — Exchange Traded Notes
Exchange-traded notes (ETNs) are issued by a major bank as senior debt notes. This differs from ETFs, which consist of securities or derivative contracts. When you buy an ETN, you receive a debt investment similar to a bond. ETNs are backed by high-credit rating banks so they are considered secure investment products. However, the notes are not totally absent of credit risk.
Though ETNs are technically not true ETFs, people nonetheless lump them into the same category.
When the market plummets, investors like to short their positions. However, margins may not allow for this, if there are restrictions on selling certain investments. Enter inverse ETFs, which create short positions when you buy them, by providing inverse reactions to the direction of the underlying index or asset.
Leveraged ETFs are controversial vehicles, best suited for advanced ETF trading strategies. A common misconception with leveraged ETFs is that they produce exponential annual returns, when in fact their goal is to offer leveraged daily returns on underlying indexes and assets. But even this intention is far from a sure thing. So before you add leveraged ETFs to your portfolio, conduct thorough research.
Actively Managed ETFs
In the ongoing war between ETFs vs. mutual funds, there just may be a compromise with Actively Managed ETFs. These combine the benefits of both mutual and exchange-traded funds into one asset while eliminating some of the disadvantages.
Growing ETF popularity has lead to an innovative crop of funds such as Volatility ETFs and Tax-Deferred ETFs. And as this world continues to grow, so will the different variations.