Expect the unexpected when looking at narrow ETF portfolios.
What's in your exchange-traded fund? The question seems easy enough. Not only is it simple to find the holdings of most ETFs because they are index funds whose constituents are published for the world to see, but ETF names also appear to telegraph their contents. There's not much doubt what benchmark the iShares S&P 500 Index
Take the Technology Select Sector SPDR
The proliferation of ETFs tracking narrowly defined indexes has made it more important to be on the lookout for such idiosyncrasies. Often ETFs and their indexes slice their market segments into such small slivers that there aren't enough viable, liquid stocks left to populate a diversified portfolio. Index engineers then often fill out the benchmark with securities that, at best, offer only indirect exposure to the area in question.
There aren't many pure nanotechnology plays out there, for example, and the few that exist, such as Nanophase Technologies
Private equity is not widely held by individual investors. A flurry of mergers, acquisitions, and leveraged buyouts, as well as reports of eye-popping returns garnered by institutional investors, however, has ignited a lot of interest in private equity. Despite that interest, a fund that purports to offer exposure to private-equity firms whose shares trade on U.S. stock exchanges still includes some holdings that stretch the admittedly loose definition of what a private-equity firm should be.
The PowerShares Listed Private Equity Portfolio
Institutional investors, such as Yale University's David Swenson, have made killings with private equity in the past, but they have access to firms and funds the average investor doesn't. I don't think this ETF changes that. More private-equity firms and hedge funds may end up selling shares to the public in the future, as Fortress Investment Group did last week, but right now there's not enough out there for a pure private-equity index fund.
There are plenty of stocks out there to fill a defense industry index. (There are more than 70 in Morningstar's database.) Still, some holdings of the PowerShares Aerospace & Defense Portfolio
As ETFs get more specialized and investors rely on them more for precise exposure to market segments, it becomes more and more important to make sure the aim of a fund's benchmark is true.
Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.
Dan Culloton is an analyst with Morningstar.
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