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Waiter, There's a Closed-End Fund in My ETF!

Expect the unexpected when looking at narrow ETF portfolios.

Dan Culloton, 02/13/2007

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 IVV tracks or that streetTracks Gold Shares GLD owns gold bullion. Alas, appearances can be deceiving. A number of ETF portfolios include stocks that might surprise investors who thought they were getting pure exposure to the industry or the sector specified in the ETF's name.

Take the Technology Select Sector SPDR XLK, for example. The sector bellwethers are there--Microsoft MSFT, Cisco Systems CSCO, and Google GOOG--but so are a couple of massive telecommunications service providers. Indeed, AT&T T and Verizon Communications VZ are both top-10 holdings and help give this fund a bigger telecom stake than any other conventional or exchange-traded technology fund. In 2006, this was a virtue as service providers rebounded sharply. That hasn't and won't always be the case, though. This ETF can look out of step with other funds tracking the tech sector when big telecom stocks lag or fall, as they did in 2005.

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 NANX or Altair Nanotechnologies ALTI, can best be described as unprofitable nanofirms. That explains why a lot of big companies whose main business isn't nanotechnology show up in PowerShares Lux Nanotech Portfolio PXN. Sure, companies such as General Electric GE, Hewlett-Packard HPC, and Toyota Motor TM are researching ways to use nanotech to improve everything from aircraft engines to printer ink to car components, but those efforts are often small parts of their operations. On top of that, you don't need a nanotech specific fund to get exposure to these widely held stocks.

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 PSP owns stakes in some recognizable private-equity names, including Apollo Investment AINV and KKR Financial KFN, a REIT managed by an affiliate of private-equity and buyout firm Kohlberg Kravis Roberts. But it's a stretch to classify as private equity everything in the Red Rocks Capital Listed Private Equity Index that this ETF tracks. Pinnacle West Capital PNW is a utility holding company. CIT Group CIT provides some financing for small and midsized private firms, but also for home and student loans. The index even includes closed-end funds, such as HQ Healthcare HQH and HQ Life Sciences HQL, to gain exposure to areas in which there are not a lot of publicly traded private-equity firms.PAGEBREAK

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 PPA and its index, the Spade Defense Index, might surprise the average investor. The ETF and index include consumer media companies like the nation's largest satellite television service provider DirecTV DTV and Sirius Satellite Radio SIRI. The index's author, the International Space Business Council, included the companies in the benchmark because there is a lot of cross-pollination between the strategic and commercial satellite subsectors. Commercial satellite firms use defense satellites, and their economic health affects suppliers of government satellites and defense technologies. The ISBC also has said the commercial satellite companies have improved the benchmark's performance in certain periods the past, though that may not be the case in the future.

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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