Morningstar Solutions
ETF Solutions
Specialty ETFs: Buyer Beware
Slide 2: Specialty ETFs: Buyer Beware

The proliferation of exchange-traded funds has managed to spawn exchange products that slice and dice the market in a bewildering number of ways. There are products that let you invest in junior gold miners, small-cap Brazilian stocks, or even a product that invests only in firms headquartered in Oklahoma. And that doesn't even begin to cover inverse and leveraged ETFs that are increasingly finding their way into individual investor's portfolios.

So are any of these products good investment ideas?

Slide 3: Specialty ETFs: Buyer Beware

As with most things in the investing world, there is no black or white answer if any particular product is a good fit for a portfolio. Your individual financial situation, risk tolerance, and other holdings are going to be the main drivers of the decision. But there are still some steps everyone can take to assess the suitability of these exotic ETFs.

Slide 4: Specialty ETFs: Buyer Beware

First off, these products do not represent a good core portfolio holding. They will not provide the broad exposure that serves as the bedrock of a well-constructed portfolio and should, at most, be used opportunistically as satellite holdings.

Be sure you have your bases covered in domestic and global stocks, bonds, cash, and government securities before you take a hard look at these more specialized funds.

Slide 5: Specialty ETFs: Buyer Beware

It is crucial to figure out exactly what the fund's objective is and how the fund tries to meet that objective.

Some products are reasonably straightforward. Take  Market Vectors Brazil Small-Cap BRF. It tracks a Brazilian small-cap index by going out into the marketplace and actually buying the components of the index. In this case, you'd expect your return to be very similar to that of the underlying index.

 

Slide 6: Specialty ETFs: Buyer Beware
Other funds can be a bit more challenging to understand. A good example is the  iPath S&P 500 VIX Short-Term Futures ETN VXX. If the name itself isn't bewildering enough, a little digging shows how complex these funds can become. Although the name implies that investors should expect to get the return of the volatility index, VIX, in reality the fund tracks a portfolio of near-term futures on the VIX index. This means that the return of the fund can be materially different from that of the VIX index. The fund is an exchange-traded note, which means it doesn't actually hold any of the futures contacts. It is just a debt obligation of the issuer. More information on ETNs is available here.
Slide 7: Specialty ETFs: Buyer Beware

After you figure out what these products do, you need to take an even deeper dive to figure out if they are appropriate for your portfolio. For equity products, it is crucial to look at what stocks actually make up the index. Many specialty, country, or sector ETFs can have huge concentrations in just one or two stocks. You may think you have a well-diversified portfolio, but really your investment hinges on the performance of one or two stocks. The portfolio section of the ETF report on Morningstar.com is an easy way to see the fund's top 25 holdings.

You can use Portfolio X-Ray as another tool that can ensure that a specialty ETF doesn't overlap your existing holdings.

Click here to view the accompanying video.
Slide 8: Specialty ETFs: Buyer Beware

So now you've done your homework. You know how the ETF works, what it tracks, and what it holds. But does it make sense to pull the trigger? The answer should depend on these questions:

1. Is this a fundamentally sound investment idea? Or are you just chasing trends and talking heads?

2. Does the fund actually fulfill your investment objective, or does the construction of the fund mean your return will be quite different from the underlying idea?

 

Slide 9: Specialty ETFs: Buyer Beware

Answering these questions can be hard. Fortunately, Morningstar's ETF analysts have scoured many of these new products and done the legwork. Reading the Premium ETF Analyst Report for a fund is the easiest way to get an overview of the fund's performance and who might find the fund suitable.

Some of these specialty funds might have a home in your portfolio, but as with most things: buyer beware.

Click here to view the accompanying video.
slideshow
Accompanying Video
Specialty ETFs: Buyer Beware
This slide does not have an accompanying video.