Burns: Our Favorite New ETFs and ETNs of 2010

Jeremy Glaser: Our favorite exchange-traded products of 2010.

I am Jeremy Glaser for Morningstar.com. I'm here today with Scott Burns. He's director of ETF research for Morningstar, to take a look at his favorite new exchange-traded products.

Scott, thanks for taking the time today.

Scott Burns: Jeremy, thanks for having me.

Glaser: So, I think you mentioned there were 218 new products that were launched this year, but I think some of them are probably more worthwhile than others. Can you give us some of your favorite launches of the year?

Burns: I think on that "more worthwhile than others" topic, a question we get a lot is, are there too many or too many launches, or how many it's enough. I think when you're in an industry that's growing, or a segment of an industry that's growing as fast as ETF market is, there's going to be a certain natural creative-destructive process that's going to happen. So, we're going to see a lot of new launches. Some may work, some may not.

But, in general, as you ask me to come here, let's talk about some of our favorites, I think, one area that was of huge interest though has been the physical commodity space this year. ETF Securities launched Physical Platinum and Physical Palladium. I believe my stats, as I checked them just before I got here, they are the two fastest-growing and largest asset gatherers of the year. So, not only do we think they were pretty good launches, but the investment community obviously agrees as well.

What's interesting about these products is they've really provided an alternative – precious metals, physical precious metals – alternative to gold and silver that we see out there. So, they have very different characteristics. I want to make sure investors realize that Platinum and Palladium are used quite a bit more in industrial usage than gold is. So things like catalytic converters and not just jewelry and whatnot. So, one thing before investing in that as a substitute for gold is to make sure that you understand those industrial applications and how that will change things.

From the fixed-income side, we actually have a couple of unique launches that came out, one, from an exposure basis. We launched emerging-market bonds this year. WisdomTree launched fund, ELD is the ticker, and Van Eck launched EMLC. Those two funds really give exposure to the emerging market countries that are out there. So, Brazil, China, Russia--maybe or maybe not you want Russia--but it's there to a certain degree. So, what we really like about this is, it gets away from some of the issues that have been plaguing developed markets, especially fixed-income in the U.S., fixed-income in Europe.

So, what we find when we look at the credit quality across developed markets and compare it to emerging markets is something we probably haven't ever seen in the past 50 years of investing, and that is that the credit quality of places like Brazil and China and South Korea is better than what we're looking at in broad-based Europe, and perhaps even the U.S. I think it's less about the credit quality in U.S. and more about the returns. So, we found those very interesting.

Another way ... it's something that's always amazed us that we slice and dice the equity portion of our portfolio across value and growth, and international, and emerging markets, and yet, a lot of people just own one fixed-income fund or ETF, etc., or maybe TIPS in a broad-basket. So, we do think the evolution is coming where we'll start slicing and dicing our fixed-income portion.

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The other one in the fixed-income is more of a unique strategy, it's not necessarily a unique exposure, and that's actually the target-date ETFs. So, iShares has launched a suite of these target-date maturity municipal bond ETFs in February and Guggenheim Funds launched the corporate bonds in June. And so what these are, are actual ETFs that mature in 2012, '15, '17, '18, et cetera. So what that's great for and unique for is the fact that advisors and investors like to do targeted investing, whether it's for college or retirement. Bonds coming due every year. They know they can count on that principal and that capital being returned to them. It's not this open-end, rates are floating, returns are floating situation that's out there.

What this provides is more liquidity than an individual bond would provide, in addition more diversification for a very, we think, very reasonable expense ratio. So you can now do that laddering, whether it's in the municipal or the corporate space, and have the benefits of diversification and liquidity to go with it. And by liquidity, what that really means is that the bid-ask spread, that transaction cost of getting in and out, is by and large a lot cheaper than if you were to buy individual bonds for that ladder.

Glaser: Was there anything in terms of risk management to us this year that you really liked?

Burns: Yes, you know the alternative space, the risk management space, was a huge area for growth for ETFs this year. We saw the VIX product launch, and unfortunately, the futures-based VIX product, contango, everyone is I think becoming familiar with contango these days, appeared in the financial markets as well, became very steep. What was historically a negative 3% roll yield turned into a negative 20% roll yield, and that product didn't do as well for investors as we would have liked initially.

But there have been a couple of other very interesting products that came out, and particularly what we really like are the Treasury curve products that came out from iPath: the Treasury Flattener and the Treasury Steepener. We actually bought the Flattener in our ETFInvestor Tactical portfolio. What these products are designed to do is either help you take advantage or mitigate risk of fluctuations in the yield curve. So the Flattener is going long the 10-year Treasury and shorting the two, and so basically, as long as the curve reduces steepness, you make profits. Steepener is, of course, the opposite, so it's long the 2 and short the 10. So as long as the curve steepens one way or the other, you make profits there.

So, given how big fixed-income flows have been into investors' portfolios--and that's true whether it's been money market, open-end funds, or ETFs--we see the flows are happening across the board. The shape of the curve risk has become quite significant. So having these products at your disposal, having these types of tools really allow investors to manage that risk and understand it a little bit, of course understanding that when you buy insurance there is always a premium to that.

So, hopefully, if you're worried about the yield curve flattening out, and you buy FLAT, and it doesn't flatten out, then the good news is that's because the rest of your portfolio continued to make money. Bad news is you won't make any money on your investment in FLAT. So you just have to be smart about how you use those hedging tools and have realistic expectations that hedging is limiting your upside and your downside as well. But I think from what we learned in 2008 and 2009, that's generally the more prudent course.

Glaser: Sounds great. Thanks for your thoughts, Scott.

Burns: All right. Thanks for having me, Jeremy.

Glaser: For Morningstar.com, I am Jeremy Glaser.