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ETFs for the Corners of Your Portfolio

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

It's ETF Investing Week on Morningstar.com, and today we are talking about some of those corners of the market where ETFs go that not a lot of other investment types go.

Here with me to dig into some of those is Morningstar's Paul Justice. He's our director of North American research for ETFs.

Thanks for joining me, Paul.

Paul Justice: It's more exciting than Shark Week for me, so I am glad to be here.

Stipp: Well, we are certainly glad to have you.

There are some areas where ETFs have gone out and given people exposure that they really couldn't get otherwise before the advent of the ETF, or at least not very easily.

I wanted to talk about a few of those. The first one I think is one that a lot of investors are taking more interest in now, and ETFs have given them that access, is commodities. How are ETFs investing in commodities, and how is it being done now that it hasn't been done in the past?

Justice: Well, we have many more commodity funds in ETFs than we do in the open-end mutual fund structure, which is really interesting given how long those investments have been around--we didn't even deem that there was enough funds to create an entire category for those before.

But now with ETFs, we are getting targeted exposure in so many ways you can't access with mutual funds ... the common ones are broad basket indexes, which you could get a mutual fund, but now you get the targeted exposure, you get down to single types of commodities: oil, natural gas copper. We are talking about wheat, corn, just about anything that you could really do down at the mercantile exchanges themselves, you are really able to do in an ETF now.

Especially popular are the precious metal funds, think about the [SPDR] Gold Fund GLD, the fourth-largest holder of gold in the world at this point. That was a fund that wasn't around back in 2003. This has really changed the landscape of the way people access markets.

Stipp: So I know one of the things with that gold fund, for example, they actually hold the commodity instead of using the futures markets to gain access. Is the holding of the commodity something that's specific to some ETFs that we hadn't seen in other investment vehicles before?

Justice: It is, so you could get it say in a closed-end fund structure at some times, but why would you want to go out and pay say a significant premium to buy a metal when you know it's broadly traded and exchanging hands and is going to be stored in the vault just like the ETF.

If I look at a horrible fund right now, there is this Sprott Silver Trust, that's trading at a 20% premium to silver prices. To me that's absurd. You could go out and buy the silver ETF and actually get a fair price and get the same silver stored in a vault for you. So, I think that getting it through ETFs has been a great way to gain access to precious metals, where you are getting the actual spot price performance.

Stipp: So ... we are going to have more information on commodity ETFs on [Thursday], but certainly some areas where investors can go now they couldn't before.

Another area is currencies. ETFs have made available all different sorts of currency exposures. How would an investor use such an ETF?

Justice: Well, there are several ways. Obviously, a lot of people are using these for speculation. So, you think that the yen is going to get weaker relative to the dollar, you can trade that through an ETF. There are so many ETFs now that are linked up to pair trades between the U.S. dollar and some other currency.

So, if you want to speculate, that's one way you could do it, or if you do have a vested interest in some of those areas, and you want to hedge out that exposure, that's another great use for the ETF, because you don't have to go long the ETF; you can also short it to neutralize any exposure you have in your portfolio.

So, you can enhance volatility, you can reduce volatility, and you can buy funds that, if currency was your main concern, but you wanted exposure to those equities, you can pair them up together and really get that targeted exposure you are looking for. So, in that case, I think having this proliferation of product choices is a great thing for someone who is a bit more sophisticated.

Stipp: Another area--and I think you'll have to explain this a little bit to me--that ETFs have branched out and given people exposure to is volatility. What does it mean to invest in volatility?

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Justice: Well, for a lot of people it means speculation, for many more people it means insurance. So this is something that you really didn't see in the mutual fund space, where you are talking about betting on or taking exposure to price dislocations or heightened uncertainty.

Certainly, it was brought to the fray in 2008 when we saw the VIX spiking above 80. Now, we have at least 15 different exchange traded products focused on volatility in some way, shape or form, which we didn't have three years ago.

I think it's a great way--it's a sophisticated instrument that you need to pair up and really know how to use, but you can focus in now on short-term futures in volatility, in midterm, an investment that's pairing volatility with the S&P 500 to try to help to smooth out that ride when we see some downside potential coming along.

To me, it's like buying an insurance policy, though. You are probably going to lose a little bit of money every single month on these products, but hope that when do pay out, they pay out big, because there was some sort of a disaster and that was a ballast.

Stipp: Certainly, an interesting exposure that's being offered by ETFs now.

Another area, Paul, and we have a lot of investment vehicles that have gone and helped people invest overseas. How are ETFs helping to expand the options that overseas investors have? Where are they going that may be we hadn't seen mutual funds tread before?

Justice: Well, I think there is two interesting points; one, ETFs are going places where we hadn't seen before, but two, we are also seeing people use ETFs in ways that mutual funds were available, but they just weren't getting used before.

I think that's especially true when you are talking about, say the case for emerging markets. Now, two of the four largest ETFs on the market today are broad-based emerging-market funds. Now, we may see the most assets concentrated in large-cap domestic equities in the U.S., but it still pales in comparison to the usage of mutual funds in the large-cap space.

ETFs are ... about 10% of the large-cap domestic equity space, so they are tiny compared to mutual funds. When we get into the emerging market space, we are talking more like 35% of all assets by U.S. investors are focused through ETFs to gain that emerging-market exposure.

So, they have made huge progress here in capturing a larger share of people's portfolios. And I think few reasons for that is, one, you get great low price on the ETF, but two active managers haven't really proven their worth all that much or at least as much as I would expect in emerging markets, because these ETFs are sitting at 4 and 5 stars at sometimes, meaning that they are beating the performance of most of their actively managed counterparts. So, you got the cost argument, the performance argument on your side, why wouldn't you look at the ETF?

Where it's especially true that people are using ETFs, and where we've seen very little activity by mutual funds, is in the realm of single-country investing. People are really using ETFs in these cases. Sometimes there might not be a mutual fund choice there, but if it is available it might be say a 2% fee and that just doesn't make a lot of sense for somebody who wants to take that targeted exposure.

Stipp: So I want to talk a little bit about some of these single-country ETFs, because we have seen some interesting phenomena around some of those recently as we've had some very targeted news happening in some very targeted areas of the world.

Can you talk a little bit about what trends we've seen, for example, in the Egypt ETF and then later in the Japan ETF, and how people have been using those vehicles as very important news has been coming out of these regions?

Justice: So, in both cases we see some market dislocations, stock exchanges closing down, price dislocation. What's interesting in both cases is that we saw investor activity picking up. So, basically the ETFs have actually garnered assets throughout this crisis. Look at Japan just a couple of months back in November and December, that was a $4 billion fund. Now we know that the Japan market itself has gone down since that time, but the ETF now has over $7 billion in assets. People are actually putting money in there, making bets on Japan. And Egypt who experienced similar growth, and that exchange was closed for a very, very long period of time.

Stipp: So, I think this is an interesting trend. So does mean that a lot of contrarian investors are saying "the markets are disrupted briefly because of whether it's the natural disaster or whether it's uprisings in that country." Is it a bunch of contrarians going in and buying this fund? Is that why we're seeing the popularity spike there?

Justice: I don't know what it means, but I know why I don't know it. Let me put it that way. So, what we can see in some of these ETFs is that we actually have people making more bets. Now, we don't actually know if these are long bets or short bets, but generally what's going to happen is you are going to see assets flow into the ETFs. So, if you are new to the market, you may think "oh, well people want to buy those funds, I guess." That's not necessarily the case. That may be an institution that's putting money into the ETF to create more shares, while they are hedging out their exposure on some other side for the sole reason of being able to lend those shares out to someone who wants to short them.

So, there is an opportunity for the institutions to make money in the share-lending aspect. So, we can accommodate larger short interest and potentially people who also think that the countries are going to recover.

We can't do the same investor experience studies on ETFs that we do with mutual funds, where we knew that you can't short it, so if money is coming in, that's people making a long bet. With ETF, it is a whole different game.

Stipp: So very important thing to consider when you see that increased interest in some of these single-country ETFs, it could be bets against the country. It could be bets for the country. You can't automatically assume one way or the other?

Justice: Yeah, we just know that there is more people standing at the table.

Stipp: All right, Paul. Very interesting insights on those single-country ETFs as well as some of the other areas of the market where ETFs have offered investors exposure that they didn't have before. Thanks for joining me today.

Justice: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.