The Weird World of ETFs

The proliferation of exchange-traded funds has led to the creation of increasingly specialized products. Here are some of the most exotic

by Marc Hogan

Exchange-traded fund launches are quickly becoming as routine as the launches at Cape Canaveral. Fund companies rolled out 155 new ETFs in 2006, according to Boston consultancy Financial Research Corp. As new products hit the market, the nature of the products is changing (see BusinessWeek.com, 5/5/06, "ETFs: Sliced, Diced, and Razor-Thin"). Best known as cheap, tax-efficient portfolio diversifiers, ETFs now provide exposure to even the narrowest—and sometimes most outlandish—investment niches.

Just last week, 22 new ProShares ETFs from Bethesda (Md.)-based ProFunds Group started trading on the American Stock Exchange. Boston's State Street Global Advisors (STT) unveiled its new SPDR FTSE/Macquarie Global Infrastructure 100 ETF (GII). Meanwhile, New York upstart XShares (formerly Ferghana-Wellspring) announced a deal with the Chicago Climate Exchange to build ETFs based on carbon emissions credits.

Investors shouldn't assume something is a smart investment simply because it's an ETF. "The package does not make the product," says Philip Edwards, managing director of Standard & Poor's Investor Services (MHP). "Don't invest in anything you don't understand."

ETFs may be carving the market into thinner and thinner slices, but a well-diversified portfolio remains as important as ever for investing success (see BusinessWeek.com, 6/22/06, "Spread Your Bets in ETFs"). This Five for the Money looks at five of ETF providers' most unusual offerings.

1. PowerShares Lux Nanotech Portfolio (PXN)

Fast-growing Wheaton (Ill.)-based PowerShares has contributed its share of today's vast pool of niche-oriented ETFs. Since being acquired by Amvescap (AVZ) early last year, the company has nearly doubled its ETF lineup, from 36 to about 70. Many of those funds, such as PowerShares Lux Nanotech Portfolio, focus on such narrow slivers of the market that they could be unduly risky for most investors.

Some nanotechnology stocks could certainly thrive in the future, but for most of us the potential volatility may not be worth it. "Focusing on these industries in one fund is a rather perilous course," says Morningstar (MORN) ETF analyst Dan Culloton. "They're going to be very volatile, because not all of these firms are going to survive."

Culloton says industries like nanotech can be so narrow that ETFs tracking them must buy some unlikely stocks to fill out their portfolios. For example, PowerShares Lux Nanotech's holdings include such household names as Toyota Motor (TM), IBM (IBM), Hewlett-Packard (HPQ), Intel (INTC), 3M (MMM), and General Electric (GE). Such blue-chips could decrease the ETF's aforementioned volatility, but they mean investors aren't exactly getting a pure nanotech play.

PowerShares Lux Nanotech Portfolio logged a total market return of –6.3% for the year ended Feb. 6, trailing the Standard & Poor's 500-stock index by 22.95 percentage points. The ETF carries an expense ratio 0.73%. Investors should remember that buying or selling ETF shares also incurs brokerage commissions.

2. HealthShares Enabling Technologies ETF (HHV)

Speaking of ETFs for tiny subsectors: XShares' HealthShares ETFs each target a specific segment of the health-care, life-science, and biotech industries. Launched in late January, the five HealthShares offerings so far include the likes of HealthShares CardioDevices ETF (HHE), HealthShares Diagnostistics ETF (HHD), and HealthShares Emerging Cancer ETF (HHJ). HealthShares Enabling Technologies ETF tracks companies involved in technologies "that enable and support the discovery, clinical development, and manufacturing activities of pharmaceutical and biotechnology companies," according to the prospectus. Top holdings include Sangamo Biosciences (SGMO) and Illumina (ILMN).

The same caveats about potential volatility apply to these narrowly focused ETFs. Furthermore, the stocks such funds invest in might not even be the ones that ultimately profit from new technologies, Morningstar's Culloton notes. In The Future for Investors, Wharton professor Jeremy Siegel writes that companies that benefit from technological advances usually tend to be big, boring ones, not necessarily those laying the wires and expanding the networks. "That's an important thing for investors to remember," Culloton says.

Net annual operating expenses for each HealthShares ETF are capped at 0.95%, not including brokerage commissions. XShares has also filed with the Securities & Exchange Commission to launch a series of ETFs dubbed StateShares, which would home in on geographic subsectors. The funds would track S&P indexes for California, Ohio, Missouri, North Carolina, and 18 other states.