When researching ETFs, read the prospectus and information found on the issuer’s website. There are many different types of ETFs, depending on how the fund is tracked, but also how the securities are weighted, whether there is any additional risk exposure, etc. Make sure you understand exactly what you’re buying before you invest.

Types of ETFs

ETF Index

The most common type of ETF, an index ETF tracks a specific US or foreign stock index (eg, NASDAQ 100, FTSE 100, S&P 500, Russell 2000, etc.). There is a wide variety of index ETFs for investors to choose from.

Sector/Industry ETF

These ETFs represent a specific sector (industry group), e.g. technology, energy, materials, industry, health, finance, utilities, consumer staples, etc. They track the collective performance of that industry. As with most other types of ETFs, there are US ETFs as well as foreign and global sector ETFs.

Specific Size ETFs

These ETFs are defined by the market capitalization of the individual stocks within. For example, large caps (generally over $10 billion in market cap), mid caps ($2 billion to $10 billion), small caps ($300 billion to $2 billion), micro caps ($50 billion – $300 thousand).

Country-Specific ETFs

These ETFs track the performance of the markets of an individual country or, in some cases, an entire region (eg Eastern Europe, Eurozone, Latin America, Asia, etc.). There are numerous international ETFs listed on US and foreign stock exchanges.

Commodity ETFs

Commodity ETFs track the performance of a commodity (eg, oil, natural gas, gold, silver) or a basket of commodities (eg, precious metals, base metals, agricultural commodities, etc.).

currency ETFs

A currency ETF gives investors the ability to track the performance of various currencies around the world, such as the US dollar, Japanese yen, British pound, Euro, etc. (It is important to note that while FOREX is essentially a 24-hour market, currency ETFs have the disadvantage of being available for trading only during stock market trading hours.)

fixed income ETFs

ETFs that track corporate bond indices or treasury bills.

ETFs by weighting model

Equivalent

Most ETFs (and indices) are market capitalization weighted, which means that larger companies have a much larger representation in the index and a greater influence on price movement. Most of the index capitalization is concentrated in the major holdings.

Some providers now offer equal-weighted ETFs (index and sector), which provide a broader representation of companies within the index. Each stock is initially assigned the same weight, allowing you to spread your risk equally across all stocks in the index. It also means you get more exposure to small and mid-sized companies, which often outperform larger-caps.

The other problem with market capitalization weighting is that stocks that have risen rapidly in price and become overvalued will have a higher weighting in the index. (The higher a stock’s valuation, the higher its market capitalization.) Equally weighted ETFs avoid being overweight stocks trading above fair value.

To maintain the same weight, an equal-weight ETF needs to be rebalanced periodically (usually quarterly).

This means that such ETFs (compared to traditional index ETFs) generally have higher expense ratios as well as higher bid-ask spreads (since they tend to be traded less). Since rebalancing involves the sale of shares that have appreciated more, it leads to higher transaction fees but also a higher tax liability (due to the realization of capital gains).

While equal-weight ETFs are a great addition to the ETF universe, they tend to be slightly more expensive and less tax efficient, all of which can result in a lower compound return. Investors should carefully consider whether these ETFs will benefit their portfolio.

fundamentally weighted

While traditional indices are weighted by market capitalization, fundamentally weighted ETFs offer an alternative, weighting companies based on fundamental factors (such as book value, earnings, dividends, etc.).

Some ETFs are weighted to suit a certain investment style. For example, there are a variety of value ETFs that select companies based on combinations of price/earnings, price/book value, price/cash flow ratio, dividend yield, and so on.

As we’ve seen with the same weighting, ETFs that aren’t market-cap weighted tend to have higher portfolio turnover (since they have to buy and sell holdings as prices fluctuate). This translates into higher transaction costs and lower tax efficiency; both generally apply to fundamental-weighted ETFs as well.

Actively Managed ETFs

Actively managed ETFs have been around since 2008 and have so far not proven very popular with investors. These ETFs, instead of tracking an index, use a manager to select the securities to be included in the fund.

Actively managed ETFs present similar issues to traditional actively managed mutual funds…the expense ratio and transaction costs are higher, and the tax liabilities are higher.

Therefore, the manager has to add enough value to compensate for this. Now, as we can see with most mutual funds, that rarely happens. Since most managers do not outperform the market averages, the benefits of actively managed ETFs may be questionable (at least until we start to see some track record for these funds).

While ETFs were first introduced as low-cost, transparent, passive investment vehicles, today there are also a number of highly complex ETFs. Some of them have proven very popular with experienced traders and investors, but it is essential that you fully understand the risks before investing in these more exotic vehicles.