'Pure-play' ETFs might be a shrewd investment

They're called "pure-play" exchange-traded funds (ETFs). And they're the latest rage in the ETF sector.

But are they too much of a risk?

According to Dictionary.com, a mutual fund is an investment company "that gives small investors access to a well-diversified portfolio of equities, bonds and other securities," professionally managed to "match the objective stated in the (fund's) prospectus."

These days, the "other securities" can extend from ordinary common stocks and bonds to commodity futures, currencies, market indexes and various types of derivatives. And the "objective" can range from simple growth to complex hedging strategies.

However, regardless of the underlying securities used or the specific objectives involved, the term "well diversified" exemplifies the basic principle underlying the "fund" concept. Funds are vehicles intended to give smaller retail investors access to a much-wider array of assets than they could otherwise afford.

Given that definition, a question arises about the latest trend in the rapidly expanding world of exchange-traded funds - the creation of a number of these so-called "pure-play" ETFs. The question is: Can such narrowly focused investment vehicles really be considered "funds" - and do their benefits outweigh the potential risks?

For those not entirely familiar with them, ETFs are fundamentally the same as regular mutual funds in that their shares represent fractional ownership in a broad pool of underlying assets. However, rather than being bought and sold directly from and to the fund-management company at the current net asset value (NAV), ETF shares trade on organized exchanges, much like the stocks of individual corporations.

As such, though ETF prices generally approximate the per-share value of the fund's underlying assets, the share price can vary substantially on an intraday basis, and can sometimes stay at a premium or discount to NAV for prolonged periods, depending on investor expectations and shifting market demand.

(Note: ETFs are similar in structure and tradability to so-called "closed-end funds," but closed-end funds are unit trusts and not considered to be ETFs.)

ETFs were first introduced in the United States in 1993 and were initially used primarily to mirror the performance of various sector and market indexes, particularly those of foreign stock exchanges difficult for individual U.S. investors to access. However, more liberal indexing provisions were allowed in 2006. And in early 2008, the Securities and Exchange Commission (SEC) authorized creation of the first "actively managed" ETFs, sparking an explosion in new offerings linked to all manner of assets, from biotech and energy stocks to metals and agricultural products.

Indeed, it was proposed formation of an agricultural ETF that prompted the question posed above. In early April, Teucrium Trading LLC, a Vermont-based investment firm, announced plans to offer a "pure play" ETF focusing exclusively on corn - and doing so with about as tight a focus as you can get.

According to the initial release, The Teucrium Corn Fund, which will trade on NYSEArca under the symbol "CORN," will offer investors a "well-diversified" corn asset pool featuring just three Chicago Board of Trade (CBOT) futures contracts. Specifically, sponsors say, the fund will "track a daily weighted average of closing settlement prices for the second-to-expire CBOT futures contract, weighted at 35%; the third-to-expire contract, weighted at 30%; and the final 35% based on the contract expiring in the December following the expiration of the third-to-expire contract."

Presumably, blending three futures contracts will offer slightly less risk for investors who desire corn exposure than simply buying one contract outright - backers say it will lessen the impact of "contango" and "backwardation," if any. However, the only real benefits for corn fund investors will likely be a lower cost based on a smaller unit size (CBOT corn futures represent 5,000 bushels, worth roughly $18,500 at recent prices) and the absence of a futures margin requirement.

That's a minimal advantage for farmers, processors, end users and others who really need to make corn investments, meaning the pure-play corn ETF may wind up being primarily a speculative vehicle - as is also the case with many other commodity-based ETFs.

In reality, says Money Morning Contributing Editor Shah Gilani - himself, a former hedge fund manager - the major beneficiaries of many of the new pure play ETFs will be the companies creating them. But he also says that's no reason to dismiss them.

"The singular, compelling reason for creators or sponsors of ETF products to construct exchange-traded tracking devices is their own profitability," says Gilani. "It's an assets-under-management/fee-generating strategy."

And that's not necessarily a bad thing, Gilani says.

"As with most Wall Street [retail] products, the sponsors will work to ensure their funds are successful," he explains. "Because, if customers do well with new products, the fee and trading opportunities for the fund manager and affiliated broker-dealer companies will expand."

Plus, he says, the reward for retail investors can be substantial "if the fund sponsor gets it right."

"The level of diversification within the ETF itself is not nearly as important as the added diversification an investor can get by including focused ETFs in his or her portfolio," Gilani contends. "The entire movement towards ETFs is rational, practical and ultimately great for investors. ETFs are excellent tools investors can use to diversify out of the dangerously narrow confines of equity exposure and onto the much larger landscape of non-correlative asset classes."

Gilani does caution that "pure-play" ETFs are never exactly pure plays.

"By their nature, they are derivatives," he notes. They are "tamer and more manageable members of the family of derivative products, but [they are] derivatives, nonetheless. The key to successful pure-play ETFs lies in how they are constructed - in other words, how they track their commodity, benchmark, index, idea, whatever.

"That's the first question investors must ask - will the ETF track correspondingly," Gilani continues. "And, if it does, is there liquidity? Typically, ETF investors look at daily volume to determine liquidity, but that's not enough. With pure plays, they need to look at the liquidity in the underlying instruments the sponsor is holding in the fund portfolio, as well as the history of the bid-ask spreads for the shares themselves."

Examples of potential problem pure plays would include an interest-rate ETF holding thinly-traded notes or bonds issued by a creditor with poor credit ratings, as well as commodity ETFs focusing on secondary or thinly traded futures or products.

Money Morning Contributing Editor Martin Hutchinson echoes Gilani's concerns about tracking error.

"The primary worry with complex ETFs is that they don't provide what it says on the box," Hutchinson says, citing inverse index funds as an example. "Inverse ETFs accumulate huge tracking errors, meaning even investors who choose their exposures correctly can end up losing money when they should have gained."

In spite of that, Hutchinson likes the use of ETFs to get broad exposure to a market index or investments in a particular country, "provided they are big enough to be liquid and have low expenses." However, he questions the value of ETFs with a really narrow focus.

"If ETFs just invest in a basket of stocks or commodities, they're fine," he says. "But if they attempt to get exposure to a sector through futures or derivatives, there are almost certainly hidden risks that ordinary investors don't recognize. I'd personally avoid more-exotic ETFs - the fancier they get, the greater the risks."

The issue of expenses raised by Hutchinson could also turn out to be a major concern for investors in actively managed pure-play ETFs. A recent survey conducted by ETFdb.com found that the average passive (or index) ETF has an annual management fee of about 0.25% of assets, plus or minus 0.05%.

By contrast, the fees of the new actively managed funds are much closer to those charged by ordinary mutual funds - ranging from 0.79% to as much as 1.50%. Over time, that can translate into a huge difference in cumulative returns.

Still, in spite of the above concerns and caveats, it's safe to say that ETFs are here to stay - and the wave of new pure-play ETFs is still a long way from cresting. And, when it comes to adding agricultural commodities, hard assets, foreign equities and specialty stocks to the portfolio-diversification mix, that's likely to be a good thing for investors.

As proof, the ETF Trends newsletter lists four distinct benefits of commodity ETFs for the average investor:

• With commodity-based ETFs, you have three different ways you can get your exposure - through funds investing in the actual physical commodities, funds that hold futures contracts or funds that hold the stock of commodity producers (miners, refiners, exploration firms, etc.). With some commodities and products, such as coal and steel, equity-based ETFs are the only means of gaining exposure.
• You don't have to be an expert on any given commodity - the fund managers employ pros to do the analysis for you.
• ETF prices are less volatile than those for physical commodities or futures, responding more to long-term trends than day-to-day fluctuations. ETFs also tend to cushion disparities between market prices and production costs, which can sometimes trigger sudden sharp declines in physical or futures markets.
• Unlike futures and some commodities, ETF trades are treated like stock trades with respect to taxes, and may qualify for long-term capital gains rates (15%) - though you should always check with your own tax professional in making the determination.

With respect to disadvantages equity-based commodity funds, ETF Trends cites just two:

• If your ETF invests in a company that goes bad - because of mismanagement, natural disasters, labor strikes or whatever - your shares can drop in value regardless of what happens with the price of the associated commodity.
• Companies engaged in the active use of commodities generally hedge their exposure to future price fluctuations. Thus, the company's stock price may not benefit from a rise in the commodity price.

If, given this summary of benefits and drawbacks, you think adding some pure-play ETFs to your portfolio could provide needed diversification and enhance your profit potential, following are several commodity-based ones that have shown good performance and are rapidly gaining in popularity, as well as a few of the older, broad-based ones providing access to foreign or specialty markets:

• Market Vectors Gold Miners ETF (NYSE: GDX, Stock Forum), recent price $52.34: Founded in May 2006 as an index fund, but now actively managed, the biggest GDX holdings include Barrick Gold Corp. (NYSE: ABX, Stock Forum), Goldcorp Inc. (NYSE: GG, Stock Forum) and Newmont Mining Corp. (NYSE: NEM, Stock Forum). Its year-to-date market return through April 28 was 25.06%.
• SPDR S&P Metals & Mining Trust (NYSE: XME, Stock Forum), recent price $53.18: This fund invests primarily in companies dealing in industrial metals, with Titanium Metals Corp. (NYSE: TIE, Stock Forum) its largest recent holding. Its year-to-date market return in 2010 has been 54.49%.
• PowerShares DB Agriculture (NYSE: DBA, Stock Forum), recent price $23.71: Just over three years old, this diversified agricultural-products fund holds wheat, corn, soybeans and sugar futures, among others. It moved in a fairly tight range last year, producing a 7.6% return, but it's down just over 2.3% so far this year. However, adverse spring weather conditions are prompting many analysts to predict poor crops in many areas this summer, leading to higher grain prices.
• Market Vectors Steel Index ETF Fund (NYSE: SLX, Stock Forum), recent price $58.59: Founded in October 2006, SLX has major holdings among the international steel producers and suppliers, including Vale S.A. ADRs (NYSE: VALE, Stock Forum ) and Rio Tinto PLC (NYSE: RTP, Stock Forum ). Year-to-date market return for 2010 has been 73.3%.
• PowerShares Global Coal Fund (NYSE: PKOL, Stock Forum), recent price $27.03: Just 19 months old, this fund has heavy interests in Chinese mining and energy companies, with a few U.S. miners thrown in for balance. The return to date in 2010 has been an impressive 93.14%
• iShares Dow Jones U.S. Oil & Gas Exploration & Production (NYSE: IEO, Stock Forum), recent price $53.07: A specialty oil and gas fund founded in 2006, IEO's holdings read like a Who's Who of U.S. energy producers, including Occidental Petroleum Corp. (NYSE: OXY, Stock Forum) and XTO Energy Inc. (NYSE: XTO, Stock Forum). The year-to-date return so far has been 29.1%, but could ramp up thanks to the Gulf oil spill and higher projected oil prices this summer.
• First Trust ISE Global Copper (NASDAQ: CU, Stock Forum), recent price $27.60: Just over a month old, this pure-play offering tracks the ISE Global Copper Index. No return numbers are yet available, but the price is up more than a dollar from its first-week (March 12) close.
• First Trust ISE Global Platinum (NASDAQ: PLTM, Stock Forum), recent price $28.52: Introduced a couple of days earlier than its sister (brother?) copper fund, this metals pure play tracks ISE's Global Platinum Index - which has been stronger than copper, sending the share price up almost $3.00 from its opening week close.
• SPDR KBW Bank ETF (NYSE: KBE, Stock Forum), recent price $26.33: This fund, which focuses on major U.S. banks - largest holdings include Bank of America Corp. (NYSE: BAC, Stock Forum) and Citigroup Inc. (NYSE: C, Stock Forum) - was among the top ETF performers in the first quarter of 2010, gaining 22.1%.
• First Trust Biotechnology Index Fund (NYSE: FBT, Stock Forum), recent price $32.59: This fund, founded in June 2006, rode the biotech surge to an impressive 30.1% gain in the first quarter. Be aware, however, that it may be prone to tracking error since the index it follows weights stocks equally rather than by market cap, which gives added emphasis to the sector's smaller, riskier stocks - most of which it's likely you've never heard of.
• iShares Brazil ETF (NYSE: EWZ, Stock Forum), recent price $65.67: A darling of many international analysts and newsletter writers, this fund, founded in July 2000, was among the top performers over the past year, gaining 124% (versus 77% for the S&P 500) from the market bottom last March through mid-April 2010. It invests exclusively in Brazilian stocks and could continue to prosper given recent optimistic forecasts for the South American economy. This ETF was also the topic of highly successful "Buy, Sell or Hold" pick in Money Morning back in October 2008 at $29.94 - the shares have soared 119% since that time.
• Wisdom Tree Pacific (ex-Japan) Equity Inc. (NYSE: DNH, Stock Forum), recent price $52.78: A lesser-known Asian fund that focuses on non-Japanese dividend stocks, the four-year-old DNH has major holdings in Australia, New Zealand and Indonesia and has produced a 64.6% market return so far in 2010.

And, of course, don't forget to watch for "CORN" when it starts trading. As Shah Gilani says: "How they manage backwardation, contango and daily price-limit moves with this corn pure play will be something to watch. I hope they get it right because there's a place for agricultural-product exposure in nearly every portfolio."