To date, we have treated exchange traded funds (ETFs) primarily as passively managed, index trackers.
But there is more to ETFs. A whole lot more. There are ETFs that invest in every possible asset class. Not to mention leveraged, inverse, and actively managed funds.
All these other ETFs trade exactly as the ETFs we previously discussed. The only difference is the assets within the ETF portfolio and/or the investment tactics used by the ETF.
We will quickly review a few common alternative asset ETFs below. In later posts, we will go through the leveraged, inverse, and actively managed funds.
Fixed Income ETFs
Instead of equities, fixed income ETFs invest in bonds, money market instruments, and preferred shares.
Within these ETFs, there may be a specific focus. For example, short or long term bond funds. Maybe a ladder bond fund. Perhaps emerging market preferred share ETFs.
We have covered money market instruments, bonds, and preferred shares already, so please refer to those posts should you require a refresher on the asset class.
Real Estate ETFs
Real Estate Investment Trust (REIT) ETFs invest in shares of equity REITs and real estate derivatives.
REIT ETFs track REIT related indices. In the U.S., two popular indices are the MSCI U.S. REIT Index and the Dow Jones U.S. REIT Index. These indices contain just under 70% of the publicly-traded REITs in the U.S. domestic market.
We will cover REITs when we look at real estate as an asset class. They have characteristics of both equities and fixed income investments. REITs experience price fluctuations based on their underlying investments and expectations for their associated real estate markets. REITs also pay out high dividends annually as they disburse profits to shareholders.
Both REITs and REIT ETFs are interesting investments as they provide indirect exposure to the real estate market.
Commodity ETFs
Commodities are another separate asset class from more traditional investments such as equities or bonds. They may add diversification potential in one’s portfolio. That said, commodities are quite complex and should be invested in with great care (and knowledge).
Commodity ETFs may track an individual commodity, such as oil or gold.
Other commodity ETFs may track a basket of various commodities. For example, the ETRACS Bloomberg Commodity Index Total Return ETN (DJCI) tracks the collateralized returns in a basket of 23 different commodities.
Some investors also include a third type of ETF as a commodity ETF. Namely, ETFs made up of companies that produce a specific commodity. The belief is that the performance of companies involved in a specific commodity related sector will reflect changes in demand and price for the commodity itself.
When the price of gold rises, there should be increased demand for the commodity. This will create more business for companies mining gold. Also, at increased prices, the mining companies will receive higher amounts for their supply. Both of these will serve to strengthen profitability and share price for the mining companies.
This is what drives ETFs such as VanEck Vectors Gold Miners ETF (GDX). It invests in shares and American depositary receipts of companies involved in the gold mining industry.
I do not consider this third group of ETFs to be true commodity ETFs. Rather, they are simply equity ETFs investing in a specialized market segment. However, when calculating my portfolio asset allocation, I typically include these companies in any allocations I may have for commodities or precious metals.
Currency ETFs
These ETFs track specific currencies. Either a single currency or a basket of currencies.
For investors that want exposure to foreign exchange without having to trade on the more complex futures or forex markets, this is a good solution.
Investors might want foreign exchange exposure for a few reasons. These include: hedging against other investments or business activities; belief that your domestic currency will depreciate relative to a foreign currency; obtaining higher interest rates in the foreign currency than in your domestic market.
Currency ETFs are probably better used as shorter-term investments. This is because rates of return on cash tend to be the lowest available on all asset classes.
Unless you wish to hedge other activities or speculate on relative changes in currency values, find other avenues to invest in foreign markets. Purchase shares in foreign companies or foreign pay bonds instead, as these will have higher expected returns than foreign currency interest rates.
Okay, just a quick overview of those ETFs. As you can see, there are a variety of ETFs available in different asset classes. These greatly assist investors in creating well-diversified portfolios.
As ETFs tend to be low cost instruments relative to other options, they aid in cost minimization. That said, never forget that cost is often a direct function of work involved. As we move away from simple equity index trackers, the work required to maintain an ETF increases. Watch total expense ratios for all investments. This is especially true with more complex ETFs.
