Exchange-traded funds have swept the stock market over the past decade and have been a blessing for many investors.
But while large index-based funds, such as those that track the Standard & Poor’s 500, may fairly represent the index’s stocks, smaller niche ETFs don’t always deliver strictly what their names promise, and you might wind up indirectly buying a lot of something you didn’t really want.
This doesn’t mean you should avoid ETFs entirely. After all, top investor Warren Buffett recommends S&P index ETFs as the top choice for most investors.
But if a tightly focused investment is what you are after, you have to know what’s in your fund.
So why bother with ETFs? Index mutual funds are similarly cheap and diversified, but they don’t offer ETFs’ flexibility and focus. ETFs trade throughout the day like stocks, while mutual funds are priced and traded at the end of the day.
So investors can move in and out of ETFs quickly and easily. Plus, ETFs offer an increasing range of investment themes, slicing and dicing the market by almost any category imaginable — capitalization, industry, value, country and more.
Looking inside an ETF
If you really want to bore in on a specific sector, ETFs can let you do that — at least, that’s the idea.
Take a look at the iShares MSCI Spain Capped ETF, which is meant to give investors access to large and midsize companies in a single country, according to its fund manager. But while the fund does use stocks listed in Spain, the revenue of those companies largely come from outside the country.
According to asset manager Horizon Kinetics, the top 10 companies within this ETF, which account for more than two-thirds of its total assets, derived 53 percent of their sales from outside Spain as of Dec. 31, 2016.
The iShares MSCI United Kingdom ETF has a similar issue. The fund means to be U.K.-focused, but it’s stuffed with global multinationals, which derived 64 percent of their revenue from outside the U.K. in 2016, according to Horizon Kinetics.
These aren’t isolated events; mismatches can occur in many funds. Small-company ETFs might have little exposure to truly small companies, preferring to shade into more liquid midsize firms.
And as Horizon notes, supposedly value-themed ETFs may deliver less growth and yet be more costly than the overall S&P 500, so hardly a value.
If you want to figure out what’s really in an ETF, you will have to dig beyond its name.
What’s going on?
The rise in ETF investing has created a market where fund managers are awash in cash that must be placed in themed investments.
Over the past decade, more than $1 trillion has moved from actively managed stock mutual funds to passively managed stock index funds and ETFs.
The more money an ETF has, the more it will be forced to chase larger companies, since these stocks can more easily absorb the dollars flowing in. But there’s a limited selection of large, liquid companies.
And, returning to the earlier examples, these companies tend to operate globally, so only small percentages of their revenue come from any one country. It ends up being hard for an ETF to get “pure” exposure to, say, Spain or the U.K.
What can investors do?
The first step is understanding that a niche ETF might not be quite as focused as its name suggests. Then you can find out much of what a fund does own, because each ETF details its top 10 stakes, including names and position sizes.
But you will have to dig deeper — into the EDGAR database on the Securities and Exchange Commission website, for example — if you want to determine how much business a company does in a certain niche. That defeats much of the purpose of this kind of ETF: speed and simplicity.
The information the ETF provides can also help investors who assume that a themed fund will help them diversify their portfolio.
For example, in the Spain fund, the top position, Banco Santander, makes up more than 18 percent of the fund’s assets — so if you already own that stock, or another fund that contains that stock, your portfolio’s diversity will actually suffer.
With so many funds investing in the same large companies, you might end up with a bigger allocation to one company than you want.
So if you’re looking to ETFs for diversification — or for a precisely targeted investment — read the fine print first.
James Royal is a writer at NerdWallet. E-mail: email@example.com.