You'd be hard-pressed not to have at least heard of ETFs by now.
It's short for exchange-traded funds, and they're a type of investment vehicle that typically seeks to track a well-known index—like the S&P 500—in the hopes of closely mirroring those market benchmarks.
But while you may just be familiarizing yourself with the concept, ETFs have actually been around for a couple of decades—so they're not as new to the investment landscape as you'd think.
And certain ETFs now go well beyond plain-vanilla index tracking.
Interested in China’s biggest companies? Looking to invest in biotech firms? Want to buy bonds based in other countries?
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There’s an ETF for that.
Indeed, according to analysis site ETF.com, more than 130 new ETFs were launched last year, and the majority of them tracked something more exotic than a major stock-market index.
Of course, a crowded market can lead to a lot of head-scratching—especially if you're talking about more complex investing concepts.
“What I’ve frequently seen is that someone will hear about an ETF from a friend, or read about it, and then buy it—without really understanding what it is and the role it plays in their portfolio,” says Mike Piper, author of “Investing Made Simple” and founder of personal-finance blog Oblivious Investor.
So with the help of some investing pros, we’ve put together an educational primer on five types of ETFs that are garnering buzz these days. Think of it as a mini class on the next wave of ETFs.
The 101 on ... International ETFs
Your German car. Your Japanese smartphone. Your Indian spices. It goes without saying that we live in a very global economy these days.
Indeed, some of the world’s fastest-growing economies are overseas, which is why some investors find international ETFs appealing.
In a nutshell, international ETFs typically aim to track indexes that either invest in a wide swath of securities situated across the globe, or zero in on specific countries or regions. For instance, an investor interested in big companies in Asia or small firms in Europe could use an international ETF as an avenue into these markets.
According to Piper, international ETFs can add diversification and long-term growth to a portfolio, but that said, he cautions that venturing outside of a broad-based international ETF could mean taking on more risk.
Some international funds invest in securities based in such developing economies as Eastern Europe and Latin America. So while these regions can show potential for future growth, factors like political unrest and lax corporate governance can add to their risk profile.
The 101 on ... Currency-Hedged ETFs
Seasoned globetrotters know the joy of having their dollar go far in Mexico—only to feel the pain of the pinch to their wallet in London.
Well, the same exchange rates that can stretch or shrink a travel budget also have the potential to impact the international portion of an investment portfolio.
After all, a dip in the worth of a country’s currency against the U.S. dollar could also mean a dip in the value of that country’s securities for U.S. investors.
And that's where currency-hedged ETFs come in. They're a subset of international ETFs designed to help give investors access to global markets, while seeking to minimize the impact of exchange rates.
That said, Patricia Oey, a senior analyst primarily covering international equity strategies with investment research firm Morningstar, says there are a couple of things to keep in mind.
For one, currency-hedged ETFs tend to come with higher management costs. She also notes that currency risk is typically more of a concern for shorter-term investors, as opposed to those with a long time horizon.
"The major currencies tend to move in cycles, so over the long term, these fluctuations tend to net out," Oey explains.
The 101 on ... Bond ETFs
Although bonds themselves are familiar territory to investors, bond ETFs are relative newbies to the investing scene—most offerings are less than a decade old.
These ETFs invest in a basket of bonds that may include a mix of different types—such as U.S. Treasuries, municipal bonds and corporate bonds—or they may focus on a specific bond sector, such as international or long-term bonds.
In either case, the goal is to help investors add a fixed-income component to their portfolios.
Since the commercial real-estate industry isn’t well represented in big indexes like the S&P 500, REIT ETFs can help provide a way into a part of the economy that may be otherwise hard to access.
Bonds are typically viewed as a way to help offset some of the risk of investing in equity markets.
But that doesn’t mean you shouldn’t pay close attention to the types of bonds you’re investing in.
“You should always look at the underlying basket of bonds in an ETF to help match the objective of your portfolio to the types of bonds you’re going to buy,” says Rick Ferri, author of “The ETF Book” and founder of Michigan-based investment management firm Portfolio Solutions.
For instance, if your goal is to be broadly diversified, you may want to consider a total bond market index. Or if you think you’ll need the money in the near future, you might look into a short-term bond fund.
The 101 on ... Factor ETFs
It may bear a nebulous-sounding moniker, but upon closer investigation the name makes sense: Factor ETFs track companies based on different attributes—or factors—outside of the typical measurements used to track the major, plain-vanilla market indexes.
Signs you’re looking at a factor ETF? Their names will include the specific strategy they’re following, such as value or low volatility, Ferri says.
A value factor ETF, for instance, screens for companies whose shares appear to be undervalued in the market and are therefore deemed to potentially be a bargain. And a low-volatility ETF focuses on firms that tend to have smaller stock-price swings.
Like currency-hedged ETFs, factor ETFs may charge higher fees than plain-vanilla ETFs, since more administrative overhead is required to manage them.
And don’t be confused if you hear something that seems like a factor ETF but is being described as a “smart beta” or "strategic beta" ETF.
“In many cases, 'smart beta' is just a new marketing term for concepts—like value factor ETFs—that have been around for awhile,” Piper says.
The 101 on ... REIT ETFs
According to the U.S. Bureau of Economic Analysis, the real estate, rentals and leasing sectors contributed to about 13% of the U.S. gross domestic product in 2014.
For investors who don't have the ability to snatch up investment properties themselves, one investment vehicle that can potentially diversify a portfolio with such holdings is a REIT ETF.
These funds are designed to track the performance of indexes made up of real estate investment trusts, which are companies that either invest in income-producing properties (such as apartment rentals or office buildings), own mortgages—or do a hybrid of both.
Since the commercial real-estate industry isn’t well represented in big indexes like the S&P 500, REIT ETFs can help provide a way into a part of the economy that may be otherwise hard to access, Ferri says.
“Most real estate is capitalized privately, [but] through REITs, you have a very small signature in the stock market,” he explains. “They can help give you a better footprint [in your portfolio] for what the economy looks like, as opposed to just what the stock market looks like.”
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Investing involves risk, including possible loss of principal. Diversification and asset allocation may not protect against market risk or loss of principal.
International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets or in concentrations of single countries.
There can be no assurance that performance will be enhanced for funds that seek to provide exposure to certain quantitative investment characteristics ("factors"). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses. Real estate investment trusts (“REITs”) are subject to changes in economic conditions, credit risk and interest rate fluctuations.