Alternative Asset Class ETFs

On 11/27/2010, in Exchange Traded Funds, by Jordan Wilson

To date we have treated exchange traded funds (ETFs) strictly as index trackers.

In our examples, we have focussed on stock indices.

But there is more to ETFs than simply being stock index trackers.

Before leaving ETFs, I want to briefly discuss some other available ETF options.

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.

Today we will quickly review some other available ETF asset classes.

Fixed Income ETFs

Instead of equities, fixed income ETFs invest in bonds and possibly money market instruments and preferred shares.

Like fixed income mutual funds, these ETFs can hold a wide range of securities from short term Treasury instruments to long-term bonds.

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 passively 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 and vary 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. So they provide added diversification potential when included 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 E-TRACS DJ-UBS Commodity Index Total Return (DJCI) tracks the collateralized returns in a basket of 19 commodities representing the energy, precious metals, industrial metals, grains, softs and livestock sectors.

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 Market Vectors Gold Miners ETF (GDX). It invests at least 80% of its assets 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 would 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.

And because ETFs tend to be low cost instruments relative to other options, they also 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 trackers, the work required to maintain an ETF increases. You need to carefully watch total expense ratios for all investments. And this is especially true with more complex ETFs.

Next we will review ETFs that use other investment strategies than pure passivity.

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