As ETFs continue to grow know what you own

When it comes to exchange-traded funds (ETFs), it’s always a good idea to know what you own. That’s why our recent blog posts have focused on what we think investors really get with equal-weight and dividend growth ETFs.

One big recent development is the regulatory approval¹ of semitransparent ETFs that allow active managers to keep their strategies somewhat hidden. As the market gets more complex with new types of ETFs being introduced, we think it’s more important than ever to understand exactly what you’re investing in.

Although the list below certainly isn’t exhaustive, it could be helpful for investors trying to quickly get a handle on the various types of ETFs.

These are generally the oldest ETFs, and they represent the largest category. However, it’s important to remember that passive, index-based ETFs go well beyond just tracking the S&P 500 Index. With over 2,300 ETFs with total assets of about $4.6 trillion in just the United States,² investors have plenty of choices. Most of the first-generation, passive equity ETFs track indexes that are market cap weighted, meaning individual stocks are weighted by their market capitalization or size.

Within passively managed ETFs designed to replicate the performance of specific markets, here are some examples of how to break down the different subcategories:

• Stocks: Broad markets, sectors, industries, United States, international (regions and countries), real estate investment trusts (REITs).
• Bonds: U.S. Treasuries, corporate bonds, municipal bonds, emerging market debt.
• Commodities: Precious metals, oil, grains (may invest in futures contracts).
• Currencies: U.S. dollar, Japanese yet, euro.

Although there are many ways to categorize the remaining ETFs into different groups, this is how we would break up the rest of the industry:

• Smart beta: Although there's no set definition, this group generally combines elements of active and passive management. The goal is to outperform the market or reduce risk by focusing on stock attributes known as factors, or a combination of them, known as multifactor. In the United States, there are over 1,000 smart beta ETFs with total assets under management of about $1.1 trillion.³
• Active: Although the first ETFs were passive, they can now use active-management strategies. For example, the new semitransparent ETF structure is expected to bring more active strategies to ETFs.
• Leveraged and inverse ETFs: Both are trading vehicles designed to let traders magnify the daily performance of indexes (leverage), while inverse ETFs, for example, allow traders to bet against markets and hedge. Leveraged and inverse ETFs are designed for short-term trades, rather than as buy-and-hold investments.

There are many other categories we could have included here, but this is just a broad overview. One example is the emerging class of ETFs for environmental, social and governance (ESG) strategies. Also, exchange-traded products include various structures such as exchange-traded notes (ETNs), open-end funds, and unit investment trusts (UITs). We plan on looking at more ETF structures and their tax consequences in future posts.

1 “Statement of Commissioners Jackson and Lee on Non-Transparent Exchange Traded Funds,” sec.gov, 11/15/19. 2 xtf.com, as of 2/7/20. 3 etf.com, as of 2/25/20.