Different Types of Exchange-Traded Funds or: ETFs for All Tastes!

Investors now think they know all about exchange-traded funds (ETFs) because they have existed for 20 years and their popularity continues to grow. In late September 2010, the weekly trading volume in XIU (iShares: S&P/TSX 60 Canadian Index Fund), the most popular ETF in Canada, was close to 60 million shares (or units), surpassed only by HNU (Horizons BetaPro NYMEX Natural Gas Bull+ ETF), whose volume was 10% higher than that of XIU. 

The fact that we can name the two most popular ETFs shows that ETFs have evolved considerably since their inception. XIU is a traditional “index” ETF, while HNU is a more recent, leveraged, commodity-based ETF. At the beginning, ETFs simply passively reproduced a stock index. Then they evolved and became more diversified in terms of risk and benchmark indices: commodity-based ETFs became complex, financially engineered products. Compared to mutual funds (which are not listed on a stock exchange), ETFs generally offer the advantage that they can be bought or sold at all times during a trading session – like ordinary stocks – and ETF options are available as well. A second advantage, especially of index ETFs, is that the fees are very low compared with mutual fund fees. Mutual funds require the services of portfolio managers, which results in substantial management fees, while index ETFs do not use managers. However, the management fees of ETFs like HNU are higher than those of index ETFs, because financial engineers are involved.

The disadvantage of ETFs, and especially of index ETFs, is that they passively replicate an index, whereas mutual funds, which are managed by portfolio managers, can generate a higher return than an index.

Different types of ETFs

Index ETFs

They simply track a benchmark index, which may be a general index like the S&P/TSX 60, or sector indices, like the gold, real estate or technology indices.

Here are some examples :
Claymore S&P/TSX Canadian Dividend ETF (CDZ), BMO International Equity Hedged to CAD Index ETF (ZDM) and   iShares DEX All Corporate Bond Index Fund (XCB).

Inverse ETFs

As their name suggests, these ETFs move in the opposite direction to their benchmark index. If the latter rises, the ETF will fall proportionally to the rise in the index. If the index falls, the ETF will rise by the same percentage. However, these ETFs behave according to investor expectations for one day only. They should not be held for more than one session. For these ETFs to move inversely to their benchmark index, financial engineers must use derivatives, like futures and swaps, which ensure exact inverse movement of the ETF for one session only. The ETFs must be restructured for the following day, so they end up somewhat modified.

Here are some examples :
Claymore Inverse 10 Yr Government Bond ETF (CIB) and Horizons BetaPro &P/TSX Capped Financials Bear+ ETF (HFD).

Speculative ETFs

These are leveraged ETFs. To double or triple the gains of the benchmark index, financial engineers use derivatives, as with inverse ETFs. Leveraged ETFs must also be restructured from one day to the next, so they should be held for only one session. If they are held for too long, the anticipated doubling or tripling effect will likely never materialize. Inverse leveraged ETFs are also available.

Here are some examples :
Horizons BetaPro MSCI Emerging Markets Bear+ ETF (HJD) and Horizons BetaPro MSCI Emerging Markets Bull+ ETF (HJU).

Commodity ETFs

These ETFs track the price of raw materials such as gold, oil or natural gas or commodities like grain and livestock. In most cases, the value of these funds is based not on the price of the products themselves, but on the price of commodity futures. For example, they are not based on the price of wheat, but on the price of wheat futures. Even though a futures contract moves in the same direction as the underlying commodity, there are occasionally discrepancies between the price of the underlying commodity and the futures price. These futures are traded on the Chicago and New York futures markets.

Here are some examples :
iShares Gold Trust (IGT) and Horizons BetaPro Comex® Copper Bull Plus ETF (HKU).

Currency ETFs

These ETFs track an exchange rate, for example, the exchange rate between the Canadian dollar and the U.S. dollar. Here, too, the price of the ETF is based on foreign exchange futures, not on the real exchange rate. Foreign exchange futures are traded on the Chicago futures market.

Here are some examples :
iPath® EUR/USD Exchange Rate ETN (ERO) and Horizons BetaPro U.S. Dollar Bear+ ETF (HDD).

Actively managed ETFs

These ETFs track an index. However, a manager will modify the index structure according to the market sectors he or she believes will perform best. For example, if the manager believes that in the coming months, the gold sector will outperform the banking sector, the manager will change the weightings of these sectors in the index. The securities in the index remain the same, but the “weight” of each one varies according to the initial structure of the index. This type of fund has higher management fees than traditional index ETFs.

Here are some examples :
iShares Alternatives Complete Portfolio Builder Fund (XAL) and   Horizons AlphaPro Seasonal Rotation ETF(HAC).

Exchange-traded notes (ETNs)

These are notes that are traded on an exchange like ETFs. They replicate the underlying debt security the same way traditional index ETFs replicate a benchmark index. Variations include inverse ETNs, leveraged ETNs, and exchange rate ETNs.

Here are some examples :
iPath ® CBOE S&P 500 BuyWrite Index ETN (BWV) and iPath® JPY/USD Exchange Rate ETN (JYN.A).

The above-mentioned ETNs are all traded on the TSX, where close to 200 variations of these products are offered. Many are multifaceted, being at the same time inverse, leveraged, commodity-based and currency-based. Investors should be familiar with the individual features of an ETN before trading it.

The author

Charles K. Langford

Charles K. Langford

PhD, Fellow CSI

Charles K. Langford is President of Charles K. Langford, Inc, Portfolio Managers. He teaches portfolio management at School of Management (École des Sciences de la Gestion), University of Québec (Montréal). He is the author of 14 books on portfolio management, derivatives strategies and technical analysis.

Until 2007 he has been vice-president overlay risk management for Visconti Venosta Teaspoon Approach Management, Ltd. Until 1990 he was portfolio manager for Refco Futures (Canada) Ltd.

He has received a Bachelor degree from Université de Montréal, a Master degree and the PhD from McGill University (Montreal); he is Fellow of CSI (Canadian Securities Institute).