Ah, Wall Street, where a great idea can make someone boatloads of money. If so, what about a great idea taken one step further? That's the typical progression of innovation in the investment world, as the recent growth explosion of exchange-traded funds more than demonstrates.
From their origins as vehicles designed to track common broad-equity indices, ETFs have branched out into funds that zero in on specific sectors, capitalization ranges, and investment strategies. If you're seeking exposure to a certain corner of the market, there's probably a corresponding ETF to suit you.
Funny thing about innovation, though -- progress is inevitably accompanied by misdirection. Some ideas go a step too far, losing sight of the original concept in their rush to branch out and grab market share. Some ETFs may now be reaching that point.
Not quite up to par
A recent Wall Street Journal article highlighted how far several new ETFs have recently strayed from their designated benchmarks. Two of the funds specifically mentioned in the article were designed to track the price of oil. According to one such fund's prospectus, since management invests in a wide variety of futures contracts and other such sophisticated instruments, the fund can occasionally stray from its benchmark. And so it has.
Note the specific types of funds experiencing these significant tracking errors -- oil ETFs. This is an extremely narrowly focused type of ETF, and I can't imagine many individual investors who'd truly need exposure to a fund tracking oil prices. Sure, it may make sense for certain institutional investors with strategic reasons for investing in this sector, or hedging against the price of oil. But for most investors, companies like ExxonMobil
I'm guessing the vast majority of individual investors are primarily drawn to new funds like these for their novelty factor. It's been historically tricky for most investors to gain exposure to certain corners of the market, including oil and other commodities. New ETFs that offer such opportunities are like shiny new toys in a shop window -- you just have to own one, although you're not really sure why. Foolish investors know that you should not buy a new gadget just because it's available. Unless you can justify exactly why it makes business sense for you to own such a fund, don't go there.
Straying from home
There's a bigger issue at play here, however -- these ETFs' wide divergence from their stated benchmarks. For more obscure areas of the market, including the oil ETFs in question, it can be very tricky to track the intended target (in this case, light, sweet crude oil) with any great degree of precision. As stated above, the prospectus for the fund in question indicates that management will use futures and other instruments to approximate the movement in oil prices, which could create benchmark variances.
In many newer ETFs like this one, fund managers are indulging in an increasing amount of active decision-making. With each new generation of ETF product, management's reach into the investment process has expanded. Indeed, it looks like the next wave of ETF developments will likely involve actively managed funds -- a whole other discussion unto itself.
The problem here is one of expectations. ETFs were originally designed for one purpose -- tracking an index, as in the case of early ETFs like SPDRs
It was once true that buying an ETF came with the reasonable assurance that you were investing in a basket of stocks representing an index. Now, some next-generation ETFs often create greater ambiguity about their true holdings, to say nothing of their ability to track the appropriate benchmark. ETFs' shift toward active management likely drives part of this pattern.
Fools should remember that discrepancies like this can arise, especially within more obscure corners of the ETF market. To avoid this problem, stick to tried and true investments. That way, you can rest assured that your investment portfolio has a much greater chance of remaining on track.
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You can learn more about exchange-traded funds in our ETF Center.
Fool contributor Amanda Kish lives in Rochester, N.Y., and wants to assure everyone it's not nearly as snowy in western New York as they think. Amanda does not own shares of any of the funds mentioned herein. Chesapeake Energy is a Motley Fool Inside Value pick. The Fool has a disclosure policy.
