You know all about exchange-traded funds, right? They're sort of like shares of mutual funds (typically index funds) that trade like stocks. ETfs offer some tax advantages, and they can be better than funds for people regularly investing modest amounts, or people who would like to short various indexes. (If you don't know all of this, get thee to our ETF Center, which will explain why you should consider adding ETFs to your portfolio.)
But here's something you may not fully appreciate: While ETFs can indeed quickly get you invested in a certain index or a certain sector, similar-sounding ones are not necessarily so similar, and they won't serve you equally well.
Consider, for example, iShares S&P GSTI Software (NYSE: IGV) and Software HOLDRs (AMEX: SWH), which are often lumped in with ETFs. Both seem as though they'll help you make money on software, right? Right. But Software HOLDRs has returned an average annual gain of 12.5% over the past five years and 7% over the past three years, underperforming the market in both cases. Meanwhile, the iShares ETF has gained an average of 16% over the past five years and 13.8% over the past three, meeting the market, roughly, over the three-year period, and topping it by nearly 3% over five years.
Then there's the issue of holdings. The HOLDRs security contains just 13 stocks, with a whopping 22% of its assets recently invested in Microsoft (Nasdaq: MSFT), 13% in Adobe (Nasdaq: ADBE), and 12% in Oracle (Nasdaq: ORCL). In fact, more than 75% of its assets are invested in just five companies. On the other hand, the iShares ETF spreads its assets over 40 holdings, with just 35% of its assets in its top five. Microsoft, Oracle and Adobe are among the top five, along with Symantec (Nasdaq: SYMC) and Electronic Arts (Nasdaq: ERTS).
What to do
So what should you do now? Avoid one and buy the other? Not necessarily. Just be aware of how similar ETFs can differ in their holdings. If you're in the market for a sector-focused ETF, look at the contenders closely. See which ones have the strongest track record. Check their fees. Understand that some will vary their holdings over time, while others have relatively fixed holdings. See what each actually invests in. Decide which ones fit best with your needs. If you want maximum Microsoft exposure in your software ETF, for example, you might opt for the HOLDR, especially if you expect big returns from the company.
Note also that these kinds of differences can apply to regional ETFs as well. Two ETFs that focus on Japan, for example, may sport significantly different records and holdings.
Meanwhile, I encourage you to learn much more about ETFs in our ETF Center. It features info on how ETFs stack up against mutual funds, how to develop an investment strategy with ETFs, how to sidestep pitfalls, and how to avoid ETF imposters.
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Longtime Fool contributor Selena Maranjian owns shares of Microsoft, which is an Inside Value pick along with Symantec. Electronic Arts is a Stock Advisor recommendation. The Motley Fool is Fools writing for Fools.
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