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The old adage "never judge a book by its cover" has been applied to a wide variety of situations over the years, from encouraging open mindedness in social situations to shopping for a car to, well, judging books by their covers. And it turns out this piece of advice can be quite valuable for investors as well, especially those who have embraced ETFs as tools for building long-term portfolios or establishing short-term tactical tilts.
For investors who wish to take a longer look under the hood of a product, the transparency offered by ETFs allows them to do just that. Most products publish a complete list of holdings on a nightly basis, allowing for a complete review of components that isn't possible with mutual funds and various other types of securities. In most cases, the holdings of an ETF are fairly predictable; most investors could guess the primary components of the S&P 500 SPDR (NYSE: SPY ) or the Energy SPDR (NYSE: XLE ) .
But in some cases, the holdings of an ETF aren't necessarily what one would expect, as unique index construction methodologies can result in a portfolio that includes some surprise components. This, of course, highlights the importance of researching the underpinnings of a product before jumping right in, taking advantage of the opportunities crated by the degree of transparency not found in mutual funds [see Never Judge an ETF by Its Cover].
Below, we outline some potentially surprising holdings in seven popular exchange-traded products [sign up for our free ETF newsletter]:
1. Wind Power ETF (NYSE: FAN ) : Royal Dutch Shell, BP, GE
This ETF is linked to the ISE Global Wind Energy Index, a benchmark that utilizes a somewhat unique methodology to offer exposure to the global wind power energy. Two thirds of the index assets goes to "pure play" wind power companies, such as Iberdrola Renovables and EDP Renovaveis. The other third goes to companies "determined to be significant participants in the wind energy industry despite not being exclusive to such industry," a group that includes firms that may be major players in the wind power space but that maintain other operations as well. General Electric (NYSE: GE ) , for example, is a big manufacturer of wind turbines and other wind power-related products, but wind power accounts for a relatively minor portion of the company's bottom line. The same goes for companies such as BP and Royal Dutch Shell (NYSE: RDS-A ) , two more traditional energy companies that maintain wind power operations as well.
The methodology behind FAN's index addresses a somewhat challenging question: how to include companies that are giants in the wind power space, but rely on other lines of business as their primary source of revenues. FAN's approach results in a basket of portfolio components that might be somewhat surprising; those making a play on wind power might not expect that the tactic would involve positions in some major oil and gas firms and an industrial conglomerate. Another option for wind power exposure, the PowerShares Global Wind Portfolio (Nasdaq: PWND ) , takes a slightly different approach: This fund consists almost exclusively of pure play wind power companies [see also Ten Worst Performing ETFs of 2010].
2. Gold Miners ETF (NYSE: GDX ) : Silver Wheaton, Pan American Silver, Silver Standard Resources
GDX has become extremely popular as a means for establishing "indirect" exposure to gold through stocks of the companies engaged in the extraction of the metal. This mining-based strategy offers effective leverage on spot gold prices, as the profitability of mining companies tends to fluctuate with the prevailing market price for their goods.
Most companies included in GDX generate the vast majority of their revenue from gold, but some seem to fall beyond the strict definition of "gold miners." Some of the GDX holdings, such as Silver Standard Resources, Pan American Silver, and Silver Wheaton, generate significant portions of their revenue from silver, another precious metal that often exhibits risk/return characteristics that are very different from gold. Silver Wheaton, for example, generated roughly 92% of its 2010 revenues from silver production, while just 8% of its revenues can be directly tied to gold [see also Soros Dumps Gold ETF Assets].
While silver and gold are both precious metals, these two assets are hardly identical. Unlike gold, silver is used in a wide variety of industrial applications, and as such is impacted by unique demand drivers. The relative performances in recent months highlight the potential differences; silver is up 25% this year, compared to gold's gains of just 11%.
So while gold price movements will be one of the primary drivers of GDX, investors should be aware that swings in silver will also move this popular fund. For those looking to make a more clear cut play on gold mining, Global X recently debuted its Pure Gold Miners ETF (NYSE: GGGG ) , which has the distinction of focusing on miners that generate substantially all of their revenues from gold. The aforementioned silver-centric miners are nowhere to be found in that fund, which offers more of a "pure play" on gold.
3. S&P 500 Value Index Fund (NYSE: IVE ) / S&P 500 Growth Index Fund (NYSE: IVW ) : T, PG, WFC, JNJ, VZ, INTC
One popular way to segment stock markets involves bifurcating equities into growth stocks (those with low dividend yields, high pricing multiples, and higher expected earnings growth) and value stocks (those with higher distribution yields and lower pricing multiples). Growth and value strategies have been cracked wide open by the ETF world, with a number of funds offering ways to implement low maintenance style-specific strategies. IVE and IVW are among the most popular funds providing exposure to these two methodologies, offering exposure to the value and growth sub-sets of the S&P 500 Index. But some investors may be surprised to see that a number of blue chip stocks (including those listed above) make their way into both of these ETFs.
This isn't an error, but simply the result of the index methodologies underlying these funds. IVE and IVW essentially exclude the stocks with the strongest growth and value characteristics, respectively, resulting in some overlap between two products that might be expected to be mutually exclusive. IVE's value strategy aims to exclude companies which display the highest growth characteristics, while IVW's strategy aims to nix holdings that have the strongest value characteristics. The wide net that both of these indexes cast accounts for this overlap, though investor may not be satisfied with the holdings upon closer inspection.
Those looking for a more pure play option on these two strategies might want to consider Rydex's "Pure Style" alternatives, such as RPG and RPV. These funds implement a stricter definition of value and growth, resulting in a smaller portfolio and zero overlap between the components [see For ETF Investors, the Details Matter].
4. Internet HOLDRS (AMEX: HHH ) : GOOG
If you're investing in an Internet exchange-traded product, you'd probably expect to find search engine giant Google (Nasdaq: GOOG ) , which has its hands in just about everything related to the Web, among the top components. And if you're aware of some of the concentration biases common in in HOLDRS products, you might be concerned that GOOG would take up a huge chunk of HHH. But the surprise here is that GOOG is nowhere to be found in HHH, the result of another nuance of the HOLDRS methodology.
HHH was launched in late 1999, at the height of the Internet bubble. Like all HOLDRS products, this ETP launched with a set basket of component stocks, and has essentially been on cruise control ever since. There is no underlying index that rebalances at any point; stocks simply remain in the underlying basket in the same ratio indefinitely, with names occasionally coming out as companies are acquired or go bankrupt [see The Curious Case of the B2B Internet HOLRDS].
That also means that new companies aren't added to the portfolio; since Google didn't go public until 2004, it is left out of reach for this product. Instead Internet giant Amazon.com, which has a market cap equal to about half of Google, is in the top slot with an allocation of about 44%. Other Internet-related companies, including eBay, Priceline, and Earthlink, round out the portfolio, but GOOG is nowhere to be seen [see Five Facts Every Investor Must Know About HOLDRS].
5. Copper Miners ETF (Nasdaq: CU ) : Rio Tinto
In addition to being a widely used industrial metal, copper has become popular as an investable asset capable of providing a hedge against inflation and indirect exposure to the insatiable appetite for raw materials among emerging markets. There are multiple ETPs offering exposure to copper, including ETNs linked to indexes comprised of futures contracts. Some investors prefer to maintain exposure to the metal through stocks of companies that are engaged in the extraction and production of copper, and there are multiple copper miners ETFs available.
CU is one of these such funds, investing in many companies whose operations focus on copper. But this ETF also includes a number of diversified mining companies that count on copper for only a minor portion of revenue and earnings, a result of the unique methodology behind the ISE Global Copper Index. To be included in this benchmark, companies must be actively engaged in some aspect of the copper mining industry, such as copper mining, refining or exploration. From there, the index uses a modified linear weighted methodology adjusted by revenue exposure to copper production. That means adjusting the weighting to diversified miners based on the portion of revenue attributable to copper. As a result, some big miners with relatively small copper operations make their way into this fund's holdings.
One of CU's top holdings, Rio Tinto (NYSE: RTP ) , is a perfect example. In 2010, copper accounted for about 14% of Rio Tinto's total revenue, most of which is attributable to iron ore and aluminum (energy and diamonds also account for significant portions of revenue and earnings). Similar to the aforementioned wind power ETF, this methodology allows for the inclusion of some of the world's largest copper miners. But it also results in the inclusion of companies whose primary source of revenue is not copper but other metals and natural resources.
The Global X Copper Miners ETF (NYSE: COPX ) takes a different approach, excluding broad-based mining companies and focusing instead on smaller pure play copper miners. That means that COPX excludes some of the biggest players in the copper industry, but can be used as more of a pure play on the copper industry. Each methodology has its pros and cons; investors should be aware that these products feature unique portfolios that are impacted by a unique blend of factors [see also Closer Look at Copper ETF Options].
6. SPDR S&P Homebuilders ETF (NYSE: XHB ) : Pier 1, Tempur Pedic, and Bed Bath & Beyond
If you were to ask investors to guess the three largest components of the largest ETF in the Building & Construction ETFdb Category, most guesses would probably include major homebuilders like NVR, Pulte, and Toll Brothers. You'd probably get about zero correct responses identifying Pier 1, Tempur Pedic, and Bed Bath & Beyond as top components of XHB, which tracks an index that represents the homebuilding sub-industry portion of the S&P Total Markets Index.
While these companies obviously aren't engaged in the construction process, they still fit in with the general investment thesis of this product. The financial health of these firms depends directly upon that of the home building industry; both Pier 1 and Bed Bath & Beyond sell products that are generally used to furnish new homes, so an increase in new building activity will generally translate to greater need for their products. And Tempur Pedic sells some of the most comfortable (and expensive) mattresses available -- another good that is generally purchased more when building activity is higher [see also Three ETFs to Watch During Hurricane Season].
7. Vanguard Emerging Markets ETF (NYSE: VWO ) : South Korea, Taiwan
VWO has most recently become the most popular emerging market ETF, surpassing the more expensive EEM in assets under management earlier this year. While VWO is the largest ETF in the Emerging Markets ETFdb Category, some see this fund's emerging markets focus as compromised by the inclusion of South Korea (14% of assets) and Taiwan (11%). These two markets are by many measures more similar to the U.S. and Western Europe than to the BRIC economies, and many agencies (including the IMF) have categorized them as "developed" for decades [see Ticking Time Bomb Under EEM].
Again, EEM and VWO are simply seeking to replicate the underlying MSCI Emerging Markets Index, which determines these two economies to fall under the "emerging" umbrella. But this methodology can have a significant impact on the risk/return profile of VWO, making it unique from BRIC ETFs or the pure play EEG [see also Highlighting Five Free ETF Tools].
Today’s Lesson: Do Your Homework
ETF issuers go through a significant amount of work to make the holdings of a product available to interested investors; as the list of interesting holdings above shows, those who take the time to look under the hood may be surprised at what they find.
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Disclosure: No positions at time of writing.
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