Reading the fine print is a good start; you'd
better read between the lines, too.

    The great promise of the exchange-traded fund (ETF) industry has been to bring institutional-quality products to the individual investor. That means low costs, low turnover, tax efficiency and sector fidelity. It means opening up new areas of the market that previously have been either inaccessible or prohibitively expensive. It means putting into the hands of investors sharp-edged tools that they can use to execute smart asset allocation policies.
    I have been a huge celebrant of ETFs, singing the praises of their transparency, innovation and applications. And I still believe that ETFs represent a profound new tool for investors-a better mousetrap, if you will-and that their future is incredibly bright.
    But recent trends in the industry have me worried. Average expense ratios are creeping up, average fund turnover is increasing, and recently, many product launches look more like reflections of marketing than reflections of the market.
    You know the ones: Listed Private Equity ... Stealth ...  ValueLine Timeliness ... BRIC.
    The funds typically are launched with a fanfare of public relations, and always -always-with a nice package of back-tested data showing how, if you had only followed this peculiar investing strategy for the past five years (which is to say, before the ETF developers even thought of it), you'd be sitting pretty on a fat cushion of compounded market-beating returns. This implicit message is loud and clear: Get in now before it's too late!
    Should you? Do these funds really help investors?
    Here's the funny thing: I don't think it's an open-and-shut case. In almost every situation, you could argue convincingly for the value of an ETF.
    Consider the aforementioned Listed Private Equity fund, from PowerShares. If there ever was a fund designed to ride the coattails of a media phenomenon, this is it. Anyone with a subscription to the Wall Street Journal or the Financial Times knows that private equity is the hottest thing on Wall Street. Fortune magazine recently anointed the private equity players the new "Masters of the Universe," and everyone from Goldman Sachs to the California Public Employees Retirement System (CalPERS) has been rushing to get into the private equity game.
    PowerShares would argue that this ETF offers individual investors the first chance to tap into this red-hot private equity market in a simple way. Private equity returns have a low correlation to public market returns, so adding private equity exposure to a portfolio should improve its risk/return profile. And if CalPERS and Goldman Sachs are doing it, why not you?
    Why not? Well, there are a number of reasons why not, and I'll explain why in a minute.
    The editors here at Financial Advisor magazine asked me to write about these newfangled "specialty ETFs," and about whether or not they make sense for investors. I'd be happy to do that, because I have enough opinions to fill a book.
    But we are going to see a lot more of these ETFs hit the market in coming months. The incremental cost of launching a new ETF is tiny, so the incentive is for fund companies to launch anything and everything and see what sticks.
    Instead of focusing on the funds on the market today, then, I thought I'd use the example of the private equity fund and lay out five ground rules to help you evaluate whether these newfangled ETFs make sense for your client's portfolios.

Rule Number 1: Check Your Commissions
    The Achilles heel of the ETF industry-commission costs-gains ever-larger importance when you are considering specialty ETFs.
    Commission costs are the one thing that keeps ETFs from wiping out the traditional mutual fund industry. Generally speaking, ETFs are cheaper, more tax-efficient and more transparent than their traditional mutual fund cousins. But because investors must pay a round-trip trading commission when they buy and sell ETFs, investors who are not making large purchases, say, $10,000 or more, are foolish to choose ETFs over traditional mutual funds when both are available. Even at $10,000, one study found that an S&P 500 investor would wait six years before his "cheaper ETF" made up the commission costs compared to a more expensive, traditional index fund.
    The problem for specialty ETFs is that, by definition, they should represent a small section of a well-structured portfolio. Even the most aggressive pension plans, for instance, only make 5% to 7% allocations to private equity. For an investor putting $10,000 to work in the market, that would mean a $500 investment in the private equity ETF. At that level, commissions will eat you alive. Even investors creating a $100,000 portfolio in one fell swoop should think twice about paying commissions for a $5,000 allocation. Remember: in investing, you get what you don't pay for.

Rule Number 2: Check The Index
    For the most part, ETFs track indexes that we have heard of before: the S&P 500, the Wilshire 5000, etc. While there are important differences between these indexes (I write about these differences all the time at, investors can at least be sure that most of the indexes are reasonably diversified and reasonably balanced, and that they follow a rules-based strategy that is not susceptible to gross manager error.
    Investors in specialty ETFs shouldn't make that leap. Many times, these ETFs track unfamiliar indexes with unusual methodologies.
    "The more specialized the index, the greater the possible difference between two indexes that may sound alike," said Allan Roth, founder of Wealth Logic LLC, an investment advisory and financial planning firm based in Colorado.
The private equity fund, for example, tracks an index from Red Rocks Capital. Never heard of them? Neither had I. As it turns out, they are a well-respected alternative asset manager based in Denver.
    They are not, however, an index firm, and their "index" of private equity names falls short on many levels. For one, it's extraordinarily narrow, with only 34 components. And unlike the 30-stock Dow Jones Industrial Average, which holds some of the most established, diversified businesses in America, the Red Rocks index holds a number of volatile small-cap names that could jerk the index around like a dog on a leash.
    The choice of components is worth noting, too. Typically, index investors don't worry about the actual companies included in an index, since it's the aggregate statistics and risk/reward ratio that matters. But with unusual and narrow indexes, it pays to drill down to the constituent level.
    In this case, the results are worrisome. The index includes companies like Millennium Pharmaceuticals, an experimental biotechnology company based in Cambridge, Mass. Millennium is presumably included because it has investments in a few start-up biotech firms. But I was a biotech analyst before I found indexing religion, and I can tell you that Millennium's value is tied to its drug development pipeline, not its investments. Investors looking for private equity exposure won't find it in Millennium's stock (though it represents 4.6% of the index).
    There are flaws with other components, too. For instance, as of October 31, the fund had a 3.5% stake in CMGI. In the old days, CMGI was a private equity firm, holding a portfolio of mostly Internet-based start-up firms. But today, the company has morphed into a supply chain management firm with $1.1 billion in revenue. It still holds stakes in a few venture start-ups, but it is not exactly a pure play on the sector
    Red Rocks seems to have been grasping at straws to cobble together an index with at least a reasonable number of components to "track" the private equity market. The vast bulk of private equity firms are privately held, as partners like to divide the spoils of their investments among themselves, and aren't inclined to share them with the public. Red Rocks Capital may have done the best it could, given the situation, but in this case that probably isn't good enough. Either way, it pays to know what you're getting into.

Rule Number 3: Check The Tracking Error And Spread
    Once you've got your index sorted out, the next thing to test is whether the ETF tracks the index. Historically, ETFs have done a phenomenal job at this-you're unlikely to see an S&P 500 ETF move more than a few basis points off of its underlying index, once you adjust for expenses.
    But in these specialty areas, tracking error can be a real issue. Whether the ETF developer decides to try to outperform the index, or whether liquidity issues in the underlying stocks make close tracking impossible, we've seen some sizeable tracking errors in the past year.
    The iShares Dow Jones Select Dividend Index Fund (NYSE: DVY), for instance, beat its benchmark in the third quarter by 50 basis points. That sounds great, of course, but past performance is not guarantee of future returns. Investors who think they are getting straight exposure to the Dow Jones index may be surprised to hear that BGI "optimizes" the fund in the pursuit of higher yields.
    On a different note, the iShares KLD Social Select Index Fund (NYSE: ECO) has trailed its benchmark by 1.6% over the past year.
    The thing to do is to look through the prospectus for three things. First, does the index hold a lot of companies? The more companies, strangely enough, the more likely the tracking error will be good, since the index's performance will be predictable and liquidity concerns will be limited.
    Second, look for an index that follows a "replication" strategy. "Replication" funds buy all the stocks in the underlying index at the appropriate weights, and generally track their benchmarks very well. Funds that follow a "sampling" methodology have more latitude, and can have more tracking error. You may want to see some real-time performance data on these funds before you jump in.
    Also beware of indexes with large positions in small-cap stocks. Although the funds may track the indexes well, this can create an "index effect," where money moving into the index forces up the prices of the underlying stocks.
    "Whatever the 'hot trend,' someone always seems to roll out a new ETF that lets traders ride the wave," noted Edward von der Linde, partner and portfolio manager at Lord Abbett, in a recent position paper on the ETF industry. ("Blind Faith," 9/13/2006.)  "[But] large inflows of money can have an exaggerated effect on many of these new products because small cap and mid-cap stocks are less liquid than large caps."
    On the flip side, when big money doesn't appear, spreads can be an issue: Many of the specialized funds are thinly traded, meaning investors can get hit when moving into and out of the funds.

Rule Number 4: Check The Back-Test
    All these specialty ETFs come packaged into the market with shiny looking back-test results. It's no surprise, of course-you'd hardly expect to see funds launched that performed poorly in the rearview mirror. But it means you should be on guard.
    "You have to be careful with the back-tests," said Paul Mazzilli, director of the Exchange-Traded Funds Research Team at Morgan Stanley. "You have to ask yourself: Did the product developers cherry-pick factors to improve performance? Sometimes the index criteria stand out as ... strange."
    All back-test results are subject to manipulation. But the general rule of thumb is that the more factors used to create the index, and the more specific those factors are, the more suspect the back-tested results become. If someone tells you that stocks with a low P/E ratio have performed well, that's an investment thesis that is worth considering. But if someone tells you that stocks with a P/E ratio between 12.5 and 14.7, which had IPOs in April, performed well, that may not be such a robust strategy.
    It sounds absurd, but it happens every day. For instance, the First Trust Dow Jones Select Microcap Index chooses stocks in part based on "six-month total return." Six months? Who's ever even heard of six-month return?
    Ask yourself: Do these guidelines pass the smell test?

Rule Number 5: Check The Turnover
    The final rule for evaluating a new index is to examine the expected turnover. The general rule is that the further an index strays from traditional market-cap weighting, the more likely it is to have high turnover. Market-timing indexes that try to pick the next hot sector have high turnover, as will equal-weighted funds that must periodically buy and sell each component to keep weights in line.
    Turnover and rebalancing is not necessarily bad; in fact, most studies show a net benefit to regular rebalancing. But tax issues and commission costs can take a bit out of total returns, and you have to make sure that the added turnover is worth the risk.
    "As Morningstar recently put it, ETFs are going Hollywood," said Roth. "Turnover is rising, expense ratios are going up and standard deviation is increasing. Some of these specialty ETFs look more like active funds, in that they are so specialized that you are betting on a particular piece of the market."

Lost Our Way? Maybe
    As a by-the-book indexer, these funds do nothing for me. Nanotechnology is absolutely fascinating, but investing in nanotechnology ... yikes. These funds stray from the original purpose of the ETF industry, which was to provide low-cost, robust, institutional-quality funds to individual investors. Most of these funds are neither robust nor institutional-grade, and increasingly, they are not low-cost either. Expense ratios on these unusual funds can hit 70 basis points, a fortune by index standards.
    "The average ETF fee has actually gone up this year," said Mazzilli, thanks in part to the rash of specialty ETFs. "The range widened, but the average fee has come up."
Another worry is that these funds are being launched at the height of different media manias-private equity, nanotechnology, clean energy, etc. They may be valid investments, but by playing on hype they are inviting investors to buy high and sell low.
    Still, I'm not one to cast all these funds aside at the drop of the hat. For small slivers of portfolios-mad money, if you will-they may make sense. And I'm always in favor of product developers pushing the boundaries of what's possible and trying to open up new markets.
    But this is certainly one of those look-before-you-leap situations. Product developers are straining to cobble together portfolios to fit the ETF format, and the new funds are not necessarily as robust as the old-line indexing brethren. As always, it pays to know what you're getting into.

Matt Hougan is assistant editor of the Journal of Indexes, a bimonthly magazine that reports on news relating to indexes and which is a sister publication of Financial Advisor magazine.