ETFs: Do Investors Really Know What They Are Buying?

By: Casey_Research

Vedran Vuk, Casey Research write: Exchange-traded funds have been all the rage in recent years – they are easy to buy, easy to sell, and often have lower expense ratios than index mutual funds. But the Casey Research team dug deep into the complex world of ETFs and found that in many cases, their names can be utterly deceptive.

Here are a few excerpts of our revealing special report, The Top Ten Misleading ETFs.

Market Vectors Junior Gold Miners (GDXJ) – This ETF sure has a funny definition of a junior mining company. In my opinion, a junior miner is a small, speculative company just getting off the ground. Our publication, Casey International Speculator, specializes in this particular kind of company. If I had to put a number on the market cap, I'd say that junior miners fall under the $500 million mark. If you really want to push the definition to its limits, maybe a market-cap ceiling of $1 billion could still qualify for junior status.

Regardless of the exact line of demarcation, most of us can agree that "junior" means "small." Furthermore, most investors can agree that market caps over a billion dollars are anything but small. A billion isn't a major, but it's clearly in mid-tier territory. That said, the Junior Gold Miners ETF's top 10 holdings are all over a billion dollar or more. The top holding, with 5.23% of assets, even has a market cap of $2.4 billion – that's not exactly a junior, to say the least, and neither are the other companies on the list:

GDXJ was a flawed idea from the very start. Junior miners are necessarily bad choices for bundling into large ETFs. A large market cap ETF funneling funds into tiny mining companies sounds like a bubble waiting to happen. This is one area where carefully selecting individual plays is the only way to go. And this ETF has come no closer to changing that approach.

SPDR Gold Shares (GLD) – Since the last two funds had problems with rolling over futures contracts, you might be thinking to yourself, "Well, why not just buy funds that actually hold the underlying assets?" That's a genius idea… if it were only so simple. Even SPDR Gold Shares (GLD), a fund that holds physical gold, has much hidden in its fine print.

At first blush, most investors think that GLD securely protects their gold and that they can retrieve it upon request. Yes, GLD has a giant vault where gold is actually kept. However, exchanging your paper shares for gold is much harder than the click of a mouse that gets you into GLD.

First of all, to retrieve the gold one must have special permission – meaning one is either a broker or market maker. And there's another footnote worth mentioning: Gold can only be redeemed at a minimum of 100,000 shares of GLD, equivalent to 10,000 gold ounces (a little over $17 million at current prices). For the high rollers reading this article, that might mean something. For the average Joe out there, that means you will never be able to redeem your GLD shares for gold. Those shares are nothing more than pieces of paper – or worse yet, electronic bytes in your account.

With a closer examination of GLD, even the high rollers are misled by GLD. Deep in the SPDR Gold Shares prospectus, the fund includes an option to redeem gold requests in cash rather than physical metal. So, even if you are holding $17 million in GLD, you still might not receive your gold upon request in the case of a crisis in the gold market.

But wait – there's more. Though GLD seems like any other ETF, it isn't. GLD is structured as a grantor trust. Hence, the investor doesn't pay taxes similar to regular ETFs. Instead, the investor pays taxes on the underlying assets – in this case, gold. Unfortunately, gold is taxed for long-term holdings at a higher rate of 28% as a collectible instead of the 15% capital gains tax. What seems like a simple fund actually has a world of complicated specifics in the fine print.

iShares MSCI Emerging Markets Eastern Europe Index Fund (ESR) – What do you think of when someone says "Eastern Europe?" The Iron Curtain, stuffed cabbage, kolaches, pierogies… No, besides that. For anyone who's been asleep for the past few decades, Eastern Europe now has more countries than most can count. In the Balkans alone, there's Slovenia, Croatia, Bosnia, Serbia, Montenegro, Macedonia, and even Kosovo… not to the mention all the other countries, such as Romania, Bulgaria, Lithuania, Estonia, the Ukraine… and the list goes on.

With so many different countries and stock exchanges, an ETF would seem like a perfect way to cover them all. Unfortunately, the MSCI Emerging Market Eastern Europe Index Fund (ESR) will cover none of those countries just mentioned. In fact, the ESR does a better job of covering Russia, with a 76% allocation, than the rest of Eastern Europe – a whole 21% of the fund is invested in Russia's Gazprom alone.

Besides Russia, the fund only holds a couple of other countries including Poland at 16%, the Czech Republic at 4.1%, and Hungary at 3.4%. Though some companies in the fund may serve Eastern Europe, this is hardly what most investors had in mind for an Eastern European ETF. If investors really want a Russian ETF, those are not hard to find.

[To find out what the other 7 ETFs are – and whether you might own one yourself – click here for your FREE special report, The Top 10 Misleading ETFs.]

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