Specialized ETFs

03/31/2006 12:00 am EST

Focus:

Charles Carlson

Editor, DRIP Investor

"Within ETFs, there is a relatively new niche of specialized funds," notes Chuck Carlson, editor of The DRIP Investor. "Not all are created equal. Some are gimmicky, and other make sense." Here he looks at several that make good sense.

"Exchange traded funds have exploded in popularity because they are easy to trade, offer improved tax efficiency, and charge reasonable expense ratios. Unlike traditional mutual funds, many can be sold short to protect gains in the event of a market downturn. And most ETFs can be purchased on margin. On the horizon are actively managed ETFs as well as those designed for alternative asset classes, currencies, and others that re-weight popular indexes.

"While investing in ETFs often makes sense, some of the newer offerings are gimmicky, tracking little-known indexes or narrowly defined industries or regions. It is debatable whether investors really need many of the newer funds. Still, specialty ETFs can be a good choice for investors who want to bet on a particular strategy. Specialized ETFs are relatively new niche funds. Provided you understand the risks and know what you are buying, such specialty funds can be good investments. To that end, we cover several relatively new specialty ETFs.

Commodities Deutsche Bank Commodity Index Tracking Fund (DBC ASE), which began trading on Feb. 6, is the first ETF to track a basket of commodities. The fund uses futures contracts to mimic an index tied to crude oil, heating oil, gold, aluminum, corn, and wheat. The fund, with a 1.50% annual expense ratio, will soon be joined by a similar ETF from iShares.

Social investing iShares KLD Select Social Index Fund (KLD NYSE) invests in companies that have favorable social and environmental characteristics, while keeping risk and performance in line with the Russell 1000 Index. The fund, launched in January 2005, has a 24% weighting in financial stocks and 21% exposure to technology.

Precious metals — Two gold ETFs dominate this space. The largest, streetTracks Gold Shares (GLD NYSE) began trading in November 2004, while iShares COMEX Gold Trust (IAU ASE) opened early last year. Both funds are tied to the price of gold bullion and charge 0.40% per year. Neither pays a dividend. iShares plans to launch an ETF linked to the price of silver. Precious metals funds are aggressive investments and may be subject to special tax treatment.

Microcaps — Three ETFs investing in the smallest US companies were launched last year. First Trust Dow Jones Select MicroCap (FDM ASE), iShares Russell Microcap (IWC NYSE), and PowerShares Zacks Micro Cap (PZI ASE) all have expense ratios of 0.60%. The funds focus on stocks with market capitalizations below $750 million. In isolation, a microcap stock fund may be quite volatile. But if you own a variety of funds, a microcap ETF could reduce the overall volatility of your portfolio."

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