Never Take Your ETF at Face Value

 | Jun 14, 2012 | 9:30 AM EDT  | Comments
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Stock quotes in this article:

SOCL

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goog

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SNDS

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SKYY

Earlier this week, Sustainable Wealth Management became the most recent company to launch an ETF, rolling out the North American Oil Sands ETF (SNDS). This unique fund is backed by a pretty compelling investment thesis: SNDS holds stocks that are engaged in extracting usable oil from the tar sands found most commonly in Alberta, Canada. Thanks to impressive technological breakthroughs and elevated prices for oil, sands have become viable sources of crude oil. The reserves are massive, too -- oil sands account for about 75% of all proven reserves in North America. So it makes sense that this industry would be an attractive destination in the current environment.

But when you take a look under the hood of SNDS, you might be a bit surprised by what you see. The fund doesn't hold small Canadian companies on the cutting edge of the oil exploration and production industry. Rather, its portfolio is like a Who's Who of big oil, with meaningful allocations to BP (BP), Chevron (CVX), Exxon (XOM), Marathon Oil (MRO), Conoco Phillips (COP) and Shell (RDS.A). Also included are some international oil behemoths, such as France's Total (TOT), China's Cnooc (CEO) and Russia's Statoil (STO).

These firms most certainly maintain operations revolving around oil sands, but they are far from "pure play" stocks in that regard. The bulk of their operations focus on more traditional methods of extracting and refining petroleum products, thus diminishing the connection between this ETF's performance and the growth of the oil sands industry.

SNDS is far from the only offender in this regard. "Mission drift" is quite common among ETFs, and a number of funds maintain portfolios that aren't completely consistent with their name or stated investment objective. The Social Media ETF (SOCL) has a major allocation to Google (GOOG), which sits in top 10 holdings. The Cloud Computing ETF (SKYY) also has a position in Google, along with Salesforce.com (CRM), IBM (IBM) and Netflix (NFLX).

Again, those companies do have operations that involve cloud technologies. But there are so many other parts of their operations that have nothing to do with the cloud-computing technology that it's tough to imagine a strong correlation between the cloud-computing trend and the ETF.

Another fund I like to pick on is the Copper Miners Index Fund (CU), which theoretically offers exposure to companies who extract and sell copper. Many of the component companies are actually diversified miners that derive substantial portions of their revenue and earnings from precious metals such as gold and silver. These types of firms generally have very different price drivers from those who mainly mine copper.

For ETF investors, there's a lesson to be learned from all of this silliness: It's always a good idea to look under the hood of a potential investment, and to confirm that the components of the fund you're considering actually jibe with the investment objective.

The ETF boom that has taken place over the last several years has given us more tools in the investing toolkit than I ever would have imagined. There are now funds available for just about every major global economy and some very narrow sub-sectors of the domestic and international economies. But, in many cases, these hyper-targeted ETFs are not nearly as precise as we might be led to believe -- and that disconnect can lead to some big disappointments if you spot a trend early, yet pick a flawed way to play.

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