4 Exotic ETF Types And How They Work

Exchange traded funds (ETFs) have gotten so popular that they’re increasingly appearing in more and more exotic incarnations. Investors should understand how they work before diving in sight unseen, though.

ETFs have morphed into several exotic forms, covering a number of market niches in nearly every way possible. Don Dion for TheStreet explains that these newer “non-traditional” ETFs area newer generation and that they do add some level of risk that more traditional ETFs don’t have:

• Leveraged and Inverse ETFs: These ETFs allow investors to gain or lose two to three times the direction of a particular index. Because these funds reset every day, they are useful only to seasoned traders who understand their risks rather than long-term buy-and-hold investors. Direxion Daily Emerging Markets Bull (EDC) is a newer example of an ETF of this type. Read our special report on leveraged and inverse ETFs here.

• Futures-Based Commodity ETFs: These ETFs seek to track commodities by investing in baskets of futures or swaps. While these ETFs may get investors one step closer to a “pure play” on commodities swap prices, they are prevented by problems such as  contango from fully performing at all times. United States Natural Gas (UNG) is one example of such a fund. It’s been in the hot seat lately because of the accusations that funds of this type are manipulating the markets. The Commodity Futures Trading Commission (CFTC) is currently weighing position limits that could affect most, if not all, of these types of funds.

• Exchange Traded Notes (ETNs): A “cousin” of ETFs, these notes track baskets of debt, secured by the provider, rather than a basket of stocks. An ETN can also be sold short, trade like a single stocks and offer special exposure to currencies or commodities. It’s important to stress that ETNs are backed by the full faith and credit of the issuer, so if the issuer defaults, you become just another creditor. Examples of ETNs include iPath India (INP) and Market Vectors Double Short Euro (DRR).

• ETFs of ETFs: These funds layer on top of other funds, giving investors more bang for their buck. But they can also compound fees and contain products some investors may not want, so look under the hood first before you buy. Many of these ETFs consist of already-existing products that are packaged together into one ETF. Powershares Autonomic Balanced Growth NFA Global Asset Portfolio (PAO) and the IndexIQ Hedge Fund (QAI) are two examples of such funds.

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