The Wall Street Journal-20080204-Investing in Funds- A Monthly Analysis- Fundamentals of Investing- Thinking Narrowly- Niche exchange-traded funds proliferated in 2007- and so did the debate over them- Here is what you need to know about these ETFs

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Investing in Funds: A Monthly Analysis; Fundamentals of Investing: Thinking Narrowly; Niche exchange-traded funds proliferated in 2007, and so did the debate over them; Here is what you need to know about these ETFs

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The investing world has a new dirty word. It's "narrow."

Increasingly, "narrow" is used to describe the bad side of exchange- traded funds, those rapidly proliferating alternatives to mutual funds. ETFs, like index-based mutual funds, are designed to represent a slice of a market. But those slices keep getting narrower as ETF firms come up with new products.

What began with funds that tracked broad stock-market benchmarks, like the Standard & Poor's 500 and the Russell 3000, soon moved on to industries and countries. Now, while an ETF like Financial Select Sector SPDR focuses on a wide range of financial-services companies, newer products focus more tightly within the industry, on banks or on insurers, for example, capital-markets firms or regional banks.

Still, that doesn't explain what's so potentially bad about narrow ETFs, or why Vanguard Group Inc. founder John Bogle likened them to "the renowned Purdey shotgun" in his "The Little Book of Common Sense Investing" last year. Read on for the explanation, plus a lot more about the pros and cons of narrow ETFs.

Q: How narrow is narrow in the world of ETFs?

A: First you have to understand what "broad" means. The original SPDR, today's largest ETF by assets, tracks the S&P 500, reflecting the value of every one of those 500 large-cap stocks. Some ETFs track even bigger baskets: iShares Russell 3000 has 2,933 stocks and Vanguard FTSE All-World ex-US ETF has 2,164.

Such products left plenty of room to go narrow -- and narrower still. Besides stock-index and industry-sector funds, ETF firms increasingly have introduced funds that follow themes or specific investment concepts, such as providing exposure to companies with valuable patents or even with attractive stock-movement patterns. Keep in mind that narrow funds are still a relatively modest part of the overall ETF picture. The SPDR's $83 billion under management, for example, is three times the roughly $26 billion in all nine Select Sector SPDRs put together. SPDRs are products of State Street Global Advisors, a unit of State Street Corp.

Meanwhile, there are some limits to how narrow an ETF can be. Diversification rules from the Internal Revenue Service and stock exchanges effectively prohibit most ETFs from holding fewer than about a dozen securities. In practice, about 20 is the minimum for an ETF. At latest count, 39 of the existing 520 stock ETFs contained 22 or fewer stocks, according to Morningstar Inc. Among them: HealthShares Emerging Cancer ETF, iShares DJ Transportation Average ETF, and SPDR S&P Homebuilder ETF.

Q: You said "most" are prohibited. What's the exception?

A: While the vast majority of ETFs are modified versions of mutual funds, some ETFs use other blueprints, setting themselves up as trusts, for example, which are simpler and less expensive to run. Trusts also can be better suited to some assets like commodities. Because of their different legal heritage, these ETFs aren't subject to the same diversification rules.

One shining example: StreetTracks Gold Shares ETF which holds just one investment: gold. Another is Merrill Lynch & Co.'s Holding Company Depositary Receipts, or Holdrs.

Like mutual funds, Holdrs own stocks, but unlike mutual funds, they have little ability to alter their holdings over the lifetime of the trust. While a Holdr "looks like an ETF, it's completely different" from a legal perspective, says John McGuire, a partner at the international law firm Morgan Lewis who specializes in investment regulatory issues.

While the Holdrs had relatively diverse portfolios when they were created between 1998 and 2001, some have shrunk as companies whose stock they held have been bought or gone out of business.

The B2B Internet Holdrs hit the market with 20 business-focused Internet companies in its portfolio just as the Internet-stock bubble was beginning to pop in February 2000. Today most of those firms no longer exist as independent companies. The trust holds just three stocks today, and more than 80% of its value is linked to just one: software company Ariba Inc. According to its prospectus, the B2B trust is scheduled to expire Dec. 31, 2040.

Q: So what exactly is so wrong with narrowness?

A: Critics think ETFs that are in narrow niche categories are dangerous for Main Street investors, and they haven't minced their words. As Mr. Bogle explained, in comparing a narrowly focused ETF to a renowned shotgun: "It's great for big-game hunting in Africa. But it's also excellent for suicide."

Their critics maintain that narrow ETFs encourage investors to try to beat the market by placing bets, both bullish and bearish, on particular sectors or countries. On top of the difficulty of making the right bet, jumping in and out of different sectors of the stock market is costly. ETF investors pay brokerage commissions every time they buy and sell shares, as well as other transaction costs and taxes.

A narrowly focused ETF also will swing more wildly in price than one that is widely diversified. In a Lipper Inc. ranking of top- and bottom-performing funds for the fourth quarter of 2007, 17 of the top 50 were ETFs, and 10 of the bottom 50 were ETFs. That total of 27 is an outsize showing by ETFs, given that the stock mutual funds screened by Lipper as of the middle of last year were outnumbering ETFs about 15 to 1. Three years ago, before the narrowness craze hit the ETF world, a total of just eight ETFs made it onto Lipper's comparable 50- best and 50-worst lists.

"Investors need to be aware, when they look at narrowly focused funds, that they involve more volatility," says Christine Hudacko, spokeswoman for Barclays PLC, whose Barclays Global Investors offers iShares funds.

Q: So, are small investors actually making a lot of market bets with these ETFs, or is this debate mostly theoretical?

A: It's hard to tell for sure. Because ETFs trade through brokerage accounts, ETF companies don't always know exactly who owns their funds. Securities brokerages could produce this information, but they are reluctant to reveal too much about their customers. But "there definitely are retail investors that are trading these things," says Jeffrey Ptak, an ETF analyst at Morningstar.

Q: Aren't other investments risky, too?

A: ETF companies bristle at the notion they're responsible for foolish behavior by investors. And they hardly have a lock on narrowly tailored funds.

In 1981, Fidelity Investments launched its Select Portfolios, with six sector mutual funds, a lineup that has since grown to more than three dozen, including funds focused on chemical manufacturers, auto makers, and paper and forest-product companies.

Then, of course, there was a profusion of technology funds in the late 1990s. Their ranks more than doubled to 77 in 1999 from 32 in 1996, near the height of the Internet boom. There are 87 today, according to Morningstar.

Some mutual funds with broad mandates also own relatively few holdings. CGM Focus has about 25 stock positions, while Janus Twenty actually has about 30 stocks currently. Smart bets have helped these concentrated funds rack up stellar records: CGM Focus returned 80% last year, and Janus Twenty sported a 35.9% return. But losses could be steep in a reversal of fortunes.

Q: Narrow ETFs have their uses, don't they?

A: Some financial advisers like using narrow ETFs to plug holes in their clients' portfolios; they can zero in on an industry subsector while avoiding having to choose among specific stocks in that subsector. And while narrow ETFs may be riskier than those aiming to represent broad swaths of the stock market, they are less volatile than individual stocks. For instance, Citigroup Inc. shares last year were hit especially hard by the subprime-loan debacle, plunging 45%. The decline of KBW Bank ETF, in which Citigroup is one of 25 stocks, wasn't quite as gut-wrenching; it posted a loss of 21.9% for the year.

Moreover, investors can use sector ETFs for things besides taking a rider on a hot corner of the stock market. Consider this: Say an executive at Exxon Mobil Corp. has a considerable portion of his wealth rolled up in the company's stock and wants to concentrate the rest of his investments away from the oil industry. Instead of buying an S&P 500 index fund, which would invest about 13% in energy stocks, he can buy eight or 10 sector ETFs to cover the entire market, except for energy.

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Mr. Salisbury is a reporter for Dow Jones Newswires in Jersey City, N.J. He can be reached at [email protected].