ETFs: What Are You Really Buying?

You need to look beyond the label at these holdings

By Tom Taulli, InvestorPlace Writer & IPO Playbook Editor

An exchange-traded fund — essentially a bundle of shares that you can trade just like a stock — can be a great way to get broad exposure to an asset class. And over the years, Wall Street has minted many niche ETFs as fund firms try to jump all over the hottest new trend.

However, if you buy these investments, you are taking some big risks.

For instance, ETFs that focus on niches usually have light trading volume. So when the market cools down, you can be susceptible to some pretty painful losses.

But one of the other landmines you can find in a niche ETF is a liberal approach to what companies are included in the index. Some of the holding choices are a stretch, some are real head-scratchers, and some are downright comical.

Let’s take a look:

Global X Social Media Index ETF

The Global X Social Media Index ETF (NASDAQ:SOCL) is off about 17% since early May thanks to the plunge in social stocks. It didn’t help that its No. 2 holding is Facebook (NASDAQ:FB), which pulled off a horrendous IPO.

But if you look further at the SOCL portfolio, you’ll notice some very not-at-all “social” stocks.

For example, SOCL holds Demand Media (NYSE:DMD), which is a collection of content sites such as eHow — not a place to connect with friends.

But even more ludicrous is the ETF’s stake in NutriSystem (NASDAQ:NTRI). I’m not sure what this has to do with social — other than the company has a Facebook page and a Twitter account.

First Trust NASDAQ CEA Smartphone Index

The growth in the mobile industry has been explosive, so it seems logical that the First Trust NASDAQ CEA Smartphone Index (NASDAQ:FONE) would do well, right?

Not this year. So far in 2012, FONE is down 17%.

In this case, what the ETF holds makes sense. FONE has holdings in Apple (NASDAQ:AAPL), maker of the ubiquitous iPhone, as well as Research In Motion (NASDAQ:RIMM), the struggling-but-still-completely-phone-making tech stock.

What doesn’t make sense is how it holds these two companies. Apple is the No. 4 holding, marginally behind Research In Motion (both just above 3%). Ask yourself this: Would you still be more or less equally weighted in AAPL and RIMM?

PowerShares Water Resources ETF

The world’s population coming in at more than 7 billion, and growing populations require more water. Still, the PowerShares Water Resources ETF (NYSE:PHO) has been slippery for investors, off by about 6% during the past year.

Sticking out like a sore thumb is ITT (NYSE:ITT). The company primarily develops components for industries like energy, electronics, aerospace and transportation. It once had a dominant water pumps and systems business, but in 2011 ITT fragmented itself, spinning the water business off as Xylem (NYSE:XYL). PHO still holds ITT and hasn’t yet incorporated XYL.

Still, you can’t put PHO’s woes on ITT. It’s up about 6% this year.

Tom Taulli runs the InvestorPlace blog IPO Playbook, a site dedicated to the hottest news and rumors about initial public offerings. He also is the author of “The Complete M&A Handbook”, “All About Short Selling” and “All About Commodities.” Follow him on Twitter at @ttaulli or reach him via email. As of this writing, he did not own a position in any of the aforementioned securities.

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