What’s an exotic ETF? In short, there are three types of ETFs: passive, smart-beta, and active. The passive funds can vary in their focus from a stock market (SPY), a sector (XLU), or a particular asset class (GLD). This seems like the exact opposite of an exotic ETF which, you’d expect, to be actively managed and/or use a complex system to outperform the market—which is what smart beta funds do.
But an ETF can be both passive and exotic, despite the seeming paradox. Take, for instance, the ETRACS Fisher-Gartman Risk On and Risk Off ETNs (ONN, OFF), which are now defunct but once used a complex and proprietary metrics system to determine which stocks were worth buying during risk on and risk off scenarios.
Unsurprisingly, the funds didn’t work very well, which is why they are no longer offered. Of course, these funds aren’t as well known as other exotic funds such as the VelocityShares Daily Inverse Vix Short-Term ETN (XIV), which had tremendous returns before it shut down earlier this year due to a blow up in the VIX.
Both the failure of XIV and that of ONN and OFF point to one risk in these funds that is often overlooked: exotic ETFs are often used for short-term trading, and while they may sometimes function to that end, in reality their long-term performance is likely to be significantly worse than the market for a variety of reasons. And that is the primary risk of these kinds of funds.
Of course, it isn’t the only risk. One fundamental problem with ONN and OFF was that they just didn’t work very well. The indexes that were their underlining benchmark didn’t actually measure anything of significance; many exotic ETFs have a similar problem. Another risk with these kinds of exotic ETFs is that what they do measure may work at one point until, eventually, they don’t.
A third and pernicious problem with exotic ETFs is that they are often well marketed and poorly designed. For instance, two levered ETFs that track so-called FANG stocks—BMO Rex 3x levered ETFs (FNGU, FNGD) don’t actually invest in FAANG stocks. While they’re close, they also expand on that exposure to other high-growth tech companies, including companies that actively compete with FAANG names such as Twitter (TWTR) and Snap (SNAP). As a result, these funds can have tremendously contradictory performance than what one would expect from the name on the tin.
The lesson? Great care is needed when it comes to exotic ETF investing, which is why they are rarely used by professionals and, when used, are often used less as a speculative tool than a hedging one. Except, of course, when institutional investors want to bet against these retail investor-oriented products.