Eric Balchunas has a great perch to observe the goings on in the rapidly changing world of ETFs. Balchunas is the Senior ETF Analyst at Bloomberg and is now author of the well-received book: The Institutional ETF Toolbox: How Institutions Can Understand and Utilize the Fast-Growing World of ETFs.

I have been enjoying the book. It is a sophisticated look at the fast-growing world of ETFs. It is pitched toward institutional investors, but I also think curious individual investors would find it of interest as well. One section in particular struck a chord with me. Balchunas’ thoughts on rating ETFs based on their ability to “surprise” investors is a good framework to think about the risk profiles of the many types of ETFs.

The following is an excerpt from Chapter 5 of Balchunas’ new book The Institutional ETF Toolbox: How Institutions Can Understand and Utilize the Fast-Growing World of ETFs from Bloomberg Press. Copyright (c) 2016 by Eric Balchunas.

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The Nasty Surprise ETF Rating System

I said earlier that I didn’t think star ratings based on performance made sense when it comes to ETFs. But I do think that a rating system that alerts investors of any potential surprises could be useful—especially considering that there are now over 1,800 ETFs covering every asset class, sector, industry, region, country, commodity, strategy, currency out there, and maybe some things you’ve never even heard of before. They also hold everything from emerging‐market bonds to futures contracts to swap agreements. And they keep getting more and more complex.

“ETFs are not going to blow up the world, but the complexity—that is going to create a problem.” –Stephen Elgee, Periscope Capital

For this reason, I developed my own shorthand ETF rating system that I can use to easily alert someone as to the potential for a nasty surprise inside an ETF. I modeled it after a rating system we all know very well: movie ratings. Before you dismiss it as absurd or silly, hear me out.

What do movie ratings do? They “provide parents with advance information about the content of movies to help them determine what’s appropriate for their children.” As such, a rating system for ETFs is needed to provide investors with advance information about what is appropriate for their investment.

While movie ratings look at the levels of things such as violence, nudity, and drug use, my rating system looks at the levels and complexities of the holdings, structure, fees, weightings, and taxation. Basically, it flags all the little bugaboos that can equate to a surprise or bad experience and then adds them together to determine a rating. Perhaps this is more appropriate for a retail audience, but I think given the avalanche of new complex products, anyone doing ETF investing could benefit from it.

This makes more sense to me than putting ETFs into two buckets of “safe” or “dangerous,” which is what many tend to do. The dangers are way more nuanced than that. ETFs that invest in senior loans, oil futures, or MLPs or use leverage all have some degree of unwelcome surprises for investors unfamiliar with the terrain.

This isn’t to say an ETF with an R rating should be automatically avoided. It just means the ETF has some gremlins in it that could turn nasty if you don’t know what you are getting into and so you should take time to understand how to use the product correctly. The higher the rating, the more you need to check yourself and read the fine print.

Following is a general look at my ratings, which I may reference at times in the book. It will hopefully help with shorthand communication and provide some insight into how you should be approaching your own ETF due diligence and maybe creating your own system.

G

Anything that holds developed market stocks or bonds using standard market capitalization-weighted indices. This is for straightforward ETFs with no complications that need explaining. Plain vanilla ETFs. Think Vanguard.

Examples: iShares Core S&P 500 ETF (IVV), Vanguard Short‐Term Government Bond ETF (VGSH).

PG

Any ETF that tracks stocks or bonds but uses an index that isn’t traditional market cap weighted. This is mostly for ETFs that attempt to outperform the market and could introduce added risk, like smart beta and actively managed ETFs. This category will also include any plain vanilla ETF where the tax treatment is slightly different, such as physically backed gold ETFs.

Examples: Guggenheim S&P 500 Equal Weight ETF (RSP), SPDR Gold Shares (GLD).

PG‐13

ETFs that track slightly more exotic stocks and bonds that could pose liquidity concerns, such as emerging markets or junk bond ETFs. Also includes specialized products that involve particularly tricky markets, increased complexity or have big tax consequences- such as China, MLPs, interest rate–hedged ETFs, liquid alternatives, and option‐writing strategies.

Examples: iShares MSCI Frontier Markets 100 (FM), PowerShares Senior Loan Portfolio (BKLN), Alerian MLP ETF (AMLP).

R

Not suitable for average investors. Must read fine print. Could get hurt. Any ETF that predominantly holds derivatives such as swaps or futures. This includes all leveraged and inverse ETFs plus all single‐commodity ETFs that hold futures contracts. It will also include ETNs, which carry credit risk. Basically, any product that has the potential to lose lots of money.

Examples: Direxion Daily Gold Miners Bull 3X Shares (NUGT), United States Oil Fund (USO), JPMorgan Alerian MLP ETN (AMJ).

NC‐17

These are the products that make—or should make—even professional investors think twice. Basically, a category reserved for leveraged ETNs that track futures. In other words, you get the triple whammy of leverage, roll costs, and credit risk all rolled up into one product.

Examples: VelocityShares Daily 2x VIX Short‐Term ETN (TVIX).

While a system using movie ratings will never be used in any official way, there’s no reason we can’t do it here in this book as a way to reference the level of nasty surprises an ETF has. For those creating their own system, I would recommend a system like this that uses more than two tiers.

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The following excerpt was from The Institutional ETF Toolbox: How Institutions Can Understand and Utilize the Fast-Growing World of ETFs is with the permission of Bloomberg Press. You can find it at bookstores everywhere including Amazon.