Investors seem to have an insatiable appetite for Exchange Traded Funds (ETFs). These securities are attractive for many reasons, including the ease with which they can be bought and sold, low management fees, and tax efficiencies via in-kind redemptions. Beyond these well advertised benefits, many investors and industry participants have very little understanding of how ETFs actually function.
When an investor buys a traditional equity index mutual fund, the fund manager buys the proportionate amount of securities in the underlying index. When investors redeem their shares the process is reversed, the securities are sold and the investor receives the net asset value. It’s pretty straightforward.
Buying an ETF is as simple as buying a stock or mutual fund. However, what goes on behind the scenes in an ETF transaction is far more complex and is highly dependent on multiple players in the market to insure a smooth operation. The illustration below shows how the ETF creation and redemption process works:
Behind the curtain.
authorised Participants or APs play a critical role in keeping the ETF shares trading at or near their net asset value. APs are financial institutions (unrelated to the ETF fund manager) who arbitrage discrepancies between the ETF’s market price and the ETF’s net asset value. APs create and redeem ETF shares know as “creation units” by trading baskets of the underlying securities with the EFT fund manager. Because of the limited redeemability of ETF shares, ETFs are not considered to be, and may not call themselves, mutual funds.
ETFs get increasingly more complex when they move beyond tracking large liquid equity indices and migrate toward leveraged, commodity, or actively managed instruments. Most leveraged and commodity
Please see important disclosures at the end of this document.
ETFs rely on swaps, futures and other derivative securities to reach their targets. This introduces more risks, including counter party risk, to the already complex equation. In some cases holding leveraged ETFs for more than a day or two can generate meaningful deviations from the targeted benchmark.
Are ETFs right for you?
Originally, ETFs were marketed mostly to institutional investors as a trading tool to facilitate hedging and as an alternative to using futures contracts. ETFs can be sold short and are exempt from the uptick rule, which makes them very attractive to aggressive traders like hedge funds.
Today ETFs are heavily marketed to individual investors. While we believe that ETFs can be a useful tool for investors, particularly those who are active traders, we are concerned that as Wall Street gets more creative with new ETF concepts, the quality of these new ETFs will deteriorate.
It shouldn’t come as a surprise that Wall Street loves ETFs. They require a huge amount of behind the scenes trading, making them a virtual gold mine for trading firms.
Many firms have recently announced that they have waived commissions for trading ETFs. As a general rule we believe that when Wall Street wants to give something away (particularly something that requires a bottle of aspirin to fully understand), it’s time to start asking questions!
Investors may not need to understand every nuance of how ETFs work, but the people peddling them certainly should, and most of them don’t. ETFs are far more complex than the marketing folks would lead you to believe and when investment products get more complex, risks go up.
ETFs were designed by traders for traders. If you’re not going to be actively trading, consider instead a well-managed, low cost traditional index mutual fund.
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