Exchange-traded fund

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An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks.[1][2] An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features.[3][4] ETFs are the most popular type of exchange-traded product.[5]

Only authorized participants, which are large broker-dealers that have entered into agreements with the ETF's distributor, actually buy or sell shares of an ETF directly from or to the ETF, and then only in creation units, which are large blocks of tens of thousands of ETF shares, usually exchanged in-kind with baskets of the underlying securities. Authorized participants may wish to invest in the ETF shares for the long-term, but they usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates the net asset value of the underlying assets.[6] Other investors, such as individuals using a retail broker, trade ETF shares on this secondary market.

An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. Closed-end funds are not considered to be ETFs, even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively managed ETFs.[6]

Structure[edit]

An ETF is a type of fund, some entity such as a corporation or trust that owns assets (bonds, stocks, gold bars, etc.) and divides ownership of itself into shares that are held by shareholders. The details of the structure can vary by country, or even by state in the United States. The shareholders indirectly own the assets of the fund, and they will typically get an annual report. Shareholders are entitled to a share of the profits, such as interest or dividends, and they may get a residual value in case the fund is liquidated. Their ownership of the fund can easily be bought and sold.

ETFs are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a stock exchange through a broker-dealer. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value (NAV). Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks varying in size from 25,000 to 200,000 shares, called creation units. Purchases and redemptions of the creation units generally are in kind, with the institutional investor contributing or receiving a basket of securities of the same type and proportion held by the ETF, although some ETFs may require or permit a purchasing or redeeming shareholder to substitute cash for some or all of the securities in the basket of assets.[6]

The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals.[6]

If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF: its shares trade at a discount from net asset value.

In the United States, most ETFs are structured as open-end management investment companies (the same structure used by mutual funds and money market funds), although a few ETFs, including some of the largest ones, are structured as unit investment trusts. ETFs structured as open-end funds have greater flexibility in constructing a portfolio and are not prohibited from participating in securities lending programs or from using futures and options in achieving their investment objectives.[7]

Under existing regulations, a new ETF must receive an order from the Securities and Exchange Commission (SEC), giving it relief from provisions of the Investment Company Act of 1940 that would not otherwise allow the ETF structure. In 2008, the SEC proposed rules that would allow the creation of ETFs without the need for exemptive orders. Under the SEC proposal, an ETF would be defined as a registered open-end management investment company that:

  • issues (or redeems) creation units in exchange for the deposit (or delivery) of basket assets the current value of which is disseminated per share by a national securities exchange at regular intervals during the trading day
  • identifies itself as an ETF in any sales literature
  • issues shares that are approved for listing and trading on a securities exchange
  • discloses each business day on its publicly available web site the prior business day's net asset value and closing market price of the fund's shares, and the premium or discount of the closing market price against the net asset value of the fund's shares as a percentage of net asset value
  • either is an index fund, or discloses each business day on its publicly available web site the identities and weighting of the component securities and other assets held by the fund[6]

The SEC rule proposal would allow ETFs either to be index funds or to be fully transparent actively managed funds. Historically, all ETFs in the United States have been index funds. In 2008, however, the SEC began issuing exemptive orders to fully transparent actively managed ETFs. The first such order was to PowerShares Actively Managed Exchange-Traded Fund Trust,[8] and the first actively managed ETF in the United States was the Bear Stearns Current Yield Fund, a short-term income fund that began trading on the American Stock Exchange under the symbol YYY on March 25, 2008.[9] The SEC rule proposal indicates that the SEC may still consider future applications for exemptive orders for actively managed ETFs that do not satisfy the proposed rule's transparency requirements.[6]

Some ETFs invest primarily in commodities or commodity-based instruments, such as crude oil and precious metals. Although these commodity ETFs are similar in practice to ETFs that invest in securities, they are not investment companies under the Investment Company Act of 1940.[6]

Publicly traded grantor trusts, such as Merrill Lynch's HOLDRs securities, are sometimes considered to be ETFs, although they lack many of the characteristics of other ETFs. Investors in a grantor trust have a direct interest in the underlying basket of securities, which does not change except to reflect corporate actions such as stock splits and mergers. Funds of this type are not investment companies under the Investment Company Act of 1940.[10]

As of 2009, there were approximately 1,500 exchange-traded funds traded on US exchanges.[11] This count uses the wider definition of ETF, including HOLDRs and closed-end funds.

History[edit]

ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. This product, however, was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in stopping sales in the United States.[12]

A similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange (TSE) in 1990. The shares, which tracked the TSE 35 and later the TSE 100 indices, proved to be popular. The popularity of these products led the American Stock Exchange to try to develop something that would satisfy SEC regulation in the United States.[12]

Nathan Most and Steven Bloom, under the direction of Ivers Riley, designed and developed Standard & Poor's Depositary Receipts (NYSE ArcaSPY), which were introduced in January 1993.[13][14] Known as SPDRs or "Spiders", the fund became the largest ETF in the world. In May 1995 they introduced the MidCap SPDRs (NYSE ArcaMDY).

Barclays Global Investors, a subsidiary of Barclays PLC, entered the fray in 1996 with World Equity Benchmark Shares (WEBS) subsequently renamed iShares MSCI Index Fund Shares. WEBS tracked MSCI country indices, originally 17, of the funds' index provider, Morgan Stanley. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind.[15][16]

In 1998, State Street Global Advisors introduced "Sector Spiders", which follow nine sectors of the S&P 500.[17] Also in 1998, the "Dow Diamonds" (NYSE ArcaDIA) were introduced, tracking the famous Dow Jones Industrial Average. In 1999, the influential "cubes" (NASDAQQQQ), were launched attempting to replicate the movement of the NASDAQ-100.

In 2000, Barclays Global Investors put a significant effort behind the ETF marketplace, with a strong emphasis on education and distribution to reach long-term investors. The iShares line was launched in early 2000. Within five years iShares had surpassed the assets of any other ETF competitor in the U.S. and Europe. Barclays Global Investors was sold to BlackRock in 2009.

The Vanguard Group entered the market in 2001. The first fund was Vanguard Total Stock Market ETF (NYSE ArcaVTI), which has become quite popular, and they made the Vanguard Extended Market Index ETF (VXF).

iShares made the first bond funds in July 2002, based on US Treasury bonds and corporate bonds, such as iShares iBoxx $ Invst Grade Crp Bond (LQD). They also created a TIPS fund. In 2007, they introduced funds based on junk and muni bonds; about the same time SPDR and Vanguard got in gear and created several of their bond funds.

Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes. As of January 2014, there were over 1,500 ETFs traded in the U.S., with over $1.7 trillion in assets.[18]

Investment uses[edit]

ETFs generally provide the easy diversification, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options. Because ETFs can be economically acquired, held, and disposed of, some investors invest in ETF shares as a long-term investment for asset allocation purposes, while other investors trade ETF shares frequently to implement market timing investment strategies.[7] Among the advantages of ETFs are the following:[10][19]

  • Lower costs – ETFs generally have lower costs than other investment products because most ETFs are not actively managed and because ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have lower marketing, distribution and accounting expenses, and most ETFs do not have 12b-1 fees.
  • Buying and selling flexibility – ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. As publicly traded securities, their shares can be purchased on margin and sold short, enabling the use of hedging strategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade.
  • Tax efficiency – ETFs generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions.
  • Market exposure and diversification – ETFs provide an economical way to rebalance portfolio allocations and to "equitize" cash by investing it quickly. An index ETF inherently provides diversification across an entire index. ETFs offer exposure to a diverse variety of markets, including broad-based indices, broad-based international and country-specific indices, industry sector-specific indices, bond indices, and commodities.
  • Transparency – ETFs, whether index funds or actively managed, have transparent portfolios and are priced at frequent intervals throughout the trading day.

Some of these advantages derive from the status of most ETFs as index funds.

Types[edit]

For more details on this topic, see List of American exchange-traded funds.

Index ETFs[edit]

Most ETFs are index funds that attempt to replicate the performance of a specific index. Indexes may be based on stocks, bonds, commodities, or currencies. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index.[7] As of June 2012, in the United States, about 1200 index ETFs exist, with about 50 actively managed ETFs. Index ETF assets are about $1.2 trillion, compared with about $7 billion for actively managed ETFs.[20] Some index ETFs, known as leveraged ETFs or inverse ETFs, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of the index.[21]

Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called replication. Other index ETFs use representative sampling, investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as futures, option and swap contracts, and securities not in the underlying index, that the fund's adviser believes will help the ETF to achieve its investment objective. There are various ways the ETF can be weighted, such as equal weighting or revenue weighting.[22] For index ETFs that invest in indices with thousands of underlying securities, some index ETFs employ "aggressive sampling" and invest in only a tiny percentage of the underlying securities.[23][24]

Stock ETFs[edit]

The first and most popular ETFs track stocks. Many funds track national indexes; for example, Vanguard Total Stock Market ETF NYSE ArcaVTI tracks the MSCI US Broad Market Index, and several funds track the S&P 500, both indexes for US stocks. Other funds own stocks from many countries; for example, Vanguard Total International Stock Index NYSE ArcaVXUS tracks the MSCI All Country World ex USA Investable Market Index, while the iShares MSCI EAFE Index NYSE ArcaEFA tracks the MSCI EAFE Index, both "world ex-US" indexes.

ETFs can also be sector funds. These can be broad sectors, like finance and technology, or specific niche areas, like green power. They can also be for one country or global. Critics have said that no one needs a sector fund.[25] This point is not really specific to ETFs; the issues are the same as with mutual funds. The funds are popular since people can put their money into the latest fashionable trend, rather than investing in boring areas with no "cachet".

Bond ETFs[edit]

Exchange-traded funds that invest in bonds are known as bond ETFs.[26] They thrive during economic recessions because investors pull their money out of the stock market and into bonds (for example, government treasury bonds or those issued by companies regarded as financially stable). Because of this cause and effect relationship, the performance of bond ETFs may be indicative of broader economic conditions.[27] There are several advantages to bond ETFs such as the reasonable trading commissions, but this benefit can be negatively offset by fees if bought and sold through a third party.[28]

Commodity ETFs or ETCs[edit]

Commodity ETFs (ETCs or CETFs) invest in commodities, such as precious metals, agricultural products, or hydrocarbons. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries. The idea of a Gold ETF was first officially conceptualised by Benchmark Asset Management Company Private Ltd in India when they filed a proposal with the SEBI in May 2002.[29] The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003, and the first silver exchange-traded fund was iShares Silver Trust launched on the NYSE in 2006. As of November 2010 a commodity ETF, namely SPDR Gold Shares, was the second-largest ETF by market capitalization.[30]

However, generally commodity ETFs are index funds tracking non-security indices. Because they do not invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to SEC review and they need an SEC no-action letter under the Securities Exchange Act of 1934. They may, however, be subject to regulation by the Commodity Futures Trading Commission.[31][32]

The earliest commodity ETFs, such as SPDR Gold Shares NYSE ArcaGLD and iShares Silver Trust NYSE ArcaSLV, actually owned the physical commodity (e.g., gold and silver bars). Similar to these are NYSE ArcaPALL (palladium) and NYSE ArcaPPLT (platinum). However, most ETCs implement a futures trading strategy, which may produce quite different results from owning the commodity.

Commodity ETFs trade just like shares, are simple and efficient and provide exposure to an ever-increasing range of commodities and commodity indices, including energy, metals, softs and agriculture. However, it is important for an investor to realize that there are often other factors that affect the price of a commodity ETF that might not be immediately apparent. For example, buyers of an oil ETF such as USO might think that as long as oil goes up, they will profit roughly linearly. What isn't clear to the novice investor is the method by which these funds gain exposure to their underlying commodities. In the case of many commodity funds, they simply roll so-called front-month futures contracts from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.[33][34]

ETC can also refer to exchange-traded notes, which are not exchange-traded funds.

Currency ETFs or ETCs[edit]

In 2005, Rydex Investments launched the first ever currency ETF called the Euro Currency Trust (NYSE ArcaFXE) in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares. In 2007 Deutsche Bank's db x-trackers launched EONIA Total Return Index ETF in Frankfurt tracking the euro, and later in 2008 the Sterling Money Market ETF (LSEXGBP) and US Dollar Money Market ETF (LSEXUSD) in London. In 2009, ETF Securities launched the world's largest FX platform tracking the MSFXSM Index covering 18 long or short USD ETC vs. single G10 currencies. The funds are total return products where the investor gets access to the FX spot change, local institutional interest rates and a collateral yield.

Actively managed ETFs[edit]

Most ETFs are index funds, but some ETFs do have active management. Actively managed ETFs have been offered in the United States only since 2008. The first active ETF was Bear Stearns Current Yield ETF (Ticker: YYY). [35] Currently, actively managed ETFs are fully transparent, publishing their current securities portfolios on their web sites daily. However, the SEC indicated that it was willing to consider allowing actively managed ETFs that are not fully transparent in the future,[6] and later actively managed ETFs have sought alternatives to full transparency.

The fully transparent nature of existing ETFs means that an actively managed ETF is at risk from arbitrage activities by market participants who might choose to front run its trades as daily reports of the ETF's holdings reveals its manager's trading strategy. The initial actively managed equity ETFs addressed this problem by trading only weekly or monthly. Actively managed debt ETFs, which are less susceptible to front-running, trade their holdings more frequently.[36]

The actively managed ETF market has largely been seen as more favorable to bond funds, because concerns about disclosing bond holdings are less pronounced, there are fewer product choices, and there is increased appetite for bond products. Pimco’s Enhanced Short Duration ETF NYSEMINT is the largest actively managed ETF, with approximately $3.93 billion in assets as of May 16, 2014.[37]

Actively managed ETFs grew faster in their first three years of existence than index ETFs did in their first three years of existence. As track records develop, many see actively managed ETFs as a significant competitive threat to actively managed mutual funds.[38] However, many academic studies have questioned the value of active management. Jack Bogle of Vanguard Group wrote an article in the Financial Analysts Journal where he estimated that higher fees as well as hidden costs (such a more trading fees and lower return from holding cash) reduce returns for investors by around 2.66 percentage points a year "a huge differential considering that long-term real returns from American equities have been 6.45%."[39] Even without considering hidden costs, high fees negatively affect long-term performance. In another Financial Analysts Journal article, Nobel laureate, Bill Sharpe "calculated that someone who saved via a low-cost fund would have a standard of living in retirement 20% higher than someone who saved in a high-cost fund" [40]

Exchange-traded grantor trusts[edit]

An exchange-traded grantor trust share represents a direct interest in a static basket of stocks selected from a particular industry. Such products have some properties in common with ETFs – low costs, low turnover, and tax efficiency – but are generally regarded as separate from ETFs. The leading example was Holding Company Depositary Receipts, or HOLDRs, a proprietary Merrill Lynch product, but these have now disappeared from the scene.[41][10][42]

Inverse ETFs[edit]

Leveraged ETFs[edit]

Leveraged exchange-traded funds (LETFs), or simply leveraged ETFs, are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETFs.[43] Leveraged index ETFs are often marketed as bull or bear funds. A leveraged bull ETF fund might for example attempt to achieve daily returns that are 2x or 3x more pronounced than the Dow Jones Industrial Average or the S&P 500. A leveraged inverse (bear) ETF fund on the other hand may attempt to achieve returns that are -2x or -3x the daily index return, meaning that it will gain double or triple the loss of the market. Leveraged ETFs require the use of financial engineering techniques, including the use of equity swaps, derivatives and rebalancing, and re-indexing to achieve the desired return.[44] The most common way to construct leveraged ETFs is by trading futures contracts.

The rebalancing and re-indexing of leveraged ETFs may have considerable costs when markets are volatile.[45][46] The rebalancing problem is that the fund manager incurs trading losses because he needs to buy when the index goes up and sell when the index goes down in order to maintain a fixed leverage ratio. A 2.5% daily change in the index will for example reduce value of a -2x bear fund by about 0.18% per day, which means that about a third of the fund may be wasted in trading losses within a year (1-(1-0.18%)252=36.5%). Investors may however circumvent this problem by buying or writing futures directly, accepting a varying leverage ratio.[citation needed] A more reasonable estimate of daily market changes is 0.5%, which leads to a 2.6% yearly loss of principal in a 3x leveraged fund.

The re-indexing problem of leveraged ETFs stems from the arithmetic effect of volatility of the underlying index. Take, for example, an index that begins at 100 and a 2X fund based on that index that also starts at 100. In a first trading period (for example, a day), the index rises 10% to 110. The 2X fund will then rise 20% to 120. The index then drops back to 100 (a drop of 9.09%), so that it is now even. The drop in the 2X fund will be 18.18% (2*9.09). But 18.18% of 120 is 21.82. This puts the value of the 2X fund at 98.18. Even though the index is unchanged after two trading periods, an investor in the 2X fund would have lost 1.82%. This decline in value can be even greater for inverse funds (leveraged funds with negative multipliers such as -1, -2, or -3). It always occurs when the change in value of the underlying index changes direction. And the decay in value increases with volatility of the underlying index.

The effect of leverage is also reflected in the pricing of options written on leveraged ETFs. In particular, the terminal payoff of a leveraged ETF European/American put or call depends on the realized variance (hence the path) of the underlying index. The impact of leverage ratio can also be observed from the implied volatility surfaces of leveraged ETF options.[47] For instance, the implied volatility curves of inverse leveraged ETFs (with negative multipliers such as -1, -2, or -3) are commonly observed to be increasing in strike, which is characteristically different from the implied volatility smiles or skews seen for index options or non-leveraged ETF options.

ETFs compared to mutual funds[edit]

Costs[edit]

Because ETFs trade on an exchange, each transaction is generally subject to a brokerage commission. Commissions depend on the brokerage and which plan is chosen by the customer. For example, a typical flat fee schedule from an online brokerage firm in the United States ranges from $10 to $20, but it can be as low as $0 with discount brokers. Due to this commission cost, the amount invested has a great bearing; someone who wishes to invest $100 per month may have a significant percentage of their investment destroyed immediately, while for someone making a $200,000 investment, the commission cost may be negligible. Generally, mutual funds obtained directly from the fund company itself do not charge a brokerage fee. Thus, when low or no-cost transactions are available, ETFs become very competitive.[48]

ETFs have a lower expense ratio than comparable mutual funds. Not only does an ETF have lower shareholder-related expenses, but because it does not have to invest cash contributions or fund cash redemptions, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses.[49] Mutual funds can charge 1% to 3%, or more; index fund expense ratios are generally lower, while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.[50]

The cost difference is more evident when compared with mutual funds that charge a front-end or back-end load as ETFs do not have loads at all. The redemption fee and short-term trading fees are examples of other fees associated with mutual funds that do not exist with ETFs. Traders should be cautious if they plan to trade inverse and leveraged ETFs for short periods of time. Close attention should be paid to transaction costs and daily performance rates as the potential combined compound loss can sometimes go unrecognized and offset potential gains over a longer period of time.[51]

Taxation[edit]

ETFs are structured for tax efficiency and can be more attractive than mutual funds. In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute the capital gains to its shareholders. This can happen whenever the mutual fund sells portfolio securities, whether to reallocate its investments or to fund shareholder redemptions. These gains are taxable to all shareholders, even those who reinvest the gains distributions in more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF shares on the stock market, as they would a stock, or effect a non-taxable redemption of a creation unit for portfolio securities), so that investors generally only realize capital gains when they sell their own shares or when the ETF trades to reflect changes in the underlying index.[7]

In most cases, ETFs are more tax-efficient than conventional mutual funds in the same asset classes or categories.[52] Because Vanguard's ETFs are a share-class of their mutual funds, they don't get all the tax advantages if there are net redemptions on the mutual fund shares.[53] Although they do not get all the tax advantages, they get an additional advantage from tax loss harvesting any capital losses from net redemptions.[54][55]

In the U.K., ETFs can be shielded from capital gains tax by placing them in an Individual Savings Account or self-invested personal pension, in the same manner as many other shares. Because UK-resident ETFs would be liable for UK corporation tax on non-UK dividends, most ETFs which hold non-UK companies sold to UK investors are issued in Ireland or Luxembourg.[56]

Trading[edit]

An important benefit of an ETF is the stock-like features offered. A mutual fund is bought or sold at the end of a day's trading, whereas ETFs can be traded whenever the market is open. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement).[57] Also, many ETFs have the capability for options (puts and calls) to be written against them. Covered call strategies allow investors and traders to potentially increase their returns on their ETF purchases by collecting premiums (the proceeds of a call sale or write) on calls written against them. Mutual funds do not offer those features.[58]

Risks[edit]

Tracking Error[edit]

The ETF tracking error is the difference between the returns of the ETF and its reference index or asset. A non-zero tracking error therefore represents a failure to replicate the reference as stated in the ETF prospectus. The tracking error is computed based on the prevailing price of the ETF and its reference. It is different than the premium/discount which is the difference between the ETF’s NAV (updated only once a day) and its market price. Tracking errors are more significant when the ETF provider uses strategies other than full replication of the underlying index. Some of the most liquid equity ETFs tend to have better tracking performance because the underlying is also sufficiently liquid, allowing for full replication. [59] In contrast, some ETFs, such as commodities ETFs and their leveraged ETFs, do not necessarily employ full replication because the physical assets cannot be stored easily or used to create a leveraged exposure, or the reference asset or index is illiquid. [60] Futures-based ETFs may also suffer from negative roll yields, as seen in the VIX futures market.

Effects on stability[edit]

ETFs that buy and hold commodities or futures of commodities have become popular. For example, SPDR Gold Shares ETF (GLD) has 41 million ounces in trust.[61] The silver ETF, SLV, is also very large. The commodity ETFs are in effect consumers of their target commodities, thereby affecting the price in a spurious fashion.[62][63][64] In the words of the IMF, “Some market participants believe the growing popularity of exchange-traded funds (ETFs) may have contributed to equity price appreciation in some emerging economies, and warn that leverage embedded in ETFs could pose financial stability risks if equity prices were to decline for a protracted period.”[65]

Regulatory risk[edit]

Synthetic ETFs are attracting regulatory attention from the FSB, [66] the IMF, [67] and the BIS. [68] Areas of concern include the lack of transparency in products and increasing complexity; conflicts of interest; and lack of regulatory compliance.

Counterparty risk[edit]

A synthetic ETF has counterparty risk, because the counterparty is contractually obligated to match the return on the index. The deal is arranged with collateral posted by the swap counterparty. A potential hazard is that the investment bank offering the ETF might post its own collateral, and that collateral could be of dubious quality. Furthermore, the investment bank could use its own trading desk as counterparty. These types of set-ups are not allowed under the European guidelines, Undertakings for Collective Investment in Transferable Securities (UCITS), so the investor should look for UCITS III-compliant funds. [62]

Liquidity[edit]

ETFs have a wide range of liquidity. Some funds are constantly traded, with tens of millions of shares per day changing hands, while others trade only once in a while, even not trading for some days. There are many funds that do not trade very often. This just means that most trading is conducted in the most popular funds. The most active funds (such as SPY, IWM, QQQ, et cetera) are very liquid, with high volume and tight spreads. In these cases, the investor is almost sure to get a "reasonable" price, even in difficult conditions. With other funds, it is worthwhile to take some care in execution. This does not mean that less popular funds are not a quality investment. This is in contrast with traditional mutual funds, where everyone who trades on the same day gets the same price.

Criticism[edit]

John C. Bogle, founder of the Vanguard Group, a leading issuer of index mutual funds (and, since Bogle's retirement, of ETFs), has argued that ETFs represent short-term speculation, that their trading expenses decrease returns to investors, and that most ETFs provide insufficient diversification. He concedes that a broadly diversified ETF that is held over time can be a good investment.[69]

ETFs are dependent on the efficacy of the arbitrage mechanism in order for their share price to track net asset value. While the average deviation between the daily closing price and the daily NAV of ETFs that track domestic indices is generally less than 2%, the deviations may be more significant for ETFs that track certain foreign indices.[7] The Wall Street Journal reported in November 2008, during a period of market turbulence, that some lightly traded ETFs frequently had deviations of 5% or more, exceeding 10% in a handful of cases, although even for these niche ETFs, the average deviation was only a little more than 1%. The trades with the greatest deviations tended to be made immediately after the market opened.[70]

According to a study on ETF returns in 2009 by Morgan Stanley, ETFs missed in 2009 their targets by an average of 1.25 percentage points, a gap more than twice as wide as the 0.52-percentage-point average they posted in 2008.[71] Part of this so-called tracking error is attributed to the proliferation of ETFs targeting exotic investments or areas where trading is less frequent, such as emerging-market stocks, future-contracts based commodity indices and junk bonds.[citation needed]

The tax advantages of ETFs are of no relevance for investors using tax-deferred accounts (or indeed, investors who are tax-exempt in the first place).[72] However, the lower expense ratios are proving difficult for the proponents of traditional mutual funds to overcome.

In a survey of investment professionals, the most frequently cited disadvantage of ETFs was the unknown, untested indices used by many ETFs, followed by the overwhelming number of choices.[4]

Some critics claim that ETFs can be, and have been, used to manipulate market prices, including having been used for short selling that has been asserted by some observers (including Jim Cramer of theStreet.com) to have contributed to the market collapse of 2008.

Issuers of ETFs[edit]

See also[edit]

References[edit]

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Further reading[edit]

  • Carrell, Lawrence. ETFs for the Long Run: What They Are, How They Work, and Simple Strategies for Successful Long-Term Investing. JW Wiley, 2008. ISBN 978-0-470-13894-6
  • Ferri, Richard A. The ETF Book: All You Need to Know About Exchange-Traded Funds. Wiley, 2009. ISBN 0-470-53746-9
  • Humphries, William. Leveraged ETFs: The Trojan Horse Has Passed the Margin-Rule Gates. 34 Seattle U.L. Rev. 299 (2010), available at [2].
  • Koesterich, Russ. The ETF Strategist: Balancing Risk and Reward for Superior Returns. Portfolio, 2008. ISBN 978-1-59184-207-1

External links[edit]