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With the Securities and Exchange Commission’s launching of a broad, agency-wide review of exchange-traded funds and the recent Senate subcommittee hearings concerning the rapidly growing $1 trillion ETF industry and its potential impact on market volatility, now is a good time to review IFA’s concerns with ETFs and other exchange-traded products.


An exchange-traded fund is similar to a mutual fund in that it exposes investors to potentially a large number of holdings, saving them the trouble and expense of attempting to construct a diversified portfolio from individual securities. However, there are many important differences that investors should take the time to understand before utilizing ETFs in their portfolios. The diagram below shows how a mutual fund transacts with clients and the capital markets.

 (Source: Morningstar ®)

Exchange-traded funds significantly differ in structure. The ETF providers rely on “authorized participants” to act as intermediaries between the fund and the capital markets. The diagram below shows how investors (or traders) acquire and sell ETF shares. Perhaps the most noteworthy difference between ETFs and mutual funds is that the former trades throughout the day while the latter is priced only once per day at the market close.


 (Source: Morningstar ®)

One of the primary arguments in favor of ETFs is that they often charge lower expense ratios than corresponding index mutual funds. ETF providers are able to charge these lower fees because they are not required to provide customer service and they benefit from the outsourcing of capital market activities. However, since capital market participants do not work for free, the costs are ultimately borne by ETF shareholders. In recognition of these costs, Morningstar has introduced a new metric, “estimated holding cost” in order to capture the true cost of ETFs. Additional costs include rebalancing costs and the costs of relying on derivatives to achieve the targeted index exposure. For example, Morningstar’s estimated holding cost of the SPDR S&P 500 (SPY) is 0.16% vs. a net expense ratio of 0.09%.

When buying or selling ETF shares, investors should be concerned with both the liquidity of the ETF shares (the bid/ask spread and the depth of the order book) as well as the liquidity of the underlying securities held by the ETF. Large trades can move the market, and very large trades (say 50,000 shares or more) may require the assistance of an authorized participant which will carry an additional cost. If the underlying securities of the ETF have liquidity issues, a divergence between the net asset value and the market value per share can persist despite the apparent incentive for authorized participants to arbitrage the difference. The bottom line here is that even if commissions are free, the cost of trading ETFs most definitely is not.

While perhaps not originally intended as such, ETFs have evolved into market-timing and tactical allocation tools. Since there is no redemption fee or minimum required holding period, investors can use ETFs to take a very short-term position in an index. For the most widely held ETF (SPY), the average daily volume is about 20% of the total shares outstanding, which means the average holding period per share is just 5 days!

Finance is one of the few areas of life where most innovation is unhelpful at best quite harmful at worst, and unfortunately, ETFs have been the focal point for much of it. One example to have emerged in the last few years is leveraged and inverse ETFs.  IFA advises investors to steer clear of these high-risk securities which utilize derivatives to deliver their targeted returns. Quite often, the actual realized returns are very different from the returns anticipated by investors. For example, in 2008, The Dow Jones US Select REIT Index dropped by 37%. However, buyers of the Proshares Ultrashort Real Estate ETF (SRS), rather than making the killing they may have expected, suffered a worse loss than the index itself (50%)! Individual investors (and most institutional investors) have no good reason to buy funds that are not backed by actual shares or bonds.

Another recent innovation that investors should avoid is the commodity-linked ETF. IFA advises against the inclusion of commodities in our client’s portfolios primarily because they do not have a real expected return. They are also highly volatile. Also, commodity-linked ETFs such as USO (United States Oil) and UNG (United States Natural Gas) have failed to provide the same returns as the underlying commodities. One reason for this failure is that savvy traders know in advance the positions that will be taken by these ETFs and can trade ahead of them. This very subject was addressed in an IFA Quote of the Week.

An offshoot of exchange-traded funds is the exchange-traded note (ETN), which is an unsecured debt security where the issuer agrees to pay the return of an index, commodity, or currency (minus a fee). They are often used to make bets on currency movements or on changes in market volatility (e.g., iPath VIX futures issued by Barclays). Unlike ETFs, ETNs carry default risk, which has no upside and a substantial downside. Investors in the ETNs issued by Lehman Brothers got to experience this pain first-hand in 2008.

An additional type of ETF that investors would do well to avoid is the extremely specialized fund such as the PowerShares Lux Nanotech ETF (PXN) or the EGShares India Infrastructure ETF (INXX). Aside from the difficulties in trading due to high spreads, investors in these funds are taking on risks that carry no additional expected returns. For the record, as of September 30th, the five-year annualized return of PXN was -19.42%, compared to 1.15% for the Morningstar Technology category, and the one-year return for INXX was -35.83%, compared to -17.63% for the Vanguard Emerging Markets Index Fund, according to Morningstar.com. An additional problem with these types of funds is the danger of not reaching the level of assets needed for profitability and thus being forced into closure. Last year, for example, Wisdomtree closed ten of its funds, and investors received cash payments for their shares.

Finally, it goes without saying that IFA advises investors to avoid the new wave of actively-managed ETFs.

One often-touted advantage of ETFs over mutual funds is their tax efficiency which derives from their ability to avoid having to place sells due to redemption requests by investors. IFA has found that the overall tax hits suffered by ETF shareholders have not been significantly lower than the tax hits received by shareholders in sensibly structured tax-managed passive mutual funds. The more important number is the return received by investors after taxes, and a well-run passive mutual fund which has far greater flexibility than an ETF can deliver those higher after-tax returns.
To summarize, ETFs are best used to achieve long-term exposures to sensibly constructed indexes as part of a globally diversified portfolio of index funds. IFA advises investors to avoid the temptation to trade ETFs, even if no commissions are charged. IFA also cautions investors away from commodity-linked ETFs, leveraged/inverse ETFs, extremely specialized ETFs, active ETFs, and exchange-traded notes.