What are Exchange Traded Funds (ETFs) ?

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what are etfs basics exchange traded funds for investorsOf the countless financial products constructed by financiers in recent decades, few if any have broadened the horizons of individual investors more than Exchange Traded Funds (ETFs). ETFs afford individual investors innumerable opportunities for portfolio diversification and exposure to otherwise inaccessible asset classes from all over the world. One should exercise caution when investing in ETFs due to certain factors, explained in this article, which may reduce total return on investment. Nevertheless, the funds can be a very useful weapon in an individual investor's arsenal.

What are ETFs?

An Exchange Traded Fund is a security which represents a basket of certain underlying assets that can include stocks, bonds, commodities, and currencies. All ETF shares are traded on exchanges, and can be bought and sold just like ordinary stocks. By reflecting the return of a certain basket of different types of assets, ETFs allow investors to diversify their holdings without the trading fees and hassle of buying each asset individually and at a significantly lower cost than mutual funds. ETFs can be constructed to reflect the price performance of single commodities. For example, the SPDR Gold Trust (GLD) is structured to reflect the performance of gold. ETFs can also be configured to replicate market return in certain geographical areas and countries. For example, the ETF iShares S&P Asia 50 Index Fund (AIA) reflects the performance of the 50 largest stocks in Asia and the MSCI Brazil Index Fund Profile (EWZ) reflects the performance of Brazilian equity markets. There are countless other combinations and concentrations of various asset classes and national origins that investors may choose from.

Mutual Funds vs. ETFs

ETFs are very similar to mutual funds but the two asset classes can be differentiated by several significant characteristics. First and foremost, ETFs have considerably lower administrative costs and fees than mutual funds. ETFs are often passively managed (by certain automatic rules rather than by fund administrators on a day-to-day basis) and reflect a relatively fixed basket of assets. By contrast, mutual funds are actively managed by investment managers, who ultimately decide what to invest in. The value of a mutual fund is constantly changing to reflect daily deposits and withdrawals. When an investor purchases shares in a mutual fund, the fund managers must quickly invest the deposit. When an investor redeems shares, the fund managers must sell assets to accommodate the redemption. This constant cycle of purchases and redemptions combined with higher marketing, distribution, and accounting expenses results in the significantly higher cost of a mutual fund investment compared to an ETF investment. Also, ETFs must accommodate a much more rigorous set of transparency requirements than mutual funds, which means that more information about the fund's size and portfolio are readily available to individual investors.

ETF Pros

  • Greater diversification of one's portfolio
  • Exposure to exotic and/or otherwise inaccessible asset classes
  • Traded on exchanges just like individual stocks
  • Lower fees and expense ratios than mutual funds
  • Tax advantages associated with less buying and selling activity compared to mutual funds
  • Useful for making pair trades to execute a more pure long or short play relative to a certain benchmark
    • Example: if an investor wanted to take a long position in Exxon Mobil (XOM) relative to the energy sector, he or she could buy shares in XOM and short shares in the ETF PowerShares DB Energy Fund (DBE).

ETF Cons

  • ETFs are only as good as their underlying assets
  • Some ETF shares trade in small, illiquid markets and cannot be bought and sold easily (many small cap companies experience a similar liquidity problem)
  • Certain aspects of leveraged, short, commodity, and currency ETFs (addressed in greater detail below)

Leveraged ETFs

Leveraged ETFs seek to magnify returns by some multiple of the change in the underlying asset. One can distinguish between leveraged and unleveraged fairly easily by fund name. ProShares x2 leveraged ETFs can be identified by the term "Ultra" (or "UltraShort"). Twice leveraged ETF names will often include a term such as "ultra", "double", "enhanced", "plus", etc. (and "ultrashort", "double short", etc. for inverse funds.) Thrice leveraged ETFs can also be identified by the name of the fund: The name will include "3x", "triple leveraged", "UltraPro" (in the case of ProShares funds), "extended" or a similar term indicating the fund's leveraged nature. Unfortunately, there is no uniform naming system across ETFs. However, compared to unleveraged ETFs, the name of the fund will include a strong word or term indicating that it is leveraged.

A 2x bull ETF is constructed to grow (or decline) at double the rate of the underlying assets. This also implies that the value of the ETF will fall at double the rate of underlying assets. For example, a 2x bear index seeks to achieve returns double the loss of the underlying assets. This implies that the fund will lose value at double rate of the increase in underlying assets value. In theory, this is an excellent method to magnify returns (despite the risk of magnified losses). However, leveraged ETFs require complex derivatives and periodic rebalancing to achieve the advertised daily return. When markets change by a certain percentage, managers are forced to buy/sell assets in order to rebalance the fund and maintain the initial leverage ratio. The associated costs and required daily rebalancing continuously erode the long term value of the assets in the fund (and hence the value of shares in the fund itself). As a result, leveraged ETFs are not a long term investment. These funds are only safe as short term investments - specifically, from a few days to a few weeks maximum.

Finally, investors should exercise caution when investing in ETFs which hold currency or commodity futures contracts directly rather than through a proxy instrument, such as equity in currency or commodity related companies. Funds which elect to invest directly in futures contracts are forced to continuously roll over contracts. When this occurs, depending on the prices and maturity dates of the contracts held by the fund, the owners of the contracts can be forced to accept very high costs to roll over the expiring contracts to the next month, which can continuously erode the value of the fund over a long period of time. The resulting tracking error can erode returns. For example, between January 17, 2011, and January 17, 2012, the spot price of gold rose about 23% while the price performance of the ETF PowerShares DB Gold (DGL), a commodity fund structured to track the price of gold, achieved returns of only 20%. This tracking error is relatively small but it can make a significant difference in realized gains/losses. In addition, other commodity ETFs can have significantly larger tracking errors. In conclusion, both leveraged ETFs and commodity ETFs will lose money in the long run. Such funds are designed as short term plays only.

Conclusion

Exchange Traded Funds offer individual investors invaluable opportunities for both exposure to exotic asset classes and portfolio diversification. However, there are innumerable varieties of ETFs, many of which come with important caveats, such as the necessary rebalancing of leveraged funds and certain commodity funds. ETF investing offers an accessible opportunity to achieve greater and more stable returns without the high fees of mutual funds and is an important tool for individual investors.