ETFs can trip up the unwary

Exchange traded funds have been wildly popular among ordinary investors, and that has some regulators and financial advisers nervous.

They are concerned investors simply don’t understand these products well enough to invest in them wisely. Many advisers are proponents of ETF investing, but they, too, warn that not every fund is right for every investor.

The state Regulation and Licensing Department, which is responsible for overseeing the state’s investment industry, recently published an advisory saying that an association of state securities regulators has identified unsuitable ETF sales as a top threat to Main Street investors.

“We continue to actively scrutinize a variety of issues related to ETF sales practices, such as point of sale disclosures, and the suitability of these products . . . . ,” said J. Dee Dennis Jr., the department’s superintendent.

“The number of ETFs that are shut down or liquidated, while previously a rare occurrence, is on the rise, up 500 percent in each of the last three years over 2007 levels,” according to RLD.

The department is also concerned investors don’t understand the brokerage fees they might incur and the tax consequences of some ETF investments.

An exchange traded fund is a security that tracks an index, a commodity or a basket of assets and trades like a stock on an exchange.

Complications and risks

ETFs are usually described as being like mutual funds except that they trade like stocks. Financial advisers say that isn’t exactly true. ETFs can be more complicated than mutual funds, there are different risks associated with owning them, and they are not for every investor in every situation. Like everything else in investing, the experts say, you have to understand your objectives, then choose the assets that get you there, whether they are mutual funds, ETFs or other instruments.

Mutual funds have been around for decades, and most investors are familiar with them. Just about every employer’s 401(k) plan offers them. ETFs were first offered in 1993 and have only recently begun to appear in 401(k) offerings.

Mutual funds can own all manner of assets, but most investors buy them to gain access to a diversified portfolio of stocks, bonds or both. Mutual funds are either actively managed or indexed. Active fund managers try to outperform the markets they invest in. They might look for undervalued stocks to assemble into a portfolio, or they’ll assemble a portfolio of junk bonds when they expect interest rates to decline. Index fund managers buy instruments to replicate the performance of a benchmark. For example, an index fund can be composed entirely of the stocks that make up the Standard & Poors 500 Index.

Mutual fund investors buy shares of the fund from the company that administers the fund. When investors want their money back, the administrator redeems the shares. The price of the fund is set daily in the late afternoon and reflects the value of the holdings in the fund. If share prices of stocks held by a fund increased during the day, the fund’s price increases, too.

There are only as many mutual fund shares as the fund company decides to issue. When the fund has sold as many shares as it cares to, the fund is closed to new investors.

Supply, demand determine price

ETF shares are traded among investors the same way as stocks. When you buy an ETF, you have a broker place an order for you on an exchange like Nasdaq or the New York Stock Exchange. The price of the ETF is determined by supply and demand for fund shares, and it changes constantly throughout the trading day. If markets are efficient the price of the ETF will bear some resemblance to the assets contained in the fund, but the price you pay is determined entirely by the willingness of an owner of ETF shares to sell.

Because they trade like stocks, they have some of the same features as stocks. You’ll have to pay a broker’s commission when you buy and sell ETFs. ETFs can be shorted, meaning a speculator can sell ETF shares that he doesn’t own by borrowing them from someone, like a brokerage firm. Like stocks, investors can buy ETFs on margin – that is, with borrowed money.

ETFs can be less expensive than mutual funds. Since investors buy and sell them, the ETF manager doesn’t have to maintain an expensive administrative function to track customers’ accounts, to sell new shares or to redeem shares. Most of the estimated 2,670 ETFs are index funds, designed to replicate a benchmark, so the fund manager’s research and trading expenses can be lower than for an actively managed mutual fund. Index fund managers generally don’t trade as much as active managers do, so the costs of trading will usually be lower in an ETF than in an actively managed mutual fund.

Lower tax bills a plus

Financial advisers say most ETFs should generate a lower tax bill for the investor than a mutual fund will. As index funds that don’t do much trading compared to active funds, ETFs don’t generate the same level of taxable capital gains. ETF managers don’t redeem investors’ shares the way mutual funds do, so they don’t have to sell securities for cash to meet redemption requests. That also reduces taxable capital gains.

Laura P. Hall, portfolio manager and chief trading officer with REDW Stanley Financial Advisors, likes to use ETFs when it is difficult to find an actively managed fund that can beat an index, especially when she wants to invest funds in big-company stocks.

Don Hurst of Hurst Capital Management puts client money into ETFs sparingly. Hurst said he either finds a good actively managed mutual fund that he expects will beat the indexes, or he chooses securities himself that he expects will out-perform the market. However, some ETFs can help improve a portfolio’s diversification by filling what Hurst called “spaces” that active funds don’t. For example, a portfolio could be helped by a small investment in an ETF that tracks a specific industry or country, Hurst said.

Transaction costs can add up

Jerry Sais, portfolio manager with Bank of Albuquerque, likes ETFs for their low cost, their liquidity and their tax efficiency. He cautions that because ETFs require brokers the cost of buying and selling them can mount up, especially if the investor trades a lot. No-load mutual funds (funds that do not charge a sales fee when they are purchased) might be a better choice in that case, Sais said.

In addition to regulators’ concerns, an arcane debate has broken out in the financial press about the dangers ETFs might pose to markets in general and to unsophisticated investors in particular.

For one thing, some ETFs are very complicated. A popular commodity ETF is designed to replicate the performance of the Deutsche Bank Liquid Commodity Index, which is a basket of 14 energy, agricultural and metals commodities. The ETF does this by buying and selling derivatives and futures contracts.

Sais warns that investors accustomed to stock- or bond-only mutual funds may not understand the risk such an ETF is running.

“There may not be underlying assets in the sense of shares of a stock or bond,” he said. “You have a derivative instrument that has all kinds of different risks than just holding an asset.” The main risk is that the party on the other side of a derivative trade, known as the counterparty, may not perform.

“A derivative instrument is a contract between two entities,” Sais said. “If the counterparty can’t meet their obligation then even though the area of the market you were hoping to have exposure to has performed, your investment might not perform.”

Performance varies

The industry has issued what are known as leveraged ETFs, which use derivatives and hedging strategies designed to earn a multiple of the return on an index, and inverse ETFs, which promise to return the opposite of an index’s performance – so if you expect stocks to go down, you might buy an inverse ETF to get positive returns. Discount broker Charles Schwab warns these ETFs don’t always perform as expected.

Dennis said that investors should understand that inverse and leveraged ETFs might need to be bought and sold repeatedly in order to lock in profits. That could generate unexpected transaction fees and taxes.

Some professionals have noticed that the price of an ETF may be higher or lower than the value of securities the ETF holds. They have begun using what are known as arbitrage trades to profit from that disparity. Experts warn that could make the price of ETFs much more volatile than the average investor might be able to stomach.

Terry Smith, a London money manager, warned on his blog that it is possible for a short-seller to borrow and sell more ETF shares than the value of the assets contained in the fund. A short seller could drive the market value of the ETF shares down dramatically, Smith said.