Exchange Traded Funds (ETFs): What are these for?

Exchange Traded Funds (ETFs) have become very popular in recent years. Financial professionals, media outlets, and countless do-it-yourself investors seem to like these relatively low cost and easily traded investments. Sound bites like “low cost ETF portfolio” and “customizable portfolio” are often used to describe ETFs, but what are they?

An ETF is a security, like stocks or mutual funds, but it has some interesting features. Unlike stocks, you are not buying a share of a company directly, and unlike a mutual fund, ETFs trade on the open market. This means an ETF’s market value changes throughout the day instead of after market close, like a mutual fund. Like a mutual fund, an ETF represents a share in multiple other securities such as stocks, though you are not purchasing these investments through the fund.

ETFs were traditionally made to provide a low cost way to invest in an index. An ETF would track an index. As the aggregate value of the index would rise, investors would be able to buy and sell shares of an ETF tracking that index in real time. This appealed to some investors because an index mutual fund could only be purchased (or settle after sale) after the Net Asset Value was calculated at the end of the trading day. ETFs also tend to be less costly to manage than traditional mutual funds. They do not charge sales loads because they trade on the open market.

So what is an ETF and how does it work? This gets pretty complicated pretty fast. Unlike Mutual Funds, the ETF does not hold investments equal to the amount of money shareholders put into it. For instance, if a thousand investors each invest a thousand dollars into a mutual fund, the mutual fund company takes the one million dollars and buys one million dollars worth of stocks with it. The value of the mutual fund shares is then a fraction of the aggregate investment value going forward. This is an oversimplification, of course, but it gives you the basic idea. An ETF sells shares BASED on the value of an index, but does not hold the underlying shares of the index. At least not like a mutual fund. So when you buy and ETF, what are you actually buying? You are buying shares in an investment company which is basically saying, “hey, if you give me your money, I will track the index for you, and pay out to you whatever the index does from the time you buy your share to the time you sell it.” So how does the ETF know what the value of the shares should be if they are not using your money to buy shares of stock? ETFs use a system called arbitrage pricing. The basic idea is that the ETF does buy a basket of stocks, proportionate to an index, and hold those. When the stocks in the index go up or down, the ETF sells and buys shares on the open market. This way the ETF knows exactly how much the basket of stocks are worth at any time, and so can price shares of the overall basket in real time.

So now you have a basic idea of what an ETF is, so what do you do with them? For a retail investor, traditional ETFs can be a great way to build a low cost diversified portfolio. There are may indices representing many different asset classes. Some are very specialized. Some are even developed specifically so an ETF can be made to track that index. Of course, the traditional indices exist as well. The S&P 500, the Dow Jones, and the NASDAQ Composite all have ETFs tracking them. It is not difficult to select a large cap ETF, mid cap ETF, and Bond index ETF along with others to create a diversified portfolio which can be rebalanced and reallocated in real time throughout the trading day, without sales loads attached to the purchases. Since ETFs are sold like stocks on the open market, ticket charges and commissions do apply based on the brokerage service you are using.

There are costs and there are risks to investing, and that is true for ETFs too. While ETF are generally touted as low cost, they are not no cost investments. In addition to ticket charges and commissions, there are internal administrative expenses with ETFs. Managers, traders, accountants, marketers, and others are needed to administer the ETF, and those people tend to like to get paid for the work they do. The costs associated with an ETF will vary, and you should carefully read the prospectus (or at the very least the parts about costs, fees, and how the ETF calculates its value) prior to investing. ETFs are subject to the risks associated with other market investments, including systematic risk (risk that the entire market will go down), systemic risk (risk that the particular market sector will go down), inflation risk (inflation rates moving too fast or too slow up or down messes everything up), and management risk (because sometimes people running the show make poor decisions). Another risk involves the arbitrage pricing. While ETFs try to trade the index, and do a pretty good job of it, sometimes the price of the ETF is off in relation to the index it is tracking.

And then there’s the weird stuff. There really are some strange ETFs. Some use leverage to amplify the ups and downs of a particular index. These leveraged ETFs are for sophisticated investors with large portfolios and hedging strategies. The leveraged ETFs are usually held short term, often just a day. With this sort of investment, it is possible (very possible) to invest in the ETF, hold it a week, and be significantly down even if the index itself is up. The reason for this is the ETF resets daily. If you invest $1000.00 on day one, and it is leveraged X3, a 2% gain the first day will be tippled. Your value goes from $1000.00 to $1060.00. The next day, the index is down 2%. That loss is tippled. Now your value is $936.40. Other strange ETFs include inverse ETFs (these ETFs do the exact opposite of what the index does), and actively managed ETFs (instead of following an index, the manager modifies the portfolio, or does not follow and index very much at all). In general, you should stay away from the weird stuff unless you are a money manager, or very sophisticated accredited investor. Many financial companies actually limit or prohibit their advisors from soliciting these kinds of ETFs doe to the complexity of the investment strategies, the risks associated with them, and the limited number of qualified investors.

If your financial advisor is recommending an ETF portfolio, consider the following. Are each of the ETFs following a defined index? Do you recognize the index? If it is a specialized index, do you know something about the industry and the specific companies which make up the index? Do the indexes of the various ETFs have companies which overlap, perhaps causing over exposure to a single company? Are the asset classes appropriate for you? How does the ETF portfolio relate to other investments you have? ETFs may be a good option for you, but you still need to understand how they relate to your overall investment strategy and your investment goals. Watch out for advisors who try to oversimplify things. Be cautious if the advisor deflects your questions, tells you, “oh you don’t what to know how they do that…,” or, “these are just like mutual funds, but cheaper and better.” Part of a financial advisor’s responsibility is making sure you understand what you are investing in, the risks involved, and how the investment helps you.

The information contained in this blog is general in nature and should not be viewed, and is not intended by the author to be viewed, as legal advice. For specific legal advice, please discuss your situation with a qualified attorney.