You should know something about ETFs

First things first, if you’re unsure what an ETF (exchange-traded fund) is, let me explain broadly. An ETF is something you can invest money into, it’s an investment vehicle. Like mutual funds, ETFs provide a way for investors to own multiple companies through one fund. You might even have some money invested in ETFs through your 401k or other investment accounts.

ETFs have quickly become a very popular investment option in the US. We hear a lot about robo-advisors these days, their offerings consist almost exclusively of ETFs. In 2016, seven of the top ten traded securities in the US market were ETFs. Assets deposited and held within ETFs have grown substantially within the last 15 years:

Besides all that, ETFs are cool. They’re based on algorithms, you can buy and track them through really nice apps, they’re usually super cheap, the list goes on. They’re the perfect investment for this generation. I’ll admit, they appeal to my millennial preferences too. But, there are a few important things to understand about ETFs before making any investment decisions, and there’s a reason we don’t recommend them.

Now let’s define ETF a little more specifically. The easiest way to explain them is by a comparison with mutual funds. Mutual funds have been around for much longer, they’re a little simpler, and probably a little more familiar. We’ll look at two distinguishing characteristics between mutual funds and ETFs:

1) Ownership.

A mutual fund owns shares of different companies. So if you buy one share of a mutual fund, you’re actually investing in each of the different companies that the mutual fund owns. Different mutual funds make different decisions on which companies they own. Some are actively managed, meaning there’s a manager buying and selling different shares within the mutual fund; some are passively managed, meaning they own a group of companies that are chosen based on a set of rules and the companies don’t change too much; some are index funds (which is a type of passive fund), which means they own the same companies that an index tracks (like the S&P 500); there’s no shortage to the type of mutual fund you can own, there are lots of them, and they’ve been a very popular investment vehicle for a long time. The thing to remember is that the value of a mutual fund is the value of the stocks it owns. Mutual funds actually own stock shares.

ETFs also invests in different companies, and different ETFs have different criteria for the companies or sectors they invest in (the most popular ETFs track with the S&P 500). However, ETFs don’t actually own stock shares in those companies. Instead, they own pledged assets, which are contracts to provide shares. Essentially, ETFs own rights to shares. This brings benefits like low expense ratios within ETFs (no fees for buying and selling stocks since the only things that trade within an ETF are contracts) and occasional tax savings (if you have a taxable account).

2) Fund type.

Mutual funds are their own separate type of investment, they’re not like stocks. Mutual funds are only valued once per day, after the close of market. Then all the stocks and investments within the fund are added up and the value of the mutual fund is determined anew. Because of this, you can only buy and sell mutual funds once per day, when the value has been calculated. Mutual funds are a longer type of investment by design. That doesn’t mean the holdings within the mutual fund are long term, a mutual fund manager could be making trades inside the mutual fund at any time, but the mutual fund itself can’t be day-traded or hedged or anything you might do with stock holdings.

ETFs however, are traded on an exchange, which means they act like a stock. You can make inter-day trades, the value is moving whenever the market is open, you can hedge and short and order stops, and engage in all sorts of risky stock market things. It also means there’s a fee for each trade, which isn’t necessarily a problem, but you wouldn’t want to be executing lots of ETF trades. This extra trad-ability makes mutual funds appealing for many. The trade costs are a bit of a deterrent, but you can actually day-trade with ETFs.

So that’s what ETFs are. The rise of ETFs in one of the most significant changes in the world of investing over the last 20 years and many people are excited about the opportunity. Here are a few reasons why I’m less excited, and why we don’t recommend ETFs for our investors.

Regulation surrounding ETFs has proven insufficient. I’m usually not a big proponent for the increase of regulation, but when it comes to ETFs, the lack of regulation is a real problem. There currently isn’t even an official legal definition for ETFs so they’re regulated individually, fund by fund, under mutual fund rules. As you’ve seen above, ETFs differ from mutual funds in significant ways, and mutual fund regulations simply can’t account for the discrepancies.

Since ETFs own contracts for shares instead of actual shares, the value of an ETF is tied to the viability of its contracts to perform, its arbitrage mechanism. Theoretically, the value of an ETF should be the value of the promised shares (like mutual funds are valued based on the shares they own), and usually, it is, but not always. When the price diverges, the arbitrage mechanism has to kick in to bring it back. So there’s a whole new type of risk involved, the reliability of the arbitrage mechanism, which can also dramatically affect the price. The fact is, when the market is stressed, the arbitrage mechanism can fail, causing massive swings in the pricing of ETFs, unrelated to the underlying stock assignments. That’s not just a hypothetical, it has happened, and continues to happen. August 24, 2015, is one specifically egregious example. It’s not entirely clear how or why these things happen from a market perspective, and the differing regulations (even between funds with the same pledged assets) only cause more uncertainty. The whole system is shrouded. What we know is that the inconsistent regulation, the cloudy definitions, and the unreliable arbitrage mechanisms have created more risk for ETFs. Unfortunately, it’s impossible to quantify the additional risk in any meaningful way because there are still too many unknowns. Investopedia even admits in reference to ETFs, ‘the perceived increase in volatility needs further research.’ In its current state of affairs, the ETF market is simply not reliable enough to recommend as a vehicle for a person’s life savings. There seems to be increasing support for research and regulation surrounding ETFs so the issue is certainly not over-with, perhaps we could even end up recommending ETFs to all of our investors in the future, but for now, stick with some good old mutual funds.

 

Sources:

Financial Times: The $5tn ETF market balances precariously on outdated rules

Financial Times: Market turbulence revives fears over ETF structural issues

Evanson Asset Management® – Are DFA Strategies Superior?

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