ETF Guide: ET-what? A primer on exchange-traded products

February 28, 2013 06:00 PM

Click here for Futures' 2013 ETF Guide.

Two decades ago, State Street Bank introduced the SPDR S&P 500 to the market and the first exchange-traded fund (ETF) was born. Now, 20 years later, traders have their pick of more than 1,400 ETFs, along with various other exchange-traded products (ETPs).

ETPs can offer many advantages to traders, notably diversity, ease of use and cost-effectiveness. But before adding these products to their portfolios, traders also should be aware of the corresponding risks. Here, industry experts offer an overview of the products that fall within this asset class, and some common pros and cons of trading them.

In simplest terms, ETFs are securities that track the performance of an underlying index or asset. Traders who buy ETFs own shares of a pool of securities, and, in the event that the company managing the fund goes out of business, those traders still own those securities. Although they would have to find a new manager for their ETFs — or liquidate them altogether — they will not lose their investment.

One of the greatest strengths of ETFs is their sheer variety. There are ETFs covering almost every asset class and market sector — from commodities to forex and equities — and traders can use them for numerous purposes.

“They can be used for retirement, income generation, speculation, for any purpose and any opinion the customer may have,” says George Fischer, director of product management at E*Trade. “They’re simple and easy to understand. So certainly they offer the simplicity and availability to open an account and use it for a variety of different purposes.”

Traders who are lacking exposure to a specific asset class can remedy that problem easily by buying an ETF that comprises stocks from various companies within that sector.

This approach also can help to reduce risk because traders own shares in multiple companies. “You’re not taking a [position] on any one particular company, but you do want exposure to the sector to help control the risk in your portfolio,” says Michael Iachini, managing director of ETF research at Charles Schwab. “And you can take examples like that from any part of the market, whether that’s bonds or stocks or individual countries or parts of the commodities market, too.”

ETFs are especially helpful if traders want to invest in a market sector that lies outside their expertise. A trader looking for more exposure to Chinese stocks, for instance, simply can buy an ETF comprising shares of multiple Chinese businesses rather than researching individual companies, Iachini says.

Aside from their ease of use, ETFs also are affordable, says Michael Burke, vice president of client training and education at TradeStation. Although the price of ETFs can vary, many fall within the $10 to $50 range.

They also can be traded intraday, unlike mutual funds, which are priced only once at the end of each day. To take advantage of this, traders should divide their trading days to avoid the times at the beginning and end of the day when the volatility curve is highest, advises Eric Pollackov, managing director of ETFs for Charles Schwab. “We try to eliminate [the high volatility curve], and I try to advise clients to trade intraday from 10 a.m. to 3 p.m. ET, because volatility creates uncertainty and uncertainty creates wider markets and wider markets create poor executions for investors,” he says.

Finally, because of the way in which they are structured, many ETFs are more tax-efficient than mutual funds. ETFs generally are subject to capital gains taxes only if the entire investment is sold, while mutual funds incur these taxes for in-kind transactions.

Risk vs. reward

Of course, every investment product has its risks, and, for all their advantages, ETFs are no exception. For one thing, although ETFs can enable traders to add diversity to their portfolio, the sheer number of products available poses its own risks, Burke says. “With so many of these products, many ETFs fail, and there is just not enough trading volume to make it worthwhile for a trader to get involved,” he says. “You don’t want to trade an ETF that doesn’t have enough liquidity to make the entry and exit of that position fluid.”

To reduce the risk of investing in ETFs that ultimately might close down, traders may want to focus their attention on funds that have more than $100 million in assets. According to data from Charles Schwab, 89% of ETFs that close have less than $20 million in assets.

Burke also advises unseasoned traders to be careful of leveraged ETFs, which use debt and derivatives in an attempt to achieve returns that are several times that of the underlying index. These products can be tempting, as they offer the potential for increased profits. But with the possibility of increased profits comes the risk of increased losses in the event that the index drops. Given that possibility, Burke says, traders should not introduce leveraged ETFs to their portfolios until they are comfortable using standard ETFs. 

The best way to minimize overall risk, industry experts say, is to do your research before adding ETFs to your portfolio. “Just because you can invest in anything you can think of doesn’t mean you should, without first doing your homework,” Iachini says.

While trading, investors also should know basic information such as the bid-ask spreads and broker commissions, and be aware that many of the parties executing ETF trades are professional market makers (Pollackov puts the number at anywhere between 70% and 80%).

Fortunately, because ETFs are generally transparent, traders can calculate the net asset value (NAV) by dividing the total value of the ETF portfolio by the number of shares it contains. By comparing the NAV with the price at which the ETF actually is trading at any given time, traders hopefully can avoid buying high and selling low.

Understanding ETNs

Although ETFs are the major asset class under the ETP umbrella, traders also have other options within the category, namely, exchange-traded notes (ETNs). ETNs are similar to ETFs in that both track the performance of a given index. But, while ETFs hold the underlying assets of that index, ETNs represent debt issued by a bank, which promises to pay the return on the index.

This guaranteed return is an advantage that ETNs hold over ETFs, which are subject to tracking error. “You don’t have to worry that the ETF portfolio manager might not buy all the right stocks…therefore it doesn’t track the index perfectly,” Iachini says. “With an ETN, there’s a promise: They say, ‘We will pay you this return.’”

But, unlike ETFs, ETNs are dependent on the good credit of the issuer for their survival. “The downside is [the ETN] is only as good as the bank’s ability to make good on that promise,” he says. “So, if the issuer of the bank standing behind the ETN goes under, then you can be wiped out entirely.”

An infamous example of this is Lehman Brothers, which launched its three Opta ETNs just months before its September 2008 collapse. 

A bright future

Notwithstanding certain risks posed by ETPs, the class — particularly ETFs — continues to garner investor interest. The popularity of certain ETFs generally depends on two factors, according to Iachini. The first is the political, fiscal and economic climate of the domestic and global markets. Recently, for example, the continued low interest rate environment in the United States has led to a boom in fixed-income ETFs. 

Iachini notes that emerging markets were another strong sector in 2012, and says that Europe is “starting to firm up” as investors regain some confidence in the future prospects of the Eurozone.

Second, money often flows into previously untapped asset classes that suddenly become accessible via new ETFs. “If they can get it in an ETF that they couldn’t get before, you’re likely to see some of those ETFs do well,” Iachini says.

On a broader scale, the popularity of ETFs is only likely to grow in the coming years, particularly if they become an investment of choice in 401(k) accounts, according to Pollackov, who notes that there are more than 7,000 U.S.-registered mutual funds compared with more than 1,400 ETFs. 

“If I were a compare/contrast kind of person, I’d think we’d only be in the second or third inning of a nine-inning baseball game,” he says. “I think that only has room to grow.”

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