Friday, January 13, 2012

Introduction to ETFs

By Tim Dulaney, PhD

Exchange-traded funds (ETFs) are investment funds that are listed on a major stock exchange and typically track some underlying security, index, commodity, or other asset. ETFs, like mutual funds, are often designed to track assets that are otherwise difficult to purchase individually or in small amounts, such as an index or commodity. Compared to mutual funds, ETFs are characterized by generally lower fees and higher liquidity because ETFs are traded on major market exchanges. In addition, it is much easier for retail investors to purchase ETF shares rather than attempt the complicated and cumbersome process of achieving similar exposure themselves.

ETFs enable retail investors to purchase exposure to a wide variety of asset portfolios and investment strategies with relatively small investments. Many ETFs have been tailored to offer highly specific return characteristics for different investment objectives (good example here). Put simply, ETFs make sophisticated investment strategies easy and accessible.

This does, however, mean that retail investors can use ETFs to achieve exposure that would be deemed unsuitable if purchased through the underlying asset itself. For example, a 3x leveraged ETF borrows 200% of the equity in its portfolio (put differently, equity represents only 33% of the portfolio value). It is highly unlikely that a retail investor would be able to achieve this leverage in a retail margin account, for both regulatory and suitability reasons. Therefore ETFs can be used to sidestep market regulations and enable retail investors to take otherwise prohibited positions.

This potential suitability issue has gained the attention of both FINRA and the SEC. FINRA’s Notice to Members on non-traditional ETFs warns that “while such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis.” Likewise, the SEC released an Investor Alert “because [they] believe individual investors may be confused about the performance objectives of leveraged and inverse exchange-traded funds.” It is clear that investors must understand the specifics of complex ETFs, and that their particular risks must be clearly disclosed.

Exchange Traded Notes (ETNs) are in many ways similar to ETFs. ETNs trade on major stock exchanges and generally seek to track some index or commodity. In some sense, ETNs are to ETFs as bonds are to stocks. Although the value of an ETN depends upon the underlying asset to which it is linked, the value also depends on the credit quality of the issuer. This means that even if the asset being tracked by the ETN does not change in value, a decrease in the credit quality of the issuer will decrease the value of the notes. Unlike ETFs, but similar to bonds, ETNs mature and are basically debt instruments of the issuer. Futhermore, ETNs do not actually hold the underlying asset while ETFs do. ETFs seek to track the returns of a given index or asset, but ETNs simply promise the returns of the index or asset.

In future blog posts, we will talk specifically about a few types of ETFs (for example, Leveraged, Inverse Leveraged and Futures-Based ETFs).

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