Thursday, March 28, 2013

TD Ameritrade Data Suggests Retail Investors Use ETFs in 'Sophisticated Ways'

By Tim Dulaney, PhD and Tim Husson, PhD

Exchange-traded funds (ETFs) are increasingly popular among retail investors.  ETFs tend to have lower expense ratios than comparable mutual funds, and can be traded intraday like stock, giving them a comparable advantage that has proven attractive.  The number of ETF issuers has grown, and that competition has driven down prices in what has become known in the financial press as the "ETF Fee War".

TD Ameritrade has produced an infographic (PDF) that shows how their clients use ETFs, and the results are pretty interesting.  Their headline is that
At TD Ameritrade, more investors, young and old, are using ETFs in increasingly sophisticated ways.
Indeed, while 45% of ETF assets held at TD Ameritrade are stock-based, only 10% are equity, and a full 28% are in commodities and alternative investment classes, which TD Ameritrade notes is mostly precious metals.  Also, the percentage of assets held in ETFs declines with age, suggesting that ETFs are more popular among younger investors (though it could also be that older investors have accumulated more funds in other investment classes).

But perhaps the most surprising finding is that more than half of the ETF trades at TD Ameritrade were not on ETFs themselves, but options on ETFs.  Options are derivatives that give investors the right to purchase or sell an asset (such as an ETF) in the future -- we covered the basics of options contracts in a previous post.  Most of the ETFs with large total assets under management also have option markets, such as those at the CBOE.  While these markets are common (we even have a paper on ETF options), and the underlying options often quite liquid, it is surprising that such a large percentage of ETF transactions are in options contracts, especially for retail investors.

ETFs offer several advantages to investors, most notably lower-cost access to index investing strategies.  However, because they can be traded intraday and can be linked to highly complex indexes, they can be very risky choices for derivatives trades and other complex strategies. John Bogle, founder of Vanguard and champion of index investing, has been vocal recently about these and other risks of ETFs, even stating: “The ETF is like the famous Purdy shotgun that’s made over in England. It’s great for big game hunting, and it’s great for suicide.”

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