If You Don’t Understand How an ETF Works, Don’t Buy It
May 31st 2012 at 10:36am by John Spence
Market commentators and regulators are taking a closer look at exchange traded funds and notes as the products become a more integral part of the financial-market landscape.
The main concerns are that exchange traded products could be exacerbating market volatility, and that unsuspecting individual investors may end up burning themselves with increasingly complex ETFs.
The bottom line for investors is simple: If you don’t completely understand how an ETF works, then don’t buy it. [ETNs are Not ETFs]
“I don’t care if it’s a single stock ETF or some crazy warrant that trades in Hong Kong,” said James Ross, head of State Street’s ETF business, in a Bloomberg News report Thursday. “If you are hitting a button to buy a product and don’t understand it, you probably should stop.”
Talented Bloomberg reporter Christopher Condon does yeoman’s work here in an exhaustive and well-researched overview of the history of the business and some important risks for ETF and ETN investors. It should be required reading for investors who are new to these products or are considering using them.
In fact, more mutual-fund investors appear to making the switch to ETFs. U.S. investors added $4.82 to exchange traded products last year for every $1 they deposited with mutual funds, according to the report. There are more than 1,400 exchange traded products, or ETPs, on the market.
The oldest funds that also hold most of the industry’s assets are “plain-vanilla,” passively managed portfolios designed to track major stock and bond indices. However, the business has branched out into sectors, leveraged and inverse funds that hold derivatives, actively managed funds, and other complex strategies. [Are Leveraged ETFs Too Dangerous for Investors?]
Condon points out that some of these exotic ETFs are designed for hedge funds and sophisticated traders, but can also be purchased by any individual investor with a brokerage account.
“If you make it available to the masses, watch out, because the masses might buy them,” said Morningstar’s Paul Justice in the Bloomberg article.
Not surprisingly, some providers of sophisticated ETFs think that view is too paternalistic.
“Generally, it’s good if you’re providing investors more choice and more access to institutional-class strategies,” said Adam Patti, CEO of ETF manager IndexIQ, in the story. “Why should institutions and the ultra-high-net- worth have the only access to sophisticated investment strategies?”
More choice is a good thing, but only if investors do their homework and make sure to fully understand an ETF before purchasing it.
The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.