Checkpoints on How to Really Understand ETFs

July 26th at 8:00am by Tom Lydon

Critics of exchange traded funds have cited them as culprits to market inefficiencies and likened them to a bubble that will eventually burst. Recent claims that blame ETFs for deteriorating market stability and as exposing unnecessary risk are unfounded.

“The reality is the ETF is an access product, providing access to a wider range of commodities at an affordable price. It’s wrong to think of it as a foreign product,” Townsend Lansing of ETFSecurities said. “It’s not a distortion of the markets; it’s just that more people are trading the underlying. Quite simply, it’s another way of trading a product.” [FINRA Warns on ETN Risks]

Recent claims that ETFs are hard to understand and that they expose investors to unnecessary risk have been overstated. Many industry critics have been quick to blame  a lack of transparency in ETFs, and also attribute the market meltdown in 2008 to some of the derivative-based products, reports Thomas McMahen for FE TrustNet.

“There is far greater transparency with an ETF than with an investment fund, particularly when it comes to charges,” Lansing said. [ETFs Tracking the Same Index Can Perform Differently]

Lansing has a simple checklist for ETF investors to follow, and this will help them to understand the underlying index the fund is tracking, which is essential to knowing what an ETF really is. [Tom Lydon on Fox Business: Three Hidden Factors Everyone Should Know When Trading ETFs]

  • Understand the asset class the fund is tracking. For instance, a commodity focused ETF usually tracks futures contracts, which means the fund is not tracking the real time price of the commodity. Factors such as contango and backwardation are common, and can appear to be a problem if an investor is not aware of them.
  • The structure of a fund is also important. UCITS funds have a high level of corporate governance and transparency. If your product is not UCITS, you need to ask why. There are legitimate reasons – for example some products aren’t UCITS funds because you can’t get UCITS status for a product tracking a single commodity. This is basically bankruptcy protection.
  • It is important to know if the fund is physically-backed. The issue of physical ownership is one of the most controversial with regard to ETFs, with synthetic versions of the products accused of further increasing risk. If the fund is not physically supported, the credit risk endured must be known beforehand.

Tisha Guerrero contributed to this article. 

The opinions and forecasts expressed herein are solely those of Tom Lydon, 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.

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