Exchange traded funds have opened new markets and asset classes to individual investors. Passive ETFs provide liquid and cost-efficient exposure to markets, but investors should be mindful of the risks, especially with more sophisticated ETFs.
The most common variety of ETF tries to reflect the performance of a market index, or the price of bonds, currencies or commodities. Low costs and access to niche markets that were once exclusive to institutional investors are listed among their attractions. But like traditional mutual funds, investors can get lost in the sheer number of offerings.
Also, there are structural, credit and tax differences when it comes to exchange traded funds versus exchange traded notes (ETNs).
As the ETF business has expanded, complex ETF products have emerged such as leveraged and inverse funds, and products that track VIX futures. [VIX ETFs Plummet as Traders See End to Selling]
Some leveraged ETFs can experience breathtaking one-day swings.
There is over $1 trillion invested in ETFs, although they still represent a relatively small portion of the overall mutual fund business.
Growth means increased scrutiny for ETFs. The British Financial Services Authority and the Financial Stability board have commented that the rise of ETFs could harm the financial system. More recently, Terry Smith, CEO of Tullett Prebon, remarked that the average investor may not understand the risks involved with trading the ETFs, reports Stephen Womack for Mail Online. [Risk and Your ETF Portfolio: How to Protect It.]
ETFs require due diligence like any other investment. They aren’t a magic bullet.
One advantage of transparent ETFs is that investors can monitor the portfolio. That lets them know if ETFs hold stocks, gold bullion, bonds or commodities futures contracts, for instance. Investments that hold derivatives may involve counterparty risks as well.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.