As exchange traded funds become more complex, knowing what’s inside your ETF becomes even more important.
For example, ETFs can invest in stocks, bonds, futures contracts, physical commodities and derivatives. Also, products with key differences are often lumped together under the “ETF” label. They can be structured as open-end funds, unit investment trusts or grantor trusts, for example. There are also exchange traded notes, and different structures can mean different tax treatment and credit risks, for example.
At the most basic level, ETFs are baskets of securities that trade on exchanges like individual stocks. Although the first ETFs tracked recognizable stock benchmarks such as the S&P 500, the business has expanded to cover international equities, bonds, commodities, currencies, precious metals and other sectors. There also leveraged ETFs that deliver multiples of the market’s performance, and inverse ETFs that let traders bet against markets and hedge. [What are ETFs?]
Some regulators are raising flags over ETFs that use “synthetic” strategies, lack of transparency and counterparty risk, BlackRock said in a paper released Wednesday. [BlackRock Calls for More Disclosure, Transparency in ETFs]
BlackRock, which manages the iShares ETFs, recommended that funds that use derivatives should disclose counterparty risk. The firm added that leveraged and inverse ETFs should clearly disclose how leverage creates significantly different risks than traditional ETFs.
“In short, investors need to know exactly what they are buying when they invest in ETFs and related products,” according to the paper. “The ETF industry today, however, is not doing a sufficient job in explaining those differences consistently.”
BlackRock said transparency is a key theme the ETF business needs to focus on.
“When they were first introduced more than two decades ago, ETFs helped bring a new level of transparency to the financial industry. Most ETFs continue to provide clear and transparent information about holdings and fees,” the firm noted. “Transparency in the ETF industry can and should be improved for the benefit of investors. This means transparency regarding the structure of products; transparency regarding the holdings of products; transparency about fees charged; and transparency about any counterparties, whether they are used in either securities lending or with swaps.”
The bottom line for investors is never forget to perform some research and due diligence before purchasing ETFs or any investment.