Exchange traded funds (ETFs) have become popular in recent years. They can offer broad market exposure with fewer fees than a mutual fund; however, they carry many of the same risks as mutual funds.
Most significantly, ETFs do not always track the index they are modeled after, nor do ETFs always invest in the way that their name suggests. For example, consider two ETFs that might seem similar because they both state they invest in large-cap stocks; however, they can actually be quite different. Some ETFs weight their securities based on market capitalization–the number of shares outstanding times the price per share– while others may use a price-weighted approach–share price alone determining the portfolio weights. While yet others may select or weight securities based on fundamental factors, such as a stock’s dividend yield
Weightings are important as this could affect the impact that individual securities have on the fund’s result. For example, an ETF’s holdings that are weighted by market cap will be more affected by underperformance at a large cap company than it would be by an underperforming company with a smaller market cap, because the large cap company represents a larger share of the ETF. However, if the ETF weighted each security equally, each would have an equal impact on the index’s performance. However, the equal weighting may arguably give smaller companies more influence than they have should have relative to the stated benchmark.
Another consideration with ETFs is their liquidity. Several stories have surfaced after the May 6, 2010 “Flash Crash” about the ability of ETFs to trade efficiently during high volume market periods. While that event is very unlikely to reoccur, the extreme selling pressure caused some ETF prices to plummet. Those who had set stop-loss orders (orders to sell when the price falls by a given amount) were damaged by the falling price. If not for the stop-loss, the same investors would have made back all of the loss within 15 minutes on the same day. While we never recommend placing stop-loss orders, the point here is about ETF liquidity. Without being too technical, an investor should focus on the underlying stock in an ETF to determine the funds’ liquidity. Those ETFs that track widely-used U.S. domestic indices such as the S&P 500 or the Dow Jones Industrial Average are not likely to have liquidity problems. However, some ETFs which trade in the smallest emerging markets or track infrequently traded indices are much more likely to have significant price swings because of changes in demand.
What also concerns us about ETFs is their use of derivatives and leverage. Some use plain-vanilla derivatives like S&P futures in order to get the modeling they desire. For example, if an S&P ETF were to rapidly get $1 billion in investments, the ETF would buy a derivative that acts in the same manner until the ETF is able to complete their transactions. Almost all ETFs tracking commodities like oil or agricultural products employ the use of derivatives exclusively. Other ETFs employ risk taking by using leverage, and therefore, are designed for the day trader rather than a long-term investor.
Two websites we suggest for researching ETFs are www.iShares.com and www.spdrs.com. Both offer free research tools and a variety of ETFs based on different indices, sectors, industry or even geographic regions.
Like mutual funds, it is important for an investor to understand what the underlying investments are in the ETF they want to purchase
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
