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Exchange traded funds have grown to become one of the most popular investment choices for retail investors. The total size of the global ETF market is over $1.5 trillion. The vast majority of the component assets are US or European in flavor. Growth rates in the industry are eye-popping at 20-30% annually. That’s a far cry from the more staid pace of mutual funds or other investment vehicles. The benefits of ETFs are compelling. Like mutual funds, they have broad exposure to multiple individual assets through one vehicle. And like common stock, they have the ability to trade continually throughout the day just like a regular share of common stock. ETFs are generally passive in nature. So their turnover costs are lower on average than mutual funds, improving their tax efficiency. As the market evolves, investors are finding it easier to obtain exposure to an ever-growing range of asset types, from emerging markets (example: EEM) to currencies, commodities, and so on. But as the market undergoes this explosive growth phase, a few words of caution are appropriate.

Rapid Growth and Evolution of the ETF Market

Originally, ETFs were designed to provide low-cost exposure to very broad index measures like the S&P 500 (SPY). The product came of age through the efforts of a small number of providers, including State Street’s SPDRs and Barclays’ iShares. BlackRock now owns iShares, the dominant leader of ETF issuance with over 40% of the market. It is safe to say that an iShares Russell 3000 (example: IWV) or SPY SPDR S&P 500 ETF is liquid, low-cost, and very closely correlated with its benchmark, just as intended.

However, the market’s success brings with it the predictable growth in Johnny-come-latelies. Financial firms of various sizes and reputations want to jump on the ETF bandwagon. For many of these newcomers, it’s a challenge to figure out how to differentiate their product offerings. After all, it’s pretty hard to make your product stand out if all it does is mimic the S&P 500 for a fee of 10 basis points. The chosen approach is often to carve out exotic new territory. Want to go long soybeans or short Swiss francs? Have a yen for the Sensex 50 or a basket of Middle Eastern equities (example: GAF)? Every day it seems that a new fund is coming out with a vehicle for obtaining exposure to some asset class that the vast majority of investors would not have even known existed. With this evolution come some very real risks.

ETF Benchmarks and Liquidity Risk

One of the foremost risks is simply not knowing what the benchmark is, how it is measured, and how liquid the market is for the securities that make up the benchmark. When the average retail investor hears the word “benchmark,” he or she is likely to think of the large liquid indexes like the Russell 1000 or the Barclays US Bond Aggregate (example: AGG). A benchmark for something more exotic, like Japanese yen futures, is less clear. The yen is widely traded and available in foreign exchange markets. But the actual assets that make up the JPY benchmark, off which a yen ETF trades, are not necessarily liquid and widely fungible. Understanding the calculation methodology and the market characteristics can be a daunting challenge for the typical individual investor.

Physical versus Synthetic ETFs

Another area of controversy that has been in the news recently concerns physical versus synthetic ETFs. Again, this is a measure of the market’s evolution. In earlier years, ETFs largely offered exposure to physical assets – actual stocks or bonds that traded on regulated securities exchanges. More recently, this has changed and we have seen the emergence of so-called “synthetic” ETFs. Instead of being backed by direct physical assets, they are backed by derivatives contracts written on those assets. In other words, investors don’t know who their counterparty is on the other side of the trade. Recently, synthetic ETFs have come into the crosshairs of European financial regulators. This could have implications for both investors and the firms that issue synthetic ETFs.

ETNs: Not the Same Thing as ETFs

Another area of caution pertains to Exchange Traded Notes. They are a cousin to ETFs with some notably different features. ETNs are essentially structured products. They are debt instruments, to which derivative products are attached, that pay investors according to a predetermined formula. It’s important to be aware that you are ultimately holding the credit risk of the financial institution that issues the debt instrument. Say you were to purchase an ETN issued by Bank XYZ with a payoff linked to the performance of a commodities index. If the commodities index gains 5%, then so does the value of your ETF. But, if Bank XYZ were to go into default, you would lose the value of your investment regardless of how the commodities index performs.

ETFs offer many benefits. And they have a proper place in efficient, diversified portfolios. But, for all the attractions that some of the newer, more sophisticated offerings hold, it is never a bad idea to stick to the basics and use them for their primary purpose of low-cost, liquid exposure to broad-based asset classes.

Source: Avoiding The Pitfalls Of ETF Investing