Exchange-traded funds have made for some ugly headlines. They played an integral role in the May 6 flash crash, and more recently a controversy erupted over whether prices could crash on heavily shorted ETFs. Though many consider those fears unfounded, these increasingly popular investments nonetheless pose risks, and financial advisers should be cautious.
A lot of factors make ETFs attractive. They're usually much less expensive and more tax-efficient than mutual funds. And they're as easy to buy and sell as stocks, which appeals to fee-based advisers.
"Many private banks and wealth managers have increased their use of ETFs," says Deborah Fuhr, head of BlackRock's ETF research and implementation strategy.
That's been especially so recently, because in volatile times it's easier to use an ETF to represent an investment view than to pick individual stocks or bonds, she says. ETFs typically track an index, such as the S&P 500 or one tied to emerging-markets stocks.
But the rapid growth of these investments-ETF trading now accounts for more than half of U.S. exchange volume-may have left some advisers ill-prepared.
Greg Maddox, director of manager research at Wells Fargo's private wealth group, says advisers should be wary when adding ETFs to clients' portfolios, since they're "personally on the hook" when changes must be made. "When they're using third-party managers, those managers will take out the distressed stock, or raise cash, or rotate sectors," Maddox says. "Advisers who allocate assets themselves must be much more vigilant in monitoring and trimming the portfolio."
This fall Bogan Associates in Boston released a controversial report arguing that short-sellers may borrow shares from an ETF operator and re-sell them, or even illegally sell the shares without borrowing them at all. That can effectively create multiples of phantom ETF shares, Brogan says. So fund operators might be unable to meet redemptions if there's a run on the ETF. Matt Hougan, editor-in-chief of IndexUniverse.com, an online publication covering ETFs, dismisses this. He says most ETFs require investors redeeming shares to prove they have not lent them out, preventing phantom shares.
But the furor illustrates that wealth advisers must understand the ETF's benchmark methodology and rules, and the underlying asset. "What is the underlying product-a security, a physical commodity, or a derivative like a front- or forward-month futures contract?" Fuhr says, noting that different trading costs impact the performance of ETFs.
Maddox says his group has analyzed the ALPS Master Limited Partner ETF, which launched Sept. 1 and already has over $100 million under management. It's one of the few ETFs that has elected to be taxed as a corporate entity, instead of being structured as a pass-through vehicle, as most others are. Consequently, investors could in effect be taxed twice on a portion of the income. "It's an example of where not all ETFs are created equal," Maddox says.
Maddox also cautions that wealth managers may use asset-allocation models referring to one index, sometimes imbedded in their software tools, but invest clients in ETFs referring to a different index. "We see this most often in the emerging-market space," where the tool may recommend an emerging-market portion based on a basket of 30 countries, but the wealth manager invests clients in ETFs covering only South America and China, he says.
Paul Justice, director of U.S. ETF research at Morningstar, says the flash crash pushed the bid/ask spreads on ETFs comprised of stocks wider than the bid/ask spreads on the stocks themselves, creating the possibility of paying more for an ETF than the sum of its parts. The answer during volatile times is to avoid trading ETFs, but assure good execution prices by using limit orders.
Demand is rising for ETFs. Net sales jumped by $81.6 billion in the first seven months of this year, while net sales of mutual funds fell by $221 billion, according to Strategic Insight.
Of 871 ETFs in the U.S., the top 100 account for 82.9 percent of total assets.