Ordinary (i.e., unleveraged) exchange traded funds or ETFs are supposed to be lower-risk cousins of closed-end mutual funds, but some of them are just as risky as closed-end funds, and for the same reasons, according to a recent Wall Street Journal article by Eleanor Laise, “Risks Lurk for ETF Investors.”
The difference between an open-end mutual fund and a closed-end fund is pretty clear, but the difference between a closed-end fund and an exchange traded fund is less clear.
Open-end funds generally trade only after the close of the trading day, because they are priced based upon the net asset value of the securities they hold, which is calculated at the end of each trading day. They include both index funds and actively managed funds.
Closed-end funds, on the other hand, trade throughout the day on an exchange, and may trade at a premium or a discount relative to their net asset value based upon multiple factors that affect market sentiment. Most closed-end funds are actively managed and, therefore, are subject to manager risk – the risk that they will be poorly managed ? as well as market risk.
Exchange traded funds are similar to closed-end funds in that they trade throughout the day, but, according to Morningstar, are distinguishable in that their market prices usually track their net asset values more closely than closed-end funds. Most exchange traded funds are index funds. Leveraged exchange traded funds, on the other hand, are markedly different than an ordinary exchange traded fund, and are extremely high-risk.
The most popular exchange traded fund, the SPDR, which tracks the S&P 500 stock index, is highly liquid, and the bid-ask spread is only a penny. In other words, the SPDR tracks the net assets value of the underlying index very closely, and does not trade at a significant premium or discount to the NAV.
What Ms. Laises’s article points out is that not all exchange traded funds are highly liquid. The 10 largest ETFs comprise almost 40% of total ETF assets, and the top 10 in trading volume account for 60% of total ETF volume. But less liquid exchange traded funds often trade a significant premiums or discounts to their NAV. The factors that can contribute to slack demand and illiquidity often include problems with regulators and “the fact that many of these funds now launch with the bare minimum of assets?often just $2.5 million or so,” according to the article.
Bond ETFs are especially problematic. When the underlying bonds are costly and hard to obtain, investors should expect to pay a premium of 1% to 2% in high-yield (junk) ETFs, and possibly 4% when markets are experiencing higher volatility, according to the article. The premium is essentially a load to cover the cost to trade the underlying bond portfolio.
In addition, when underlying holdings are traded infrequently, an ETF’s returns may deviate from the benchmark it is designed to track. That was a problem for some bond ETFs recently when the Federal Reserve bought agency bonds and mortgage-backed securities, thereby removing large quantities from the market. In response, Vanguard Group changed some bond index funds and ETFs to benchmarks that exclude these securities bought up by the Fed.
Bond ETFs that trade at a significant premium are the most worrisome. If investors reverse course and stampede out, they could suddenly be trading at significant discounts to NAV, if at all. “When everybody tries to get out, it’s going to be a debacle,” says Scott Freeze, president of Street One Financial.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions, and have aided clients who have been the victims of financial adviser abuse and scams. Page Perry’s attorneys are actively involved in representing institutional and individual investors regarding losses in ETF’s and other exotic investments. For further information, please contact us.