This article feels a little like exchange traded funds [ETFs] 101, but it’s important to lay the foundation for the product so distinctions can be made on the less vanilla products. It contains edited material from the Optionetics white paper titled: Risks & Rewards: Achieving Your Bottom Line with ETFs.
Early understanding of passively managed ETFs came from comparisons to mutual funds. Advantages of these types of ETFs include:
- Lower expense ratios
- Protection via put options
- Tax-efficiency due to differences in capital gains payouts
- Elimination of short-term redemption fees and end of day pricing uncertainty and
- Ability to enter & exit positions during the market day.
While ETFs offer great diversity to both investors and traders, it doesn’t mean they can be blindly used. Sound risk management principles must be applied, which includes understanding the instrument and the risks defined in the security’s prospectus. That simply is the bottom line and it could mean the difference in trading something you know versus trading something you think you know.
Investing Categories for Vanilla ETFs & Basic Mechanics
Growth in ETFs and related products has translated to growth in the variety of indices tracked. Major categories for the plain vanilla ETFs considered here include:
- Broad Based US Equity Index
- Narrow Based US Equity Index—Sector, Industry
- US Equity Style—Growth, Value
- Global & International Equity
- Bond Funds with Varying Durations—Government, Corporate, International
ETF units are created and redeemed by designated Associated Participants; typically institutional firms that provide the basket of securities in exchange for ETFs units. These units can be held or sold in the secondary market as ETF shares. Reversing the transaction, the AP can redeem ETF units in exchange for the underlying basket of securities held by the fund.
Because a passive ETF provides full disclosure of their holdings on a daily basis [transparency], this information is generally available via the fund family’s web site. In addition, the unit value for each ETF—the Intraday Indicative Value [IIV]—must be posted to the exchange every fifteen seconds using last trade data for each security in the underlying basket.
While all operational mechanics are not critical to know, understanding their implications makes for more informed decision-making. A short-list of items to evaluate for ETFs includes:
- Transparency of holdings (actively managed funds may relay on IIV)
- Variation of discount/premium pricing to NAV
- Liquidity of ETF shares via the bid-ask spread
- Availability of options
Transparency & Arbitrage Impact on Pricing: The transparency that exists in passive ETFs allows arbitrage activities to maintain a market price per share that is very close to the NAV per share. An ETF that is trading below its NAV is trading at a discount and one that is trading above its NAV is trading at a premium. Investors and traders may want to access the fund family web site for the ETF to review historical discount and premium pricing data, particularly for actively managed ETFs and passively managed ETFs that are less liquid.
Liquidity: Liquidity refers to the depth of the market for a given security. Liquid ETFs have more narrow bid-ask spreads, with a large number of shares available at both the bid price and the ask price. Since different indexes may be tracked by more than one fund family, consider alternate ETFs if the shares are illiquid. This issue is a more significant one for traders since slippage costs play a bigger role in long-term profitability.
Options: In addition to ETF liquidity, investors and traders should note the availability of options for the ETF and the liquidity of those options. Penny increment pricing in the options market is relatively new and can reduce the cost of protecting a position while minimizing trading costs.
The fund’s structure, types of assets in the portfolio, and the specific securities held in the portfolio all impact the types of risks associated with an ETP or related product, such as options. To best understand the manner in which returns are achieved and risk exposure, the best resource available to you is the security’s prospectus which is generally available on-line.
When evaluating a specific passively managed equity ETF, a short-list of considerations includes:
- Risks identified by prospectus,
- Basic liquidity issues for the security,
- Impact of construction methodology for the underlying index,
- Whether the fund is hedged from a currency standpoint (international/global funds), and
- Availability of options
Investment risk includes loss of asset value and values that do not outpace costs, typically stated in terms of inflation. Risk is typically closely related to potential reward; i.e., generally speaking the greater the potential risk, the greater the potential reward. An individual’s ability to accept different levels of risk for expected rewards is just that … individual.
To summarize, when selecting a specific ETF investors and traders should consider the impact of liquidity, slippage, commissions, and discount/premium pricing variations on their net returns, especially if there are similar ETF’s from which to choose. The risks identified here are not intended to be an exhaustive list of all potential investment risks.
Market Risk: Risk in the market that cannot be diversified away. This type of risk is also referred to as systematic risk and will be present in all funds.
Interest Rate Risk: Investing in funds that invest in bonds and other fixed income products runs the risk of locking in a rate of interest that may prove to be inferior if rates rise after the position is taken. This results in returns that are lower than prevailing rates.
Political Risk: Investments in foreign countries with less stable governments are deemed to have greater political risk than those with both stable governments and longer standing financial markets. For example, if you buy a fund representing shares of stock in a given country and the government subsequently nationalizes certain businesses, the price of those shares may be adversely affected.
Default Risk (of securities held): Fixed income investments receive interest payments based on the principal amount borrowed and a return of principle when the investment matures. Default risk refers to the potential that the borrower may be unable to make those interest payments and/or return the principle amount.
Currency risk: ETFs and related products tracking foreign equity and fixed income indices may need to purchase securities in the local currency, creating currency fluctuation risk for the fund if that risk is not hedged in some way.
Diversity Risk: Although a fund may provide returns for a narrow, but diversified index, the manner in which the fund achieves its returns may include a non-diversified approach. By reviewing the fund’s holdings and prospectus you can assess this risk (less common).
Tracking Risk: Passive ETFs and related products seek to replicate returns for a stated index. However, it’s rare for the actual returns to track perfectly given fund expenses, supply/demand issues, securities within the fund used to track returns and timing issues. Therefore, the buyer of a passively managed ETF assumes the risk that the fund may underperform its intended benchmark.
Fund Closures: Assuming a fund closure is due to lack of interest, a minor risk is the individual’s inability to replicate returns from a specific index. The value of the shares held by the ETF on the fund closure date should be returned in its entirety to the shareholder.
Option Risks: Options on ETFs and related products have similar characteristics and risks as equity options since there is an underlying security for the exercise/assignment process. See the Option Industry Council’s Characteristics and Risks of Standardized Options.
ETF’s vary by both structure and the approach used to achieve product goals. Investors and traders must consider risk factors associated with these distinctions so they understand the instruments they use to achieve their own objectives.
Optionetics. (2008). Risks & Rewards: Achieving Your Bottom Line with ETFs [White paper].
Ferri, R., CFA (2008). The ETF Book. Hoboken, NJ: John Wiley & Sons, Inc.
“Exchange Traded Funds: Proposed Rules.” Code of Federal Regulations Title 17, Pts. 239, 270 and 274, 2008 ed.
Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
Questions for Clare? Please visit the discussion board on the homepage of Optionetics.com.