Exchange Traded Funds (ETFs): Safe? or Risky Derivatives?

(part 2 of 3)

You’ve seen what ETFs are in part one of this series. Now we’ll look at the pros and cons of buying these “poor man’s derivatives.”

The advantages of exchange traded funds

ETFs beat mutual funds when it comes to costs. Even with paying both commissions on buying and selling and fees, ETF costs will usually be lower than a mutual fund.

Besides lower prices, the presumed advantages of ETFs are that they are more diversified than mutual funds. After all, a whole country or even an entire region of the world is much broader than a stock or a mutual fund.

ETFs have an advantage over stocks of being much simpler to invest in. Investment in stocks requires knowledge of companies, industries, and if you’re a technical trader, of all kinds of technical indicators of the health of a company and the industry it belongs in. ETFs only require a basic knowledge of the stock index index that ETF is based on.

ETFs also have an advantage compared to mutual funds in that again, you only need to focus on the stock index that an indexed ETF is based on. Categories of companies such as small cap, mid cap, large cap, value and growth are used by mutual funds to distinguish each from the others. Indexes upon which ETFs are based may fall into one of these categories too. But you won’t need to do as much comparative shopping. There are usually only a few ETF funds based on the same index.

The disadvantages of exchange traded funds

As hybrids, ETFs have a major disadvantage compared to stocks. There is far less trading information about them. You won’t find much news about them either at this point in time. If you own a country ETF, for example, you’ll want to keep your eye on the financial health of that country. This means taking the time to keep up with the news. If you own an indexed ETF you’ll need to keep up with what’s happening to companies included in its index.

The disadvantages of investing in derivatives

ETFs also have a major disadvantage compared to mutual funds. Last time we looked at insurance company mutual funds in retirement plans. We saw they were “derivatives” of mutual funds. One danger of all derivatives, including ETFs, is that they can vary in value from whatever investments they are based on. You learned about this danger as well as one other major disadvantage of derivatives in my post, “Insurance Company 401k Mutual Funds: The Poor Man’s Derivatives.”

ETFs are also derivatives.

The value of an ETF is derived from an underlying “basket” of securities. These baskets of stocks usually reflect an index for a particular market such as technology stocks (the NASDAQ index) or industrial stocks (the DOW JONES Index) or emerging countries (the MSCI index). The baskets are owned by “market makers.” Market makers are investment banks, hedge funds, and other large financial entities. Like life insurance companies, these entities carry “counterparty risk.” This is the risk that the other party in a contractual transaction will not pay up.

Market makers not only are risky because they could fold, but also because they have no obligation to look out for you. As the recent investigation by the SEC of Goldman Sachs revealed, market makers feel they do not have a fiduciary duty to look out for the best interests of their clients. (See my post, My Week at Suze Orman’s Merrill Lynch for more about fiduciary duty of brokers.)

TIP: You must pay attention to who is issuing your ETF. Are they a secure and prosperous bank, hedge fund or other type of company? Are they going to sell their ETF business to another institution? Do they do a lot of ETFs or just a few? Are they being sued or about to be regulated? Are they liked by their customers? Be sure to check our your ETF’s market maker!

Copyright © 2010 Nancy K. Humphreys