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

(part 3 of 3)

Risks of Investing

If you’ve ever bought a mutual fund and read its prospectus, you’ve probably seen the section where the prospectus highlights all the kinds of risks attached to that kind of fund. Unfortunately “disclosures” of risks from the financial community are much like disclosures of side effects of prescription drugs in TV commercials for those drugs. There are so many you just tune all of them out.

Is risk a four letter word? No! It’s not a bad thing if you want to live life to the fullest. But only a fool jumps off a cliff without knowing if there are rocks under the surface of the water below.

This blog series aims to reveal the chief risks of ETF’s.

Risks of derivatives in general and ETFs in particular


In Part 2 of Exchange Traded Funds (ETFs): The Safest or Riskiest Investment You Can Make? we saw two risks attached to buying any derivative.

The first risk is that the value of any derivative does not necessarily coincide with whatever investment it is based on. This is why derivatives are popular with financial speculators. They hope to profit off them. But sometimes the value of a derivative is lower than the investments it is based on.

The second risk is the danger of the issuer of the ETF not being able to pay out. This is called counterparty risk.

Other risks of ETF investing

Over the past two years, we’ve all become acutely aware of how interdependent the finances of the world are. At the beginning of the financial crisis almost every kind of investment dropped at the same time. There is “market risk” involved when investing in stocks. Market risk is when the whole market drops.

Recently we’ve seen how shaky whole countries can be. Greece is essentially “bankrupt”. It’s sovereign debt is connected with ours (via Goldman Sachs, its chief advisor), German banks, and the whole Eurozone (countries using the Euro). There is “systemic risk” from sovereign debt involved when investing in some exchange traded funds. Countries and whole regions can fail too.

Now there is another danger so new it hasn’t been defined yet. Some are calling what happened on May 6th a “flash crash” of the stock exchanges. During this record drop in stock market prices that Thursday, ETFs were hit far worse than other investments.

In spite of being a smaller proportion of total trades, over two-thirds of the erroneous trades cancelled after the drop were ETFs. An erroneous trade was one more than where 60% of its value at 2:40 pm was lost that day.) For exchange traded funds that lost less than 60%, the owners were out of luck!

ETFs were a prime victim of a perfect storm that swamped the major stock trading exchanges. Thus, there is now “exchange trading risk” involved in buying and selling exchange traded funds.

Risks unique to specialty ETFs

You have to be particularly sharp about checking into the details about any specialty ETF fund you plan to buy. Some exchange traded funds are managed by managers and their expense fees are high. In addition, speciality ETF funds in bonds, commodities (like gold), currencies, and partnership trusts, may have extra costs. Some additional costs on these investments include special taxes on these types of investments.

Exchange traded funds are sold as if they are simple products, but like other derivatives, they aren’t. Some specialty ETFs are even third-generation products that include multiple synthetic swap derivatives. These are ETFs with more than one counterparty.

Their makers claim synthetic swap derivatives are more secure than a plain-vanilla ETF that has only one counterparty. But are these synthetics really more secure than single market-maker ETFs?

TIP: ETFs are a good deal, fun to own, and an easy way to dip your toe into stock investing. But be sure to investigate the particular market maker and the stock index (or the manager) behind any exchange-traded fund you buy!

If you buy a country or regional ETF, keep in mind that your ETF depends on the particular basket of stocks from that country or region that your ETF is based on, and not on how the whole country or region does.

If you’ve never seen an ETF, check out iShares (formerly owned by Barclays Bank and now owned by private equity company, Blackrock). Click on the name of any ETF to see part of what’s in its “basket.”

Copyright © 2010 Nancy K. Humphreys

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