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ETF's and ETN's attract investors’ interest
jeannetteSHOWALTER, CFA
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 ETF is an acronym for exchange-traded funds. ETN is an acronym for exchangetraded notes. These two instruments continue to grow in popularity. There were only 221 such instruments at yearend 2005. In five years, they have more than quadrupled.
Very experienced investors are familiar with ETFs as they have proliferated for the past several years and found their way into many an institutional and retail investor’s portfolio.
As of the end of 2010, they now number 967, with an approximate value of $725 billion. If ETNs are included, the count is 1099 and total assets are $1.008 trillion. (The National Stock Exchange; www.nsx.com/content/etf-assets-list.)
There are a lot of different types of ETFs and ETNs. So, saying that you are invested in one suggests a broad spectrum of investment possibilities.
Most, but not all, ETFs are similar to mutual funds in that they offer a basket of securities in the fund but, unlike a mutual fund, which is priced/bought and sold at net asset value at the end of the day, ETFs are bought and sold intraday on the “exchanges”.
ETNs are akin to ETFs but are structured products in that they are senior notes that are obligations of the issuer but are intended to track an underlying asset.
The ETFs are promoted as vehicles allowing the benefits of mutual funds but with the added feature of intraday liquidity.
But equity ETFs took it in on the chin in May 2010. Their prices are supposed to track closely to the underlying securities in the fund. If they trade away from the underlying value, the difference is supposed to be “arbitraged” away until parity occurs. But, “The (flash) crash (of May 6, 2010) was a blow to investors who thought ETFs’ diversification provided safety. During the insanity of May 6, many ETFs didn’t behave like broadly diversified baskets of stocks — they performed like single stocks subject to the whims of panicked traders. For some ETFs, the “net asset value,” or the value of underlying holdings, fell only 8 percent or so even as the market prices of the ETFs plunged 60 percent or more. There was, in other words, a giant disconnect.” (Eleanor Laise. “After the Crash: New Rules for ETF Investors,” June 2, 2010 in Smart Money of The Wall Street Journal Digital Network.)
There are also concerns about commodity ETFs… and many a commodity ETF has been issued in recent years… grains, gold, natural gas, etc. Commodities have been “hot” and ETFs have been “hot”. Two “hots” tend to sizzle.
As most investment advisers do not hold a commodities license they cannot sell commodities/managed futures. However, they can sell commodity ETFs. Hence, ETFs are often promoted as a solution for clients wanting commodity diversification. Unfortunately, many of these commodity ETFs have serious limitations, in my opinion.
ETFs only offer “long” investing; they can only invest by owning a futures contract; the only way that gain can be realized is if the underlying asset rises in value. But managed futures allow long and short positions.
Another issue with commodity ETFs is that they do not always closely track the underlying commodity.
How so? Many ETF’s charters specify that they will invest in the front month’s futures contract (e.g. in February 2011, the front month is February 2011.) The problem this causes is that when the front month contract is about to expire, the ETF has to “roll” to the next front month. The “roll” is frequently not at the same price of the expiring month and is frequently more expensive. If there is a loss of value on the “roll”, then the ETF, to break even, must recoup that loss. This pricing problem is called “contango,” if you wish to further your research.
Lastly, the ETF can have poor correlation to the underlying commodity. For instance, perfect price synchronization is a correlation of 1.0; a correlation of only .80 means that a heck of a lot of long-only upward price movement will probably be lost by the ETF.
One reason there is imperfect tracking is that the buyers and sellers in futures versus ETFs largely differ. The futures market typically has a host of participants who cannot use ETFs as their hedging mechanism. The farmer who will be selling this year’s crop or a jeweler needing precious metals typically uses the futures market. Also, ETFs pay for marketing and advertising costs; a futures contract has none.
Before buying, determine if you really want long-only exposure to the commodity. Second, ask your investment adviser how any recommended ETF correlates to the underlying asset. Thirdly, ask your broker about what happened to ETFs during the flash crash; maybe the problems encountered have been addressed and/or maybe you need to recognize and accept some limitations. Lastly, you should also talk with your tax adviser about the tax ramifications. (For futures, tax treatment is simple: 60 percent of all net gains are taxed at capital gains rates and 40 percent is short term, regardless of the holding period.
As you learn more about these instruments, have a dialogue with your investment adviser as to suitability and real, not feigned, diversification solutions.
— Jeannette Rohn Showalter is a Southwest Florida- based chartered financial analyst, considered to be the highest designation for investment professionals. She can be reached at
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An investment in futures contracts is speculative, involves a high degree of risk and is suitable only for persons who can assume the risk of loss in excess of their margin deposits. You should carefully consider whether futures trading is appropriate for you in light of your investment experience, trading objectives, financial resources, and other relevant circumstances. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
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