Advisor Blog

Like it does with most good ideas, Wall Street has taken a simple and practical product and turned it into something dangerously complicated and difficult for most investors to fully understand.

Exchange Traded Funds (ETFs) have now been around for over 20 years.  The first ETFs, and still the best known, tracked stock indices - like the S&P 500.  These funds simply replicated the index and arbitrage kept the fund price very close to the actual net asset value of the underlying positions.  It was simple, inexpensive, tax-efficient, and transparent.

Now, we have over 2,700 different ETFs available.  Many of these are leveraged, some are designed to provide a return that is the inverse of an index (and may also employ varying degrees of leverage), and some track obscure market sectors.  Many do not own the underlying assets, but are "synthetic ETFs", meaning that they own derivatives sold by a counterparty - often a large investment banking concern.  Although the shares of these products are designed to be highly liquid, the underlying assets may not be.  A related product called an Exchange Traded Note (ETN) is entirely dependent upon the credit of the issuer, much like a bond, and does not own any underlying assets.  It is unlikely that many investors truly understand this liquidity and credit risk.

We employ a few ETFs in some portfolio constructions.  These are reviewed by our investment committee before they are approved for use and liquidity is a major factor in the evaluation.  As a result of this analysis, we made the decision some time ago not to invest in any ETNs or synthetic ETFs.  During the "flash crash" of May 2010, many of these products exhibited extremely volatile behavior due to lack of liquidity. The Economist estimates that 60-70% of the trades that were subsequently cancelled when the Dow Jones Industrial Average briefly dropped 1,000 points were in illiquid ETFs.  Employing a review process, although it probably goes unnoticed, is required by our fiduciary duty to our clients and is another way that we serve our clients' best interest.

Have a safe and happy Independence Day holiday!