ETF Pitfalls

ETFs, as wonderful as they are, have their warts. Not all ETFs operate the same way, which is why it is a good idea to look at your ETF closely.

ETF indice tracking

Most ETFs are supposed to be index funds which means tracking a defined index. However, the more obscure the index, the greater the tracking error. The crux of the ETF problem is the way they are structured. Many ETFs own a basket of stocks that (nearly) replicate their respective index. Some indices, such as commodity ETFs, use futures  contracts. No companies or assets are owned. They buy contracts on expected commodity prices which can vary widely from actual prices. Tracking error can be 0.1% to over 50% which means losses and possibly gains can be greater than expected.

ETFs closing

ETFs need enough money in assets, typically $50 million, to profit. If not, they will close. Yes, you get your money back but owner is on the hook for any tax liabilities and must hunt for a new home for the money (read: commissions). Also, the diversification the ETF offered goes away. About 140 ETFs have closed since 2008.

Leveraged ETFs

These high risk beasts are intended for day traders. They tout gains of 2x or 3x their indices, which they generally do, but the fine print generally says only for one day. Holding them longer can result in large variance of index tracking.

ETF flash crash

On May 6, 2010, the Dow lost 700 points in a few minutes. Some ETFs dropped in value to nearly zero in that time. The staffs of the Securities and Exchange Commission and the Commodities Futures Trading Commission have determined that the May 6th Flash Crash was set in motion by a huge sale of S&P 500 futures contracts by a single firm’s computer trading program, which dumped $4.1 billion of the contracts on the market in just 20 minutes. The selling accelerated as the price plunged. ETFs were hit particulary hard. Lack of liquidity and volatility caused market makers to incorrectly value the ETFs causing trading at absurd prices.

The SEC has announced the institution of circuit breakers that would trigger a five-minute suspension of trading on a stock that moves more than 10% in a five-minutes period. In addition, the SEC has said that it is considering limiting the speed of high-frequency trading and the use of “stub quotes.”

Many investors using stops through a broker were stopped out, sometimes at ludicrous prices.

What do I watch out for?

These steps will help mitigate ETF ownership problems.

1. Know how your ETFs track their index.

2. Make sure your ETF has at least $100 million in assets and has been around for at least a year. Don't be a pioneer.

3. Own a leveraged ETF? It should only be for one day.

4. Will another flash crash happen? Most likely, since the rules and computer trading on the stock exchanges have not changed much. Some advisors are steering their clients from ETFs back into traditional mutual funds.

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