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
ETF indice tracking
Most ETFs are supposed to be index funds which
means tracking a defined index.
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 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.
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
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
Some advisors are steering their clients from ETFs back
into traditional mutual funds.