Securities Regulator Issues Warnings Regarding Exchange Traded Funds (ETFs)

he New York Stock Exchange (NYSE) has issued an Informed Investor publication entitled, What You Should Know About Exchange Traded Funds. While many ETFs are passive managed funds that track U.S. equity indexes, new ETFs may entail greater risks. Let's examine the NYSE's caution to investors.

ETFs are baskets of underlying securities and, as such, often are promoted as low-cost alternatives to mutual funds. Nonetheless, there are basic differences, because an ETF trades like a stock and investors can buy and sell it throughout the trading day. The popularity of the product has been phenomenal. In 1995, there were 2 ETFs available and they had accumulated $1 billion in assets. By mid-year 2006, there were 263 ETFs available and assets had skyrocketed to $335 billion.

Such extreme popularity for, and competition between, ETFs has led to many new ETFs being "increasingly complex and specialized", according to the NYSE. The NYSE warns investors that a particular ETF may not have a cost advantage over a mutual fund, may not offer a diversification advantage over another type of investment, and may have substantial, distinct risks. Investors and/or their financial advisers must conduct sufficient due diligence to learn about these products. By reviewing written materials such as the prospectus, the NYSE suggests answering two questions: 1) from what does the ETF derive its value; and 2) how is the ETF managed?

ETFs historically have derived their value from broad market indexes such as the S&P 500 Index. Newer ETFs may derive their value from stocks in particular industries, sectors or geographic regions, or even from certain bond indexes. Still other ETFs may focus on certain investment styles such as growth or value. Note carefully that still other ETFs may derive their value from commodity prices or currency valuations. NYSE warns that, "[g]iven all of the choices, you should ensure that you are comfortable with the ETF before purchasing by discussing it with your broker, reading the prospectus or product description, researching the ETF on the Internet, or consulting one of the many independent research and ratings services that track ETFs."

In terms of risk, the NYSE cautions that the level and type of risk among ETFs "may vary significantly." The NYSE cites higher risk examples such as an ETF that tracks the price of oil, or an ETF that tracks the very smallest publicly traded companies.

Related to risk is the price volatility of ETFs. An ETF's price volatility will reflect the volatility of its underlying securities or commodities. Be sure to learn the ETF's historical price performance. While not predictive of future performance, an ETF's historical price volatility, including adjustments for expenses, is important information to consider.

Additional risks associated with ETFs include purchases on margin and short-selling, which are considered aggressive, high risk strategies. Nearly all investors should stay clear of such strategies.

In terms of management, the NYSE advises investors to determine the costs associated with ETFs. ETFs charge an annual fee equal to a percentage of invested assets. Although this fee, or "expense ratio", may be relatively low, it can "vary significantly from one ETF to another." Included will be brokerage commissions, because ETFs trade like stocks, and these commissions may have a "significant impact" on the total expense. As an example, the NYSE opines that if an investor plans to make smaller investments on a regular basis (as opposed to making one large purchase), investing in a commission-free mutual fund may be a less expensive option. That's because multiple purchases and/or sales drive up the costs of ETFs.

The NYSE advises investors to perform a cost comparison between ETFs and other products such as a mutual fund. To do so, investors and/or their financial advisers need to consider the expense ratios, commissions and investment timeframes (how long an investor plans to hold the investment).

Overall, ETFs are worth a look, so long as they are cost-justified, and their risks, given their increasing complexity and specialization, are understood and appropriate for the investor.

_______________________________________________________________________
James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.