Investing in ETFs? Make Sure You Check Under the Hood.

There has, and continues to be, much written about Exchange Traded Funds (ETFs); some positive and some negative. Often these articles create more confusion by painting all ETFs with the same brush. My goal here is not to give you a firehouse of information, but instead give you a few points to help filter through the noise.

I am a big fan of using analogies so here is my attempt at one to make the point that just knowing an investment is an ETF doesn’t tell the whole story.

Think of ETFs like a tractor trailer. I know this seems like a stretch, but stay with me. You can transport almost anything with a tractor trailer. But there can big differences in what you’re transporting and the associated risks. For example, transporting a truck full of paper towels and hauling a tank with 11,000 gallons of gasoline are vastly different. Both are tractor trailers but that’s where the similarities end. The same can be said about ETFs.

The concept behind ETFs in the early days was simple: make it easy to invest in all the securities included in an index while providing the same liquidity as buying the individual stocks themselves. As with anything, people consistently try to push the envelope to attempt to maximize profit potential in a new market.

Over the past 10 years, the amount of total net assets invested in ETFs and ETF product available has grown substantially (see graph below). More importantly, from what I have seen, that growth is being driven by ETFs that are highly specialized in a niche market. What’s troubling is that some are constructed using complex investments (i.e. futures or derivatives), leverage, or other concepts making it difficult to know exactly what’s inside the ETF and how it will respond to different types of risks.

Total Net Assets and Number of ETFs

1The funds in this category are not registered under the Investment Company Act of 1940 and invest primarily in commodities, currencies, and futures.
2The funds in this category are registered under the Investment Company Act of 1940.
Note: Data for ETFs that invest primarily in other ETFs are excluded from the totals. Components may not add to the total because of rounding.
Source: 2017 Investment Company Fact Book, www.icifactbook.org./ch3/17_fb_ch3.

With this level of exponential growth in ETFs it’s easy to see why they get so much attention. There are plain vanilla ETFs and then there are not so plain vanilla ETFs. Most of what you read in the press is about the latter. They make for better headlines and are easier to use to prey on our fear emotions. Unfortunately, this can impact how all ETFs are viewed.

Going back to my analogy with the tractor trailer, it’s crystal clear that hauling 11,000 gallons of gasoline carries more risk than a truck load of paper towels. However, with ETFs, the differences in risk are not as obvious. When Paritas constructed our Global Wealth Strategy, we focused on using ETFs that are of the plain vanilla variety. They all track established, straightforward indexes, are extremely liquid, and have competitive fees.

When you stray from these simple types of ETFs you can end up with liquidity problems, higher fees, and complex investment strategies that are untested. These problems become exacerbated in periods of market stress which is why it is so important to understand what you own.

We believe it’s extremely important to keep it simple. All ETFs aren’t equal, and they shouldn’t be treated as such.

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About the author: Douglas Hedley