Jim Wiandt

Are the Risks of Exchange-Traded Funds

A key risk inherent in exchange-traded funds (ETFs) is being misrepresented by its proponents, charges Mercer Bullard and the Consumer Federation of America. Sponsors of ETFs responded variously-challenging the critics' data, agreeing, or vowing to change future practices.

At issue is clarifying the nature of ETFs to investors. While most ordinary mutual funds can only be bought or sold at the end of the day at the calculated net asset value (NAV), ETFs are traded through the day on the American Stock Exchange at prices that aren't guaranteed to match the underlying value of the stocks in the portfolio.

With many ETFs the variations are negligible. But some of the funds trade at prices that can vary considerably from the correspondent NAV at the time of the trade. In such cases an investor who inadvertently buys an ETF at a premium to its underlying value is exposed to natural corrective forces (namely savvy traders who exploit the difference between the trading price and the NAV).

According to Mr. Bullard, the risk of price variation is greatest on international stocks. Materials from ETF proponents and the American Stock Exchange have "misrepresented" the risk, he contends.

In a Wall Street Journal article by Karen Damato and Aaron Lucchetti, various ETF supporters responded to the charges. Lee Kranefuss of Barclays Global Investors, said his firm had fully disclosed the mechanics and risks of ETFs. Even so, in May Barclays agreed to provide additional information on its ETF Web site about the daily premiums and discounts of some of its iShares.

Presently many of the ETFs that trade on the American Stock Exchange have three ticker symbols: one shows the trading value, another shows the estimated NAV of the underlying stocks, and the third shows the official NAV of the underlying stocks at the previous day's close.

Unfortunately, this information is presently only available for United States-based ETFs. The same information is not readily available to most retail investors trading in low-volume international funds. With the recent exposure to this information, however, look for this information to soon appear.

Gus Fleites, director of ETFs at State Street Global Advisors, agreed that price variation can be significant for some funds and may not always be explained clearly. Regarding ETFs that track international-stock indexes or lightly traded U.S. industry sectors, he noted, "Retail investors, beware.."

Fund specialists, including Mr. Bullard, have praised ETFs not just for allowing intra-day trading, but also for their ability to feature lower operating expenses and greater tax efficiency. Expect the transparency of trading/NAV differentials to increasingly fall into the public domain. Traders, not funds, gain from the premiums/ discounts.

With Barclays already voluntarily posting the information, it seems likely the problem will soon to be largely resolved. Aside from increased transparency cutting down the gap, one expects that the increased attention to the issue will also help narrow the premiums that are exploited by traders. In the meantime, let the buyer beware.