Lifting the veil on ETFs – Part 3 of 4

Taxation
By their nature, ETFs are tax efficient and can be more attractive than mutual funds. When a mutual fund realizes a capital gain that is not offset by a realized loss, the mutual fund must allocate the capital gains to its shareholders. These gains are taxable to all shareholders, even those who reinvest the gains distributions to purchase more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF shares on the stock market, as they would a stock), so investors generally only realize capital gains when they sell their own shares for a profit or when the ETF trades to reflect changes in the underlying index.

Trading
An important benefit of an ETF is the stock-like features offered. A mutual fund is bought or sold at the end of a day’s trading, whereas ETFs can be traded whenever the market is open. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin and invest as much or as little money as they wish.

Risks

Effects on stability
ETFs that buy and hold commodities or futures of commodities have become popular. The commodity ETFs are in effect consumers of their target commodities, thereby affecting the price in a spurious fashion. In the words of the International Monetary Fund (IMF), “Some market participants believe the growing popularity of exchange-traded funds (ETFs) may have contributed to equity price appreciation in some emerging economies, and warn that leverage embedded in ETFs could pose financial stability risks if equity prices were to decline for a protracted period.”

Regulatory risk
Areas of concern include the lack of transparency in products and increasing complexity, conflicts of interest and lack of regulatory oversight. You must take the time to do your own research before investing to fully understand these risks.

Criticism
John C. Bogle, founder of the Vanguard Group, a leading international issuer of index mutual funds (and, since Bogle’s retirement, of ETFs), has argued that ETFs represent short-term speculation, that their trading expenses decrease returns to investors, and that most ETFs provide insufficient diversification. He concedes that a broadly diversified ETF that is held over time can be a good investment.

The Wall Street Journal reported in November 2008, during a period of market turbulence, that some lightly traded ETFs frequently had deviations of 5% or more, exceeding 10% in a handful of cases. According to a study on ETF returns in 2009 by Morgan Stanley, ETFs missed their 2009 targets by an average of 1.25 percentage points, a gap more than twice as wide as the 0.52-percentage-point average they posted in 2008. Part of this so-called tracking error is attributed to the proliferation of ETFs targeting exotic investments or areas where trading is less frequent such as emerging-market stocks, future-contracts based commodity indices and junk bonds.