Following last week's light touch on the subject, there's more to be explained about exchange-traded funds (ETFs). Since they are a relatively new financial product compared to stocks themselves or mutual funds, they present elements of a noble experiment. But that hasn't phased investors. The amount in ETFs has doubled since 2012 -- to $2.12 trillion.
Here's an illustration that should get your attention: On Aug. 24, the stock market lost 4 percent, but some ETFs traded at discounts of as much as 30 percent lower than the actual value of the underlying holdings owned by the fund. Many holders of ETFs (often day traders) were so anxious to get out of the market that they were happy to sell their ETF shares at a discount to the real value. This could never happen with a conventional mutual fund. Mutual funds are valued just once a day and the value is determined by the total value of the securities they own at the close of market. Period. If investors want to sell, the fund liquidates enough of its holdings to meet what it needs to pay out to the investor.
So ETFs have a life of their own. Just like stocks, an ETFs value itself can be subject to supply and demand which, in turn, is subject to the public's perception of what may soon be happening to the value of all those underlying securities.
A seller in a panic can find a buyer at some discounted price so that the fund itself stays out of the transaction. While most ETFs trade most of the time within a fraction of a percent of the net asset value of their holdings, the times when they do not helps to illustrate how different they are from traditional mutual funds. During the so-called "flash crash" of 2010, some ETF stocks had no buyers and the values dropped to zero -- at least temporarily. Stop-loss orders, however, had some of those shares selling automatically on the way down. What a disaster for the uninitiated.
While there are some ETFs now that are actively picking and managing stocks, most are passively managed index funds investing in some cross section of the stock market. So-called "Authorized Participants" are financial institutions that assemble blocks of stocks in 50,000 share units and offer them to ETFs in return for the cash the latter has received from investors.
What makes ETFs so tax-efficient is that they do not have to sell shares to create cash for an investor who wants out. They can do an "in-kind" transaction giving the Authorized Participant enough shares to create the cash required for the distribution. No sale means no tax for the ETF itself. To the extent that this approach is limited, the fund can then sell shares whose performance would trigger the smallest amount in capital gains taxes. In short, ETFs have flexibility not afforded to conventional funds.
ETFs, however, are becoming increasingly complex. In the first six months of 2015, 133 new ETFs were launched and over 20 had the word "hedge" in their titles. Many are leveraged, which offers the opportunity to achieve, in one case, as much as 300 percent of the actual gain of the underlying securities, but we all know that leverage can work both ways.
Are ETFs cheaper to buy than mutual funds? Not necessarily. While one fund family famous for low-cost index funds also offers ETFs, the expense ratios for both investment types appear to be comparable. Brokerage firms, however, sell ETFs just as if they are stocks, so this begs the question as to whether or not ETFs purchased through a brokerage firm in "street name" are subject to the $500,000 insured limit of the Securities Investor Protection Corp. The firm itself has to remain solvent for anyone to get more than the insured maximum back. Investors in several major brokerage firms don't realize how close they came to a rude awakening in 2008 when those major, totally insolvent, firms had to be bailed out by banks -- banks which were, in turn, bailed out by taxpayers. That was almost 10 years ago, however, when we had a functioning government. We may not be that lucky the next time.
For those of us who are retirees or retirement savers, investing directly in traditional index funds offers everything we need in the way of low fees and diversification without brokerage industry interference. ETFs offer something new for advisers and brokers to talk about, but at the end of the day there's no need to feel like we're missing out on anything special. Let's keep it simple.