Although exchange exchange-traded funds have only been around for about 20 years, they have grown faster since their inception than any other type of investment in history, amassing over a whopping $2 trillion in assets during that time. And while there is still ten times that amount of money housed in traditional mutual funds, ETFs have come to represent a trend in the marketplace that embraces lower fees, greater liquidity and total transparency. Financial advisors who recommend mutual funds need to understand how ETFs work and what they can do for their clients. These products have often been marketed as simplified “one click” vehicles, which is true in some respects. But these vehicles also carry many of the same risks that are found in other types of investments.

ETF Basics

ETFs are essentially a new type of mutual fund that is created by a fund company and then traded on an exchange. Unlike traditional mutual funds that can only be bought and sold directly from the fund company, ETFs trade in the secondary market like other securities and can be bought and sold in intraday trading. ETFs are designed to trade at a price that approximates the market value of its underlying holdings. Therefore ETF issuers generally publish their holdings in the fund on a daily basis so that investors can see whether their shares are over- or under-valued and trade accordingly. Some of the larger broker-dealers are “authorized participants” that can create and redeem shares of ETFs with the fund company in order to move the share price to the level that it should be. (For more, see: 5 Things All Financial Advisors Should Know About ETFs.)

ETFs resemble traditional funds in that each share of the ETF represents an undivided interest in each of the securities held by the fund. They differ from exchange-traded notes (ETNs) in that they actually hold their underlying instruments, whereas ETNs simply represent a credit promise from the issuing bank and hold no actual securities. ETFs are also regulated by the SEC under the Investment Company Act of 1940. There are also ETFs that invest in other assets besides publicly traded securities, such as commodities and derivatives. These ETFs are governed under different rules, and a different set of rules applies to their taxation. (For related reading, see: What Advisors, Clients Should Expect from a Low-Return Future)

Types of ETFs

There is an ETF available for virtually every financial index, cap weighting, sector and passive investment strategy in existence. Index ETFs own the securities of an underlying benchmark such as the S&P 500 Index, while a “geared” index ETF would track either a multiple or the inverse of an index. A cap-weighted ETF would hold large-, mid- or small-cap stocks. (There are also blended ETFs that hold a mix of weightings or securities.) ETFs that invest in fixed income securities can often be broken down by maturity, duration or credit quality. Sector ETFs invest in areas such as technology, communications, healthcare, energy, precious metals and natural resources. The latest ETF craze is known as “smart beta” funds, which are funds that resemble index funds but have had their portfolios passively tweaked in order to adjust the cap weighting or other metrics in order to exploit perceived inefficiencies in the market. ETFs can also be actively managed in order to try to outperform an underlying benchmark. (For related reading, see: What the Future Holds for ETFs.)

Still the Same Risks

The key issue that advisors need to make investors understand about ETFs is that they essentially come with the same set of risks that come with any other type of publicly traded security. In addition to capital losses that can happen in intraday trading, ETFs are also subject to the limitations of the market maker and the behavior of the exchanges. While traditional open-ended mutual funds can always be bought and sold directly from the issuing company, ETFs are subject to trading halts, ambiguous pricing in fast markets and other shortcomings that come with exchange trading. Although these drawbacks may not be common, investors need to know that they can occur, especially during major price swings or periods of heavy trading. (For related, reading, see: Smart Beta ETFs: Latest Trends and a Look Ahead.)

When an investor buys a retail product, such as a car, they already know that there are potential pitfalls that can — and will — come with that purchase, such as engine trouble, regular maintenance and possible wrecks. But many investors do not see the potential problems that can come with ETFs, especially if they have no prior experience with them. The headlines that advertise ETFs to the public can be misleading, such as with advertisement for the ETFs that trade inversely or in multiples of the index. These instruments can be extremely volatile and are probably only appropriate for professional traders in most cases. (For related reading, see: Smart Beta: Set Up for a Fall?)

Another major problem that can come with ETFs is the temptation to start trading them regularly. This can be a perilous strategy for long-term investors who may be better off in a traditional mutual fund that cannot be traded in this manner. Open-ended funds are better vehicles for long-term investors because of their lower costs (even if they come with a sales charge). ETFs only charge the price of a commission when they are traded, but this cost can multiply rapidly when buy and sell trades are placed on a regular basis. And, of course, the investor may also miss out on key investment opportunities if they are trying to time the markets. If ETFs are purchased to achieve a long-term investment strategy, then they are better left alone. But this can be hard to do for some investors, especially when the markets head south or the investor thinks that the ETF is about to drop sharply in price. (For related reading, see: Alternatives for Low-Yielding Bonds.)

The Bottom Line

ETFs are one of the fastest-growing types of assets in the financial marketplace today. These funds may someday overshadow traditional mutual funds in assets under management due to their superior flexibility and liquidity. But investors need to understand the cons as well as the pros that come with them in order to make fully informed decisions. (For related reading, see: Income vs. Total Return: Withdrawals Reconsidered.)

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