You mean for money? Yes, well, it’s like this… see, we may have just a teensy weensy, — microscopic really — uh…problem. How about some nice “in kind” securities instead? How does that sound? What does “in kind” mean, you ask? A toaster oven? Oh, no, no, no…well…wait, would you take a toaster oven?
Ah, Wall Street and their endless product inventions to “help” out their Main Street brothers and sisters invest with confidence. Alas, with the recent volatility some of that “help” seems to be slogging through a bit of the fine print involved in one of their most popular concoctions…uh…I mean products. Namely, ETFs (exchange traded funds) and the problems have apparently come as a surprise to many.
But, let’s back up for a second or two. ETF’s, for the most part, truly have been a terrific “invention”. For those unfamiliar with the term, it is very much like it sounds. They are mutual funds that trade on an exchange (most often the New York Sock Exchange). Instead of offering to buy or sell your mutual fund at the end of every trading day (as regular mutual funds do), one can buy or sell a fund all during the day just like a stock. In addition, ETFs generally have lower fees than corresponding mutual funds. They also tend to trade very, very near the actual net asset value (NAV) of the underlying basket of securities within the fund. The reason for that is fairly straight forward: arbitrage. As any discrepancy arises (due to more selling or buying pressure of the traders that day) large firms will buy or sell the difference between the value of the fund versus the value of the actual securities in that fund and pocket the profit. As mentioned, that arbitrage usually allows regular investors to be able to sell their holdings at (or very, very near) the NAV. That in a nutshell, is the positive case for ETFs and the basis for all of those “analysts” that you see on TV, gushing about the product. Of course there are other issues such as leverage, currency variables etc. that could be covered, but for the purposes of this post, the bare basics are satisfactory.
OK, now back to that fine print. Yes, ETFs are all of those things stated in the above paragraph, but there are some less, shall we say, publicized aspects to these funds. Often, and I do mean often, you will see many a “financial planner” talk up the low fees as the prime benefit of buying an ETF as opposed to a mutual fund. And, Yes the “management fees” and “expenses” of the typical ETF is indeed almost always lower than an open-ended mutual fund. [Note: “open-ended” just means that a fund can issue new shares as more people buy into the fund. These are typically what people think of as mutual funds. There is another category called closed-end funds, that for now, we can discuss another day.] But in addition to any commission that one might pay each time that they buy and sell their ETF, there is a little something called a “spread”. While, typically, especially in the very large ETFs, these spreads can be miniscule, there are more than a few instances where that is not the case. The spread refers to the difference between the bid price and ask price and as the Wall Street Journal put it, they are more than a little significant:
A lack of liquidity can lead to wide “bid-ask spreads,” or the gap between the price buyers are willing to pay for shares of an ETF and the price sellers are asking. The wider the spread, the bigger the bite taken out of investors’ returns every time they buy or sell. A lack of liquidity also may cause the ETF to trade at a large premium or discount to net asset value, or NAV—the value of the fund’s underlying holdings. That means an investor buying the fund may overpay for that portfolio, or an investor selling could get less than that basket of securities is worth.
That’s right. You can actually sell your fund for less than its worth. Oh, and if you ever want o buy it back they will happily sell it to you for more than it’s worth. Sound like a deal? And if you’re thinking that it sounds just like the commissions that you avoided by not using a broker, well you may have a pretty darned good point there. It’s just not the lightly traded, less popular ETFs that run into a few “liquidity” snags either (although, naturally they are the most vulnerable and likely). But in times of highly volatile activity, the problems can become fairly widespread. Markets such as municipal bonds and foreign stocks that are thought of as relatively large can become ensnared in times of heavy trading. In fact, on June 20th of this year, as the market was taking a beating of 350 some odd points, some traders threw in the towel. At one large bank they came right out and said no more and refused to take any redemption orders at all. Another trader volunteered to helpfully redeem some funds with “in kind” replacements, but not, you know, actual cash. Oh, and as a cherry on top, Wall Street’s geniuses mapped out all of the contingencies and concluded that what just happened could not really happen:
“The losses for ETFs today were far beyond what the most sophisticated financial risk models could have predicated for worst-case scenarios.”
Our money is in the very best of hands. Sheesh.