by Carly Schulaka
Carly Schulaka is a managing editor at FPA. Contact her at Carly.Schulaka@FPAnet.org.
ETFs are often touted for their flexibility, transparency, and tax efficiency. They're flexible because they trade throughout the day-you don't need to wait until the market close to determine price and make a buy or sell decision. They're transparent because an ETF's current holdings, and therefore risk exposure, is often readily available online-most ETF providers update their product's complete portfolio every day. And they're tax efficient because of the minimal capital gains generally realized and distributed to owners.
You likely knew all that already. Here are a few things you may not know about ETFs:
Liquidity Is Not Tied to Daily Volume
"There is a big perception that people equate an ETF's average daily volume with liquidity," says Ed McRedmond, senior vice president of institutional and portfolio strategies at Invesco PowerShares, which has more than 100 ETFs.
According to McRedmond, although you may be used to focusing on average daily trading volume when it comes to individual stocks, that's just not the case with ETFs.
"Liquidity is much deeper than what you see on the quote screen, you just need to know how to go about accessing that liquidity," he says.
William H. Belden, managing director at Claymore Securities Inc., which offers 32 ETFs, agrees that many advisers' understanding of ETF liquidity is incomplete.
"What most advisers know about liquidity is basically the tip of the iceberg," says Belden. "The average daily volume is just one data point and is really not the best indication of liquidity. We do a lot of work educating advisers to look at the liquidity of the underlying holdings and not the fund itself.
"The product sponsors really need to step up their game with this," he says. "And advisers need to take that extra step and do a little more digging-particularly those who are doing asset allocation for the portfolios in their firm."
Not All ETFs Are Created Equal
"Not all indexes, and therefore, not all ETFs that track those indexes are created equal," says Invesco PowerShares's McRedmond. "You have to look under the hood and understand that different methods are going to create different biases. You have to determine how the ETF performs in certain market environments. You have to understand what the index method is, and how it is constructed, and what biases are built in, and which one ultimately aligns with what you want to accomplish."
Belden of Claymore Securities agrees that not all ETFs are alike, and takes this a step further explaining that the term "exchange-traded fund" is a label applied to a lot of products that are not technically ETFs.
For example, Belden says exchange-traded notes (ETNs) and commodity pools do not technically fit under the heading of an Investment Act of 1940 product (often simply referred to as the 40 Act), which requires it to be governed by a board and adhere to rules for its management and delivery.
"An ETN may track an index, but it doesn't have a board; an ETN is a dead instrument," says Belden.
Commodity pools are often popular among investors looking to gain leveraged exposure to commodities. They, too, operate in an entirely different fashion from a 40 Act product, according to Belden, however they are often mislabeled ETFs in the media, and sometimes people buy into them thinking they are ETFs.
"Although these things [about ETNs and commodity pools] are well disclosed, the label of ETF is still being applied to many of these products universally," says Belden. "Advisers really need to know what they own."
Tax Efficiency Comes from the ETF Structure, Not the Index
McRedmond of Invesco PowerShares says another misconception about ETFs relates to how they earn their reputation of being tax efficient.
"There are still some who think that the tax efficiency of an ETF is very much a function of the fact the ETF is based on an index that has a low turnover, but the tax efficiency comes from how the ETF is structured," says McRedmond.
While it's true that the index on which an ETF is based may realize low turnover of securities, other index funds based on that same index would also enjoy this tax efficiency. The ETF's true tax efficiency really comes into play because its structure enables it to meet investor redemptions without having to sell securities.
This article is part of a Trends in Investing Special Report from the June 2010 Journal of Financial Planning. For complete coverage of the Special Report, visit www.FPAjournal.org/CurrentIssue/Supplements.
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