ETF Buyer Beware

by Robert Katch

In recent years, on days when the stock or bond market is falling quickly, there has also been an even greater than expected increase in the losses on many exchange traded funds (ETF).  On these stressful down days, the feature that makes ETFs work so well most of the time often breaks down.  This causes many ETFs to deliver worse results than the underlying indexes they track or even the securities they hold.

This tends to happen when many investors chooses a moment of market panic to sell an ETF that’s built around relatively illiquid assets.  For example, emerging market bonds, high-yield bonds, and those that own thinly traded stocks often find themselves falling harder and faster on such days.  Some securities just trade poorly, so just because an ETF is easy to buy and sell doesn’t mean it can fix the trading problems of the securities it holds. In fact, it may actually make it even worse.

In a normal market, cash is paid to investors as they sell their ETFs and the securities inside the ETF are then sold in an orderly fashion almost simultaneously at nearly the same price.  However, in plunging markets no one is sure how much all the securities inside the ETF are actually worth since the securities may not trade as often, so there the risk is that the investor is given more cash than the securities inside the ETF will later be sold for in deteriorating market conditions.

Large volume sellers of ETFs, in times like this, may be forced to take the actual securities instead of cash.  However, most investors can still get cash for their ETF shares but the seller in the stressed market is forced to accept a much lower price (in the form of a wide bid-ask spread and/or a steep discount) versus what the ETF fund believes it can later sell the underlying assets for. The less liquid the securities, the bigger this cost.

We saw this happen in 2008 to several bond ETFs and it happened again in 2013’s “taper tantrum” to even more bond ETFs.  A muni-bond ETF we tracked back then had a year-to-date trailing net-asset-value total return of -2.8%, but this same ETF’s market price return for the same period was -6.9%, a difference of more than 400 basis points.  Thus, the securities inside the ETF lost only 2.8% but investors in the ETF lost 6.9%.

In recent months, volatility has been increasing in both stock and bond markets around the world.   Once again, we are seeing days where certain ETFs are behaving badly and delivering returns to investors that are worse than the securities they hold.  A liquid and marketable ETF can’t cure the problems of the illiquid or poorly trading securities it holds.  In fact, the ETF may end up amplifying the woes of investors who sell at the wrong time.

This article originally appeared in Westlake Malibu Lifestyle Magazine.

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Robert J. Katch is the founder of Manchester Financial, an Investment Counsel/Wealth Management firm located in Westlake Village. For more information call 800-492-1107.

This material is provided for general and educational purposes only, and is not legal, tax or investment advice. For each strategy or option mentioned, there are detailed tax rules that must be followed.

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