Investors Should Use Caution with Some Exchange Traded Funds

In the last decade investors have witnessed an explosive growth of exchange-traded funds (“ETFs”). As reported in Barron’s on March 17, 2014, buyers have invested more than $1.7 trillion dollars into more than 1,500 ETFs. Investors trade ETFs because these products typically have low transaction costs and expense ratios, intra-day trading (long or short), tax efficiencies, leverage and margin (if desired), and specialized indexes for tactical approaches. Researchers contend in recent journal articles and academic working papers that investors should use caution with some ETFs.

Since ETFs are derivatives, their market values are derived from the net asset values (“NAVs”) of the securities comprising the indexes upon which they are patterned. ETFs use a creation/redemption process unique to them for arbitraging mispricing away. Nevertheless, premiums and discounts do exist because prices are determined by supply and demand rather than at the calculated NAVs.

Pundits enjoy speculating about the exponential growth of ETFs; and what will happen to ETFs in the next meltdown, now that these investment vehicles hold expanding proportions of investors’ hard-earned money. This investigator will undertake a study of probable areas for caution beginning with pricing efficiency. In short, how close market prices are to the funds’ net asset values and how quickly do price discrepancies disappear.