What U.S. debt downgrade means for ETFs

August 8, 2011

A woman shades herself from the sun with an umbrella as she walks down 34th Street in New York July 22, 2011. REUTERS/Shannon Stapleton  Is it time to take cover from exchange-traded funds (ETFs) now that Standard and Poor’s has cut the U.S. debt rating?

With the recent U.S. and Euro debt crises introducing new uncertainty, volatility will be the name of the game. As the frenzy of new fund offerings abates, many funds may close because they will be unable to attract sufficient assets. But a handful of safeguards can protect you.

“The number of ETFs that are shut down or liquidated, while previously a rare occurrence, is on the rise,” said Tom Lydon, publisher of the popular ETF Web site www.etftrends.com in an email. “Closings are up 500 percent in each of the last three years over 2007 levels (which equates to one each week).”

When funds close, Lydon noted, “investors are notified and have 30 days to sell on their own or receive the market proceeds at the time of the closure.”

Keep in mind that ETF assets are not insured by any government agency and you’re subject to market and often credit risk. And while many ETFs have eliminated brokerage fees to buy and sell them, they still may not closely track the index they are named after — a frustrating glitch for many investors. The popularity and perils of ETFs recently triggered a warning from a group of state securities regulators.

The North American Securities Administrators Association warned that “some traditional ETFs may be appropriate for long-term holders, but others, including exotic-leveraged and ETFs, may require daily monitoring.”

You can get into a lot of trouble if you don’t understand the more specialized funds. While most are pools of money tied to stock and bond indexes, many use borrowed cash to bet on up or down movements in stocks, bonds, commodities and currencies.

Exotic ETFs are useful if you need them to hedge specific risks such as a large exposure to the dollar, stocks or even specific government bonds. Still, you can easily lose money because some of the synthetic or “inverse” funds are designed to move up to 300 percent in the opposite direction of the index you’re hedging — or betting against.

“Synthetic products like leveraged or inverse ETFs are not appropriate for ‘buy and hold’ investors,” advised NASAA, “because an ETF may reset each day, and its performance may quickly deviate from the underlying index, currency, commodity or basket of assets it is attempting to mirror.”

Since the more complex ETFs contain derivatives — vehicles that react to but may not directly hold securities — there’s an ongoing concern that institutions may be able to trigger dangerous gyrations in ETF trading. That could ignite another “flash crash.”

“Sudden and large investor withdrawals triggered by market events or counterparty risk concerns can also lead to funding liquidity risk,” noted a recent report by the Bank of International Settlements on systemic risks of ETFs. Translation: A big crash involving ETFs is possible and you should be careful.

Here are some guidelines:

  • If you’re a “buy and hold” investor, you can still invest in nearly all of the world stock and bond markets through ETFs. Some low-cost favorites that I hold include the iShares Barclays Aggregate Bond Fund, a basket of U.S. bonds, and the Vanguard Total World Stock Index Fund.
  • What you see is not always what you get. Each index fund is slightly different than its peer. It all depends on what the fund holds. If you want a fund to reflect closely the index you want to invest in, find a fund with a low “tracking error.”
  • Watch for fees. Except for plain-vanilla ETFs that don’t carry commissions, most exotic ETFs charge you for each transaction. Commissions can add up fast for frequent traders.
  • Taxable Events. Outside of tax-deferred accounts, your ETF trading may trigger short-term capital gains that may not be offset by losses. For investors interested in sophisticated hedging or speculation strategies, you should consult with a registered investment adviser or certified financial planner for further guidance. You may be wasting your money on your own through over-trading or poor understanding of how ETFs really work. ETFs are much like cars and trucks. Most of the time, when used prudently, they can get you to your destination safely. It’s when you throw caution to the wind that you can end up in a ditch.
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