Ask Money

The real risk with ETFs

Chris Farrell Feb 9, 2011

Question: I know the basics about ETFs: index funds that are traded like stocks. My question is what backs up ETFs? Are there actual stocks under ownership when an ETF is purchased? How does a company administer such broad based representation of stock and bond markets? Finally, is there any risk that ETFs are just another example of financial engineering that will end in an unpleasant surprise? Thomas, Rochester, NY

Answer: I don’t believe exchange traded funds (ETFs) are the financial engineering equivalent of the infamous subprime mortgages or Bernie Madoff. The traditional investor protections against fraud and malfeasance are strong. However, with experience we’re learning that the risks inherent in investing in many ETFs. It’s the market risk attached to a number of these financially engineered products that may be hazardous to your wealth. Caveat Emptor. .

As you already know, ETFs are a relatively new product that is an alternative to mutual funds. ETFs can be bought and sold like a stock. It’s no different than buying or selling shares in GE or IBM. But ETFs are designed to track the price of a designated index. Among the most popular indices are the Standard & Poor’s 500, the Dow Jones Industrial average, and the Nasdaq-100. But there are ETFs based on all kinds of indices, from junk bonds to patents. An exchange-traded fund that tracks the Egyptian stocks is attracting investor interest.

The basic investor protections are in place with ETFs. For example, it has to pass muster with the Securities & Exchange Commission. Among the important protections against malfeasance to highlight is that most ETFs have an independent third party custodian. The custodian is responsible for holding all of the securities in the ETF in segregated accounts. The custodian is separate from any investment advisor and portfolio manager. The custodian collects dividends and interest on securities in the ETF. This set-up helps prevents a Madoff type Ponzi scheme with exchange traded funds, as it does with mutual funds.

Of course, no system is ever fail safe, but the investor protections from crooks and cheaters with mutual funds and ETFs are strong. .

No, the real concern is that ETF promoters have created too many exotic and speculative pieces. For instance, ETFs that allowed investors to double their bet on the rise and fall of oil prices were a bad deal (for investors). The so-called extreme ETFs are a bad bet (pun intended) for investors.

Even the commodity-based ETFs have disappointed investors, but not Wall Street promoters and professional traders. Bloomberg BusinessWeek looked into commodity ETFs in a 2010 cover story and found that 10 well-known funds based on commodity futures have all done worse that the underlying raw materials.

The stock and bond ETFs based on broad indices are good investments for the long-term investor. I would be wary of the more exotic ETFs. That’s where the risk of financial engineering gone bad for your wallet lies.

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