ETFs don’t hold what they say?
This is an oldie, but a goodie. There are a number of skeptics out there who don’t trust the “Man.” Conspiracy theories abound in the investment community as in society at large. Conjecture aside, Wall Street hasn’t really done too much to help inspire trust over the last decade. That said, let’s take a look at the facts with respect to ETF assets.
ETFs are issued with a prospectus. For all the newbies out there who don’t know what a prospectus is, it is a document that is required by the Securities & Exchange Commission (SEC) upon issuance of a new security. ETFs are given exemptive relief from some of the more onerous restrictions of the ’40 Act (the Investment Company act of 1940 that pertains to mutual funds and ETFs). Although they receive several important exemptions, ETFs are not exempt from needing to register a prospectus with the SEC prior to first issuance of the fund. The prospectus document covers methodology and discusses who the key players are that control the inner workings of the fund. Now, that methodology could entail full replication (precise copying of the index that the fund is intended to track), or an optimized portfolio method that seeks to mimic the performance of the desired index without the drag of an extremely large number of constituents. Either method still requires disclosure and is governed by the fund’s prospectus. In other words, the fund needs to do what it says it’s going to do.
Checks and Balances
They say it takes a village to raise a child. The same can be said for an ETF. In addition to the Issuer (Blackrock, State Street, Vanguard etc.), there is a significant supporting cast that helps with the smooth functioning of an ETF. This supporting cast helps with the Creation/Redemption process, distribution of marketing materials, the index tracking and trading for the fund, and the custody of the underlying assets. That last point is critical as the ETF issuer is not the one who holds the assets. The custodian bank handles the underlying assets on behalf of the fund. Although they do not make the investment decisions, they do act as a container for all the underlying securities. The custodian banks are not small, community banks. They are large institutions with significant infrastructure and capitalization. Bank of New York (started by none other than Alexander Hamilton!), State Street, and US Bank are just a few of the large financial firms that act in a custodial fashion. State Street, for instance, has upwards of $29 Trillion, yes Trillion, under custody. It is difficult to believe they would jeopardize that type of business by allowing any one ETF to play fast and loose with its required portfolio assets.
Furthermore, Gold . . .
On a final note of paranoia impacting the exchange traded product market, let’s take a look at the SPDR Gold Trust (GLD).  The most popular gold ETF by assets under management, GLD bore the brunt of much silliness. The big rumor is that the fund doesn’t hold the precise amount of gold necessary to account for the notional value of the fund. The “gold bugs” pushed the conspiracy to such a fever pitch that it prompted gold funds to show live footage of their vaults and publish each serial number accounting for every ounce of gold they hold. The SPDR Gold Trust publishes a full list of gold bars in its vault in addition to the certificate from its vault inspector.
Focus on what matters
If you are going to worry something, make sure you worry about what matters. It is critical that investors choose funds that align with their investment objectives. Don’t be afraid to read a prospectus. At a minimum, the educational basics found on this site should arm you with the tools you need to navigate the summary prospectus. Take your time and follow prudent investment practices. Finally, remember that ETFs are excellent tools to access the market and diversify, but they are not immune from the vicissitudes of market forces.
Technically speaking, GLD is an open ended trust. It is a common structure for commodity exchange traded products. SPY, the S&P 500 tracking vehicle, is a unit investment trust. Although there are slight structural differences, they are viewed interchangeably with ETFs.
Not All ETFs Are Created Equal
With the proliferation of ETFs, it is sometimes hard to understand the nuances that separate the various funds in the market. In order to properly analyze the current stable of products, one needs to look not only at management fees and objectives, but also at fund structures. Contrary to popular belief, not everything called an ETF is, in fact, of the same structure.
Although Exchange Traded Product (ETP) is the more correct term, most people use “ETF” when referring to a wide range of products. Don’t feel bad if this is you. You are definitely not alone. Many finance industry professionals still mistakenly use the term ETF to describe everything that looks like one. This is one of those interesting situations when it may walk like a duck and quack like a duck, but it is not a duck. ETPs can take many different forms. Even though products may share many of the characteristics of ETFs, there are sometimes significant differences between them. In order to gain a better understanding, we’ll look at a few of the commonly used terms to describe ETPs. The ETP wrapper encompasses Exchange Traded Funds (ETF), Exchange Traded Notes (ETN), and Unit Investment Trusts (UIT). We will discuss each in turn to get a better handle on some of the commonly used structures available to issuers and why they may choose one over another. Let’s start with ETFs.
The Exchange Traded Fund
Exchange Traded Funds are products whose net asset value (NAV) is derived from an underlying basket of securities. Those underlying securities may be stocks, bonds, or other derivative products (even other ETFs). The fund may passively or actively track a specific benchmark. Furthermore, an ETF can choose a full replication strategy or an optimized strategy for tracking an index. In the fully replicated strategy, the fund will hold everything that the index holds in its precise weighting. On the other hand, in an optimized strategy, the fund will seek to hold the parts that capture the performance of the desired index while maintaining a minimal amount of tracking error. For instance, a full replication strategy works well for an index with a relatively small number of constituents. A fund issuer may choose an optimized approach when the index is exceptionally large (several thousand constituents) and the holding of the various underlying securities would become unwieldy.
Is it a Debt or an Equity instrument?
An Exchange Traded Note is a common structure that is often confused with ETFs. ETNs are actually debt instruments. “What does that mean?” you may rightly ask. An ETN is not equity like a typical stock, nor does it hold underlying equities like an ETF. An Exchange Traded Note is senior, unsecured, unsubordinated debt issued by a bank. The key word in that last sentence is unsecured. That means that the ETN is based on the credit worthiness of the bank that issued it. That is not a horrible thing considering the typical banks issuing ETNs are large, well capitalized institutions. That said, it is important to know what you are actually buying when you purchase an ETN. An ETN may loose value if its issuing bank runs into trouble. In a sense, there is a concentration of risk when you purchase an ETN compared to the diversification that other structures may provide. Many commodity-tracking products utilize the ETN structure. This makes sense because it can be difficult to obtain and hold physically settled commodities.
The Original Gangster . . .
Some people would be quite surprised to know that several of the most commonly traded products are Unit Investment Trusts. Most famously, the S&P 500 SPDR (SPY), is a UIT. Although UITs hold a portfolio of underlying securities similar to an ETF, the salient difference is a defined end date to the product. It may seem odd, but SPY has an end date defined in its prospectus that reads:
The Trust is scheduled to terminate on the first to occur of (a) January 22, 2118 or (b) the date 20 years after the death of the last survivor of eleven persons named in the Trust Agreement, the oldest of whom was born in 1990 and the youngest of whom was born in 1993.
In addition to a termination date, some funds will terminate if the net assets dip below a certain threshold. Although they appear a bit quirky, the UIT structure has performed well and has held up through the evolution of the ETP industry.
Know what you’re buying . . .
Although this is all very interesting, the most important takeaway is one must understand what one is buying. Today, there is no real excuse for not educating oneself on one’s investments. If you are going to be involved in the market, you don’t have to be a professional to get information on the markets. The simplest thing you can do is read the prospectus, or at least the summary prospectus. Additionally, the Education section of this site can provide a wealth of information to better prepare you for the complexities of today’s market.