Are there any negative aspects to ETFs?

No investment is perfect and neither are ETFs. Investors always gravitate to new investment vehicles with greater enthusiasm than they do for older, well-established investment vehicles. It seems almost every week new exotic or specialized ETFs are launched by ETF providers and investors are often better advised to wait before investing until the new ETF has established a bit of a track record.

The ETF structure is reliant on the efficiency of the Creation and Redemption process for the ETF share price to track the net asset value (NAV) of the underlying constituents or benchmark. While the average deviation between the daily closing price and the daily NAV of ETFs that track domestic indexes is generally less than 2%, the deviations may be more significant for ETFs that track certain foreign indexes or less liquid constituents.

Note: The Wall Street Journal reported in November 2008, during a period of market turbulence that some lightly traded ETFs frequently had deviations of 5% or more, exceeding 10% in a handful of cases. Therefore, the settlement process for some ETFs may cause pricing deviations when compared with NAVs, during volatile market conditions.

There is also a growing opinion that ETF trades made immediately after the market opens tend to create the greatest deviation between an ETF’s NAV and its trading price. This deviation in pricing has caused many investors to avoid buying and selling at the opening of stock markets.

Individual ETFs will also have varying Tracking Error margins. Even though an ETF is designed to mimic or track the performance of the underlying constituents or benchmark, they all have varying degrees of Tracking Error. The ETF’s Tracking Error may be influenced by the annual MERs, the design and structure of the ETF, the liquidity of the ETF, and the efficiency of the Creation and Redemption process.

A portion of the Tracking Error can be attributed to the dramatic growth in new ETFs targeting exotic investments or areas where trading is less frequent, less liquid, such as emerging-market stocks, future-contracts based commodity indices and junk bonds.

The stated Income Tax advantages of ETFs are of little importance for investors using tax-deferred accounts, such as TSFAs, RRSPs, or RRIFs, or investors who are tax-exempt. However, the lower expense ratios are proving difficult for the proponents of traditional mutual funds to overcome.

In a survey of investment professionals, the most frequently cited disadvantage of ETFs was the unknown, untested indexes used by many ETFs, followed by the overwhelming number of choices. Many of the new ETFs are attached to newly created, untested indices. Many of these newly manufactured ETFs create an Index first, “Back Test” the constituent’s historical data, and then create the ETF for marketing to investors. As such, these ETFs present a sizeable risk to investors because they lack a history or track record.

Note: As an aside, Back Testing is used to market a newly created investment vehicle using historical data as a Track Record for the new, previously non-existent investment vehicle. For example, if we started a brand new mutual fund that only holds shares of Google, then in our marketing literature we tell investors, “If we had started the mutual fund on the day that Google shares were first sold to the public, at $85.00, our mutual fund would be worth over $600.00 today and it would have given us an investment return of over 600%.”  Back Testing uses historical data to support the viability and potential success of the underlying investment. It is great for marketing a new investment vehicle, but not so reliable as a basis for an investment decision.

Note:  In addition, there is a school of thought that ETFs can be, and have been, used to manipulate stock market prices higher and that ETFs have been used for short selling that may have contributed to the stock market collapse of 2008 – 2009. These views are difficult to support with data or statistics, but may hold some truth given the increasing use of ETFs by individuals and institutions.

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