Restricted redemption. Unlike ownership in mutual funds, retail investors cannot redeem ETF shares at net asset value. Retail investors can only sell shares in the stock market at prices that might be quoted at a premium or discount relative to net asset value.
Trading risk. The risks of trading ETFs in the stock market include high-frequency trading, large-volume trading, “circuit breaker rules”, and “shorting”. Some ETFs may be an institution’s preferred vehicle for trading, in which case the fast trading of large volumes can increase market volatility. A large sell-off of ETF shares possibly contributed to the May 6, 2010, “flash crash” of stock prices13,14,15. The “circuit breaker rules” require stock exchanges to pause trading when there is a rapid, severe decline in market price. The pause duration depends on the severity of decline and the time of the trading day16. “Shorting” of either the underlying assets or ETF shares outstanding involves borrowing the assets, or shares, at market price, selling them at a different market price, and returning the borrowed assets, or shares, to the lender. The lender charges a fee and the borrower (“short seller”) incurs a profit or loss. A hidden risk of these activities is “failed trades” as evidenced by delayed or cancelled settlements. ETFs may lend no more than a third of their underlying assets. Mutual fund shares cannot be lent to short sellers17,18.
copyright © 2011, Douglas R. Knight
13. SEC Looks Into Effect of ETFs on Market, Scott Patterson, Wall Street Journal, September 7, 2011.
14. Choking the Recovery: And Unrecognized Risks Of Future Market Disruptions. Harold Bradley and Robert E. Litan. Published Nov. 8, 2010, revised Nov. 12, 2010. © 2010 by the Ewing Marion Kauffman Foundation. All rights reserved.
15. Exchange-Traded Funds: Too much of a good thing. The risks created by complicating a simple idea, June 23rd 2011, The Economist.
16. Circuit Breakers and Other Market Volatility Procedures. U.S. Securities and Exchange Commission, Modified: 08/09/2011.
17. Ari L. Weinberg. Exchange Traded Funds: When ETFs are Lenders. Wall Street Journal, July 6, 2011.
18. Canaries in the Coal Mine. Systemic Risk for Financial Firms and Investors. March 2011. © 2011 by the Ewing Marion Kauffman Foundation.
The legal structures of unit investment trusts (UITs) and grantor trusts (GTs) don’t permit portfolio management, so there is only a small risk of management error. By contrast, open-end investment companies (OEICs) and limited partnerships (LPs) have a managed portfolio with the associated risks of lending, borrowing, and rebalancing assets.
- Managers can earn extra fees by lending portfolio assets, but at risk of delaying the redemption of ETF shares during times of high demand and acquiring undesired collateral assets. Delayed redemption can result in the portfolio’s loss of net asset value and the systemic risk of failed trades. UITs and GTs aren’t permitted to lend assets1,2.
- The supplemental use of derivatives (e.g., swaps) is a form of borrowing that can acquire undesired collateral assets with low liquidity.
- The rebalancing of assets incurs operational costs that increase fund expenses and may inflate the tax burden of investors. The annual “portfolio turnover” is a measure of rebalancing activity. A 100% turnover means that the entire portfolio is replaced in one year, in which case any capital gains are classified as short-term and taxed at higher rate than long-term gains3.
copyright © 2012 Douglas R. Knight
1. BIS Working Papers No 343: Market structures and systemic sisks of Exchange-traded funds. Srichander Ramaswamy, Monetary and Economic Department of the Bank for International Settlements, April, 2011.
2. Exchange-Traded Funds: Too much of a good thing. The risks created by complicating a simple idea, June 23rd 2011, The Economist.
3. Portfolio Turnover. Richard Loth, Investopedia.com.