Wealth Matters: Exchange-Traded Funds Grow in Complexity

Its selling point is its simplicity: the shares are liquid, the fees are low and the holdings are easy to see. It and the many exchange-traded funds that followed were the foundation for the movement toward low-cost, passive investing that aims to increase returns by eliminating the inconsistent performance of many active investors: the fund will track whatever index it is following.

At a lunch to observe the anniversary, Jim Ross, a senior managing director at State Street Global Advisors and one of the creators of the Standard Poor’s E.T.F., which trades as SPY, said that the funds would continue over the next 20 years to be vehicles that allow people to invest in increasingly sophisticated ways.

The funds now represent a nearly $2 trillion industry, which promotes itself as easy for the average investor to understand but, as Mr. Ross indicated, is becoming ever more complex.

HISTORY The genesis of SPY was a report on the causes of the 1987 stock market crash that said that a way to trade a marketbasket of stocks would have lessened the impact of the crash. From that, an executive at the American Stock Exchange got the idea to bring together a group of commodity traders, index managers, accountants, economists and a specialist trading firm to work out the logistics of trading an entire index as if it were a single stock.

After State Street created SPY, iShares followed three years later with a host of funds that tracked different indexes in large economies, like Britain, Japan and Australia. State Street countered in 1998 with a series of funds that invested in sectors, like technology and energy, and the race was on.

Today, there are over 1,200 exchange-traded funds in the United States alone, and another 1,700 in Europe, according to ETF Global, a data provider. Many track indexes or baskets of stocks for a particular country or industry.

The funds have allowed clients and advisers to easily take a broad position. Pooneh Baghai, a senior partner at McKinsey Company, said that simplicity had allowed advisers to act more like chief investment officers, focused on asset allocations, and not stock pickers in search of a couple of winning investments.

Like most financial products, exchange-traded funds started out simple and have grown complex. The newest innovations are funds that offer enhanced returns — known as levered, or leveraged, funds — and manage volatility. The E.T.F. label gives the funds the veneer of simplicity but they can produce outcomes that investors did not expect.

One example is a fund that resets its leverage each day. Greg Peterson, director of research at Ballentine Partners, said he showed clients how they could end up losing more money than they expected.

Consider a regular S. P. 500 E.T.F. and an S. P. 500 E.T.F. that doubles the gains or losses. Both have $100 on Day 1. On the second day, the S. P. index drops 25 percent. The regular fund is down to $75; the levered one is down to $50. The following day the S. P. is up 50 percent. The regular fund rises to $112.50, and the levered one is at $100. On the fourth day, the S. P. drops 10 percent. The regular fund is down to $101.25, while the levered one is at $80.

“You’ve got to know what you’re buying,” Mr. Peterson said. “The E.T.F. will do what it says it will do. But people don’t know what to expect.”

ADVANTAGES Low fees and no distribution of taxes are two of the selling points that distinguish exchange-traded funds from mutual funds. But there are caveats.

Exchange-traded funds that allow people to invest in securities that may be less liquid or more complex would be expected to charge higher fees, and they do. The AdvisorShares Active Bear E.T.F., which focuses on betting against securities, charges 1.68 percent of the amount invested, while the average fee for most E.T.F.’s are 0.60 percent, according to ETF Global.

But even funds doing simple things charge differently. Vanguard’s S. P. 500 E.T.F. charges 0.05 percent. The iShares version costs 0.07 percent. But the State Street SPY, which is triple the size of the other two combined, charges the highest fee, 0.0945 percent. (The fee 20 years ago was 0.2 percent.)

Article source: http://www.nytimes.com/2013/02/02/your-money/exchange-traded-funds-grow-in-complexity.html?partner=rss&emc=rss