Assessing Risk: ETFs, CEFs and ETNs
03/28/2017 2:50 am EST
Ask yourself a question before you invest in any fund: How much risk am I taking? In many cases, it might be more than meets the eye, cautions Richard Moroney, editor of Dow Theory Forecasts.
Below we review various risks for three widely held types of funds.
Exchange-traded funds (ETFs)
The popularity of ETFs partly reflects the fact that they are easy to trade. Unlike open-end mutual funds, you can buy and sell ETFs throughout the day, just like a stock.
You can even use limit and stop orders. But during volatile or fast-moving markets, don’t assume a fund’s market price will track its net asset value (NAV), the underlying value of its holdings.
For example, on the morning of Aug. 24, 2015, amid a “flash crash,” some 1,278 trading halts were triggered on ETFs and their underlying stocks. The halts and delays caused institutional traders to widen their bid-ask spreads, which disrupted the pricing of ETFs.
That morning, the SEC found that about one-fifth of all ETFs plunged more than 20%, while only 5% of stocks fell that much.
Since then, the major exchanges appear to have improved the trading of ETFs. On June 24, when the Brexit vote was announced and the S&P 500 Index fell 3.6%, there were only 68 trading halts.
Closed-end funds (CEFs)
These funds often trade at a discount to their net asset value, largely because supply and demand determines the market price. For example, the average U.S. closed-end stock fund trades about 7% below the intrinsic value of its portfolio.
Several factors influence demand, including potential tax liabilities from unrealized gains and a fund’s use of leverage (borrowings used to buy additional securities), which can increase share-price volatility and expenses.
Buying a closed-end fund at a discount sounds like a great deal. But the spread can widen and hurt performance. For example, suppose you pay $9 for a closed-end fund with an NAV of $10, putting the spread at $1.
Fast forward 12 months: Assuming the NAV climbs 5% to $10.50 but the spread widens to $2, the market price would be $8.50, implying a loss of nearly 6%. To put a fund’s discount in perspective, compare it to its historical average.
Exchange-traded notes (ETNs)
Similar to exchange-traded funds, ETNs track baskets of securities and trade like stocks. But unlike ETFs, ETNs don’t own the actual underlying holdings.
Instead, they are debt securities — typically issued by a financial company — engineered to mimic the performance of an index or strategy. The issuer simply promises to pay the shareholder the return of an index, minus any fees.
Because ETNs are unsecured debt, the creditworthiness of an issuer will impact the market value. While some issuers offer collateral to help reduce the risk, performance ultimately depends on an issuer’s ability to pay.
So while an ETN’s underlying value, called the indicative value, may not change in response to a decline in an issuer’s credit quality, the market price of the ETN’s shares may drop.
Note that many ETNs track volatile market segments, including commodities and foreign currencies. In addition, some use leverage to magnify returns and potentially increase volatility.