What are the Limitations and

Consequences of ETFs?
Niall H. OMalley
Portfolio Manager, Managing Director,
Blue Point Investment Management, LLC

Before delving into the limitations and unintended

consequences of Exchange-Traded Funds (ETFs) it is
important to define an ETF. Where did these investment vehicles originate? How significant are ETFs to
investors?
The first Exchange Traded Fund was launched in January
1993 by State Street Global Advisors under the ticker
symbol SPY. The ETF was designed to track the value
of the S&P 500 Index. It is quoted at 1/10 of the value
of the S&P 500. The ETF was marketed as a spider,
shorthand for Standard & Poors Depository Receipt
(SPDR), traded on the New York Stock Exchange.

The popularity of the S&P 500 SPDR led to a family of

products. Other fund management companies, such as
Barclays creator of iShares and Vanguard, followed
suit in short order and the universe of ETFs rapidly
expanded. The S&P 500 SPDR is still one of the most
popular ETFs. Its average volume exceeds 110 million
shares on a daily basis, and its assets under management
are over $171 billion.1

How Significant are Exchange Traded

Funds and Related Exchange Traded
Products?
As a financial innovation that is approaching its 22nd
anniversary, it is fair to say Exchange Traded Funds
and the related Exchange Traded Products have been
revolutionary. Investors have entrusted over $2 trillion to
this financial innovation. ETFs have grown in popularity
since they offer investors cost effective diversification
to markets, sectors, currencies and commodities. ETFs
have evolved into a family of closely related investment
vehicles known as Exchange Traded Products (ETPs).
ETPs include Exchange Traded Notes, Leveraged ETFs,
Inverse ETFs, Exchange Traded Commodity Pools,
Exchange Traded Vehicles (ETV) and Active ETFs. The
success of ETFs and other Exchange Traded Products
is quite striking, especially when one considers the
number of companies traded on the New York Stock
Exchange and the NASDAQ,6,2512, compared to the
number of global ETFs and ETPs, 5,463. Most ETFs
and ETPs are traded in the U.S. There are 1,686 ETFs
and ETPs that invest in just U.S. securities and 3,777
that invest in varying levels of international securities.
Over 95% of the ETFs and ETPs are passively managed.
Once the exchange traded basket is established the
composition of the ETP is on autopilot, i.e. it is not
actively managed.
Note: Exchange Traded Products is often used as an
umbrella term. In the chart above Exchange Traded
Funds growth is detailed in the top line and growth
in other exchange traded structures is detailed in the
bottom line.

What Are Some of the

Benefits of ETFs?
Cost Effective Diversification
The primary strength of Exchange Traded Funds is
the cost effective passive diversification they offer an
investor. As an example, exposure to the S&P 500 Index

Figure 1. Global ETF and ETP Growth

3,000
2,400

4,000
Num of
ETFs / ETPs
3,200

1,800

2,400

1,200

1,600

Assets (US$ Bn)

600

800

0
2005

2006

2007

2008

ETP Assets

2009

2010

2011

2012

# of ETFs

ETF Assets

2013

Sep-14

# of ETPs

Source: http://www.etfgi.com/index/cookie

can be gained through the purchase on one share of

the S&P 500 SPDR ETF rather than purchasing 500
separate securities. The expense ratio for the S&P
500 SPDR is 0.09% which is very low. The average
institutional ETF expense ratio is 0.562%. ETF holdings vary widely from less than 10 securities to over
16,000 securities. An ETF, like a mutual fund, pools
the assets of multiple investors; however, ETFs tend to
be significantly less expensive and offer instantaneous
pricing information during the trading day rather than
once daily pricing as is the case with mutual funds.
Each share in an ETF represents an undivided interest
in the underlying securities less the expense ratio. To
understand the pricing variations, an investor has to
factor in the type of ETF. An additional consideration
with mutual funds is the share class and whether a
sales fee is taken. When considering mutual funds, the
investor also needs to factor in the fee structure. The
table below provides insight into the expense ratio
variations in open end funds. Both mutual funds and
2005
2006
2007
2008
2009
ETFs are considered
open-end
funds,
i.e.
there2010
is not 2011
limitation on the number of shares that they can issued.
You will notice in the table below that passive ETFs do
not 3000
have mutual fund sales commissions referred to as
front-end load/ No load and back-end load/ level load.

4000
3200
2400
1600
800

2012

2013

Sep-14

2400

Deep Liquidity for Popular ETFs

The1800
larger ETFs offer deep liquidity, e.g. the iShares
MSCI Emerging Markets ETF founded by Barclays
and1200
now managed by BlackRock has an average
daily volume that exceeds 60 million shares and assets
under management exceed $36 billion. However, not all
ETFs are highly liquid. In fact, liquidity varies widely
among ETFs. Important liquidity considerations are
2 0 1 5 B A LT I M O R E B U S I N E S S R E V I E W

15

INDEXED FUNDS

ACTIVELY MANAGED FUNDS

Table 1. 2014 Lippers Quick Reference to Open End Fund Expenses

FRONT-END LOAD /
BACK-END LOAD /
NO-LOAD LEVEL-LOAD

All 2013 Total Expense Ratios

Asset-
Weighted
Average Average

0.709

ALL EQUITY
ALL US DIVERSIFIED EQUITY (USDE)
Large-Cap
Multi-Cap
Mid-Cap
Small-Cap
BALANCED/MIXED EQUITY
OTHER DOMESTIC EQUITY
Alternative
Equity Income
Specialty Diversified
SECTOR EQUITY
ALL WORLD EQUITY
Global
International
Precious Metals
Other World Equity
ALL FIXED INCOME
ALL TAXABLE FIXED INCOME
ALL DOMESTIC TAXABLE FIXED INCOME
Short/Intermediate Taxable Fixed Income
Long Taxable Fixed Income
WORLD TAXABLE FIXED INCOME
ALL MONEY MARKET
Taxable Money Market
Tax Exempt Money Market
ALL MUNICIPAL DEBT
Short/Intermediate Municipal Debt
Long Municipal Debt

0.846 1.294
0.832
1.204
0.732 1.083
0.872 1.222
0.977 1.254
1.069 1.307
0.676 1.141
0.931
1.536
1.421 1.74
0.805 1.138
1.78 1.756
0.882 1.317
1.003
1.427
0.991 1.366
0.932 1.35
0.967 1.351
1.283 1.592
0.482
0.741
0.654
0.894
0.625 0.86
0.553 0.746
0.695 0.947
0.929
1.074
0.194
0.182
0.204 0.181
0.162 0.185
0.523
0.732
0.402 0.675
0.604 0.76

1.677 2.028
1.654
1.937
1.54 1.837
1.798 1.936
1.778 1.996
1.712 2.051
1.57 1.856
1.739
2.116
1.928 2.28
1.641 1.832
2.493 2.413
1.935 2.125
1.884
2.185
1.799 2.099
1.845 2.137
1.946 1.971
2.144 2.35
0.71
1.335
1.508
1.62
1.513 1.588
1.409 1.436
1.595 1.692
1.47
1.805
0.19
0.186
0.193 0.187
0.168 0.183
1.341
1.459
1.308 1.404
1.355 1.479

0.82 1.105
0.743
1.033
0.673 0.943
0.716 0.985
0.867 1.085
0.923 1.168
0.745 0.95
1.026
1.293
1.238 1.49
0.756 0.97
1.379 1.311
0.831 1.157
0.906
1.213
0.856 1.185
0.829 1.137
1.013 1.012
1.101 1.378
0.304
0.561
0.543
0.757
0.519 0.726
0.46 0.634
0.629 0.822
0.69
0.914
0.146
0.162
0.144 0.157
0.178 0.18
0.513
0.571
0.481 0.528
0.565 0.599

ALL INDEXED FUNDSINCLUDES ETFs

0.161

1.641

0.249

ALL EQUITY
ALL US DIVERSIFIED EQUITY (USDE)
Large-Cap
Multi-Cap
Mid-Cap
Small-Cap
BALANCED/MIXED EQUITY
ALL OTHER DOMESTIC EQUITY
S&P 500 Index
SECTOR EQUITY
ALL WORLD EQUITY
ALL FIXED INCOME
ALL (PASSIVE) ETFs
ETFs - USDE
ETFs - Sector Equity
ETFs - World Equity
ETFs - Other Equity
ETFs - Fixed Income

0.166 0.869
0.167
0.758
0.362 0.813
0.122 0.895
0.191 0.559
0.198 0.721
0.272 0.71
0.135
1.2
0.117 0.437
0.24 0.414
0.209
0.748
0.135
0.573
---
---
---
---
---
---
---
---
---
---
---
---

---

ETFs - Equity
ETFs - Fixed Income

ALL FUNDSACTIVE & INDEXED

---
---

0.833

---
---
---

0.638 1.087

1.091

1.765

AssetWeighted
Average Average

ALL ACTIVELY MANAGED FUNDS

ALL (ACTIVE) ETFs

1.104

Asset-
Weighted
Average Average

INSTITUTIONAL

1.964

1.631 1.972
1.782
1.791
2.183 2.021
1.267 1.66
1.417 1.798
1.234 1.713
1.818 1.776
1.386
2.14
1.069 1.236
1.916 1.998
1.587
1.798
1.748
1.889
---
---
---
---
---
---
---
---
---
---
---
---

---
---
---

---
---
---

1.095 1.775

0.499

0.904

0.530

0.256 0.563
0.164
0.396
0.187 0.358
0.102 0.468
0.156 0.366
0.235 0.399
0.353 0.457
0.149
0.77
0.079 0.399
0.37 0.613
0.405
0.562
0.216
0.364
0.288
0.561
0.182 0.348
0.377 0.618
0.402 0.566
0.198 0.845
0.273 0.39

0.618

0.743

1.483 1.188
0.511 0.54

0.422 0.841

Source: Peter De Sousa Barrote, Fiduciary Services Specialist, Lipper http://www.lipperweb.com/Research/Fiduciary.aspx

16

2 0 1 5 B A LT I M O R E B U S I N E S S R E V I E W

the average trading volume, assets under management,

plus the strength of the counterparties authorized
participants that create and redeem the ETF shares.
Another consideration is the complexity of the ETF in
terms of the number of securities held. Each security is
dependent on a functioning market for price discovery
which can be interrupted by trading halts and flash
crashes.
New Investment Approaches
Investors, both individual and institutional, can use
ETFs to gain rapid, cost effective diversification to
markets, sectors and various strategies, e.g. growth
and/or value. The explosion of the ETF universe has
expanded the toolset available to investors. A popular
investment approach is a combination of active and
passive investing. Investors may also take an active
management approach incorporating individual securities or actively managed funds. This is referred to as
seeking alpha. The investor is seeking a return above
the market return represented by market indexes. Some
investors prefer to pursue a purely passive approach
with ETFs and ETPs which limits down side risk offering a weighted average return.

What are Some Limitations and

Unintended Consequences of ETFs?
Short-term Trading, Taxes and
Lower Realized Price
Perhaps the biggest ETF limitation is behavioral. ETFs
are credited with being less work. All an investor has to
do is buy the basket of securities represented by an ETF
and the benefits of diversification are gained. While it is
true that ETF investing involves less work, it creates an
unintended consequence of creating less conviction in
the face of adversity a market selloff. This increases
the chance that the investor will become more reactive
and short-term oriented. For taxable investors, this
introduces the higher short-term capital gains rate. It
is important to note that taxes are not the only cost.
A potentially even greater cost is incurred when an
investor sells during a market selloff and realizes a loss.
Performance Limitation The Best Return
is an Average/Weighted Average Return
If you had a child, would you encourage them to get Cs
in school? The frequent encouragement from parents
is to seek As and Bs. Why does the same rule not apply
to your investments? How often does an index double?

The answer is not that often. When an investor invests

in an ETF, it is important to realize that they are electing
to receive an average return for the invested amount.
An average grade in school is a C. The return of an ETF
is the weighted average of the underlying securities less
the expense ratio. In short, while the ETF assets benefit
from diversification there is a performance limitation.
A Less Transparent Issue
Tracking Error & Counterparty Risk
An ETFs market price can trade at a premium or a
discount to the value of its underlying securities. Wider
bid/ask spreads occur when an ETF or security is thinly
traded which creates additional investment costs. The
creation and redemption of ETF units is dependent on
counter parties that are referred to as authorized participants. An ETF fund manager enters into contractual
relationships with one or more authorized participants.
Authorized participants create ETF fund shares in large
increments typically 50,000 fund shares. The authorized participant or participants seek to minimize pricing
differences between the market value of underlying ETF
securities and the net asset value of the ETF. Authorized
participants seek to arbitrage the pricing differences but
are dependent on functioning markets and stability of
their broker dealer operations. Flash crashes and other
market disruptions associated with high frequency
trading arbitrage can create tracking error.
Structure Risk
As the popularity of ETFs has grown, it has given way
to an alphabet soup of Exchange Traded Products
which include alternative ETFs, Exchange Traded Notes
(ETNs), alternative ETFs, exchange traded vehicles
(ETVs), exchange traded commodities or currencies
(ETCs), and other types of structures. It is important
to note that the product structures of the newer ETPs
in turn create unique risks for investors.
From a structure and regulatory perspective, ETFs are
open-ended investment companies that offer investors
an undivided interest in the underlying securities of the
fund less expenses. The same is not true with Exchange
Traded Notes (ETNs). An an ETN is just a credit obligation from the issuer, i.e. there is no collateral. The
credit obligation is only as good as the balance sheet
of the issuer. This became a painful lesson for investors
in the Lehman Brothers ETN products as they did not
own the underlying collateral, and therefore, became
unsecured creditors in the Lehman bankruptcy.

Alternative ETFs give investors the potential to invest in

investment options that are leveraged and/or inversely
correlated to its index benchmark. Typically, alternative
ETFs are designed to generate daily returns that are
a positive or negative multiple of its benchmark, e.g.
stock indexes, currencies and commodities. The math
of daily settlements introduces the risk of significant
tracking error, and introduces a tax liability that does
not exist with traditional ETFs. The primary collateral
for alternative ETFs are the derivative contracts and
money market instruments used to create the leveraged
or inverse exposure.

Sources:
https://www.spdru.com/?internalR
edirect=https%3A%2F%2Ffanyv88.com%3A443%2Fhttps%2Fwww.
spdru.com%2F&_new_user=1#/
content/debunking-myths-and-common-misconceptions-of-etfs
https://www.spdru.com/?internalR
edirect=https%3A%2F%2Ffanyv88.com%3A443%2Fhttps%2Fwww.
spdru.com%2F&_new_user=1#/
content/9-questions-every-etf-investor-should-ask-before-investing
https://www.fidelity.com/learningcenter/investment-products/etf/
drawbacks-of-etfs
http://www.forbes.com/sites/
rickferri/2013/09/02/etf-fees-creephigher/

Local Firm Participation

A Bethesda, Maryland firm, ProShares, is the worlds
largest provider of leveraged and inverse ETFs. ProShares has grown from one fund in 2006 to over 145
alternative ETFs. Another Bethesda, Maryland, based
firm is AdvisorShares which offers 28 actively managed
ETFs. Actively managed ETFs were first approved by
the Securities and Exchange Commission in 2008. The
actively managed ETF adds an active management
component to the ETF structure that has otherwise
been passively managed. T. Rowe Price has received
regulatory approval to issue actively managed ETFs.
Legg Mason has also received approval from the Securities and Exchange Commission to begin issuing actively
managed ETFs.

https://www.fidelity.com/
viewpoints/active-trader/no-stopping-ETFs
http://www1.nyse.com/about/listed/
nya_characteristics.shtml
http://www.lipperweb.com/
Research/Fiduciary.aspx
http://etfdb.com/compare/marketcap/
http://www.ici.org/pdf/per20-02.pdf
http://www.etfgi.com/index/cookie

Endnotes
1
ETF Database Top 100 ETFs by
Assets 10/16/14 NYSE 3,296 and
NASDAQ 2,955 as of 10/16/14
2

Investment Considerations

ETFs 3,868 and 1,595 ETPs

Before making any investment, it is important to identify your goals and understand the limitations and
opportunities associated with the investment you are
considering. Do you want the weighted average return?
Faced with a market selloff do you have conviction
about your investment? Are you familiar with the fund
manager? What is the underlying collateral? Exchange
Traded Funds and Products have expanded the investable universe for investors. One of the most important
benefits that ETFs and ETPs offer is their ability to
diversify a portfolio. This is especially true in emerging
and developing markets where investment options may
not otherwise be accessible. Whether investing in an
ETP or a listed company, it is important to research
your investment. Due diligence is a key consideration
that should not be overlooked whether investing passively, actively or in a blended approach.

2 0 1 5 B A LT I M O R E B U S I N E S S R E V I E W

17