ETFs and ETNs: A Cautionary Tale

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On ETFs

ETFs and ETNs: A Cautionary Tale
Michael Iachini
CFA, CFP®, Director, Investment Manager Research, Charles Schwab Investment Advisory
September 28, 2009

Key points

The more exotic the strategy, even in an ETF, the greater the potential for unpleasant capital gains surprises.
If you buy ETNs, be aware of the credit risks involved.
If you invest in ETFs, we suggest that you favor traditional, broad-based ones. See our most important criteria.

Despite market volatility, the popularity of ETFs continues to rise.

Investors withdrew $226 billion more than they deposited into long-term mutual funds in 2008,¹ but deposited $177 billion more than they withdrew from ETFs during the same period.²

However, not even the growing ETF market was immune to difficulties in 2008. Investors learned that, although many ETFs typically are tax-efficient funds that reliably provide investors with exposure to a benchmark index, there are exceptions.

During periods of time last year, some ETFs traded at prices far from the underlying value of the funds' assets. Some ETFs made huge taxable capital gains distributions. And the failure of Lehman Brothers, a Wall Street institution, made certain exchange-traded notes (ETNs) worthless.

Market price and net asset value: Not always equal
ETFs are often seen as combining the best features of mutual funds and stocks into one package.

As with a stock, you can buy or sell ETF shares at any time during the day.

As with a mutual fund (and unlike with a closed-end fund), the price you pay for an ETF on an exchange will generally be close to the value of the underlying stocks or bonds in the fund—the net asset value (NAV).

For most big, heavily traded ETFs, this close relationship between market price and NAV continues to be true in all market environments.

However, during the extreme volatility of 2008, this relationship became strained in many cases—especially for bond ETFs.

Very few people were willing to buy or sell bonds, which made it impossible for big investors to make the trades that keep exchange prices close to NAVs (see "Keeping prices close to NAVs" below). This problem occurred not only in riskier high-yield bond ETFs, but even in high-quality corporate and broad-market bond ETFs.

At one point, the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) traded at more than 11% below its NAV while at another point, it traded at more than 2% above its NAV.³

If you bought shares of this ETF when it was trading above its NAV and sold them when it was trading below, you could have lost more than 13% of your investment without the bonds in the fund even changing value at all.

Big capital gains from some inverse ETFs
We believe ETFs are usually very tax-efficient. Most ETFs can avoid making the capital gains distributions that many mutual funds must make. That means that investors will generally realize capital gains only when they sell ETF shares for a profit.

This isn't always the case, though. In 2008, a group of smaller ETFs made capital gains distributions ranging from 12% to 86% of their assets.⁴

These were all leveraged inverse funds that aim to provide a return equal to two times the opposite of their index. Due to their complicated nature and small asset bases, these ETFs were unable to reduce their capital gains exposure in the way that more traditional stock and bond ETFs generally could.

Our conclusion: The more exotic the strategy, even in an ETF, the greater the potential for unpleasant capital gains surprises.

Impact of the Lehman Brothers collapse
In the fall of 2008, when Lehman Brothers failed, investors became concerned about three ETNs that it managed.

Unlike an ETF—which represents an ownership share in a portfolio that is held separately from the assets of the company that manages the portfolio—an ETN is an unsecured bond offered by a company that promises to pay shareholders of the ETN the return on an underlying index.

So if the company offering the ETN goes bankrupt, holders of the ETN become creditors of the firm.

In fact, when Lehman went bust, shareholders of the three Lehman ETNs were left with securities that had become worthless. Shareholders' only hope now is that they will recover some pennies on the dollar in bankruptcy court.

The moral of the story: If you buy ETNs, be aware of the credit risks involved.

Not all ETFs are created equal
If you invest in ETFs, we suggest that you favor traditional, broad-based ones.

Use the ETF Center on our website to help you find ETFs that meet what we believe are important criteria:

Make sure your ETF has more than $50 million in assets.
Has more than $1 million in daily volume.
Isn't leveraged (avoid any ETF with "ultra," "short," "2x" or "3x" in its name) and isn't actually an ETN.

Keeping Prices Close to NAVs

ETFs usually trade at market prices that are close to the underlying NAVs of their stock or bond portfolios because large institutional investors (called Authorized Participants, or APs) can use arbitrage to profit from any difference between the fund's price and its NAV.

Let's say an ETF has a NAV of $20 per share but is trading at a market price of $19.80—a 1% discount to NAV. The AP can buy 50,000 shares of the ETF, deliver them to the ETF sponsor, receive in exchange shares of the underlying stocks or bonds equivalent to 50,000 ETF shares, and sell those stocks or bonds on the open market.

This nets a profit of 1% for the AP and also pushes up the market price of the ETF. The AP will keep doing this until the price equals the NAV.

If the ETF is trading at a premium to its NAV, the AP will buy shares of the underlying stocks or bonds, give them to the ETF sponsor in exchange for new ETF shares, and sell those ETF shares on the market, pushing the price back down toward its NAV.

However, if the stocks or bonds become difficult to trade on the market because other buyers and sellers are nervous, it may be difficult for the AP to engage in this arbitrage trading, meaning that prices and NAVs can diverge.

Important Disclosures

1. 2009 Investment Company Fact Book (http://www.ici.org/pdf/2009_factbook.pdf)
2. 2009 Investment Company Fact Book (http://www.ici.org/pdf/2009_factbook.pdf)
3. IndexUniverse.com, As Arbitrage Falters, Bond ETFs Teeter, December 17, 2008, www.indexuniverse.com/sections/features/5068-broken-bond-etf-arbitrage.html.
4. IndexUniverse.com, ETF Tax Shocker: Huge Payout for Rydex Inverse Funds, December 10, 2008, www.indexuniverse.com/sections/features/5047-etf-tax-shocker-huge-payout-for-rydex-inverse-funds.html.

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

Investors should monitor leveraged ETF holdings as frequently as daily.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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