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Analysis: Mainstream ETF investors may be missing best deal
February 15, 2012 / 9:41 PM / 6 years ago

Analysis: Mainstream ETF investors may be missing best deal

(Reuters) - Exchange-traded fund companies often tout their transparency. But retail investors in even the simplest of ETFs may not be getting a clear picture of what they own, how much they are paying for it, or what kind of risks they are taking.

Among the opaque areas: real-time holdings information, underlying ETF costs and risks associated with things like securities lending. The gaps in transparency sharply underscore the knowledge advantage professional traders have over individual investors, industry observers say.

These hidden items might not lead to million-dollar losses on the part of investors now, but with a growing number of retail investors trading ETFs, the issue has the potential to become a bigger concern. Case in point: 39 percent of ETF assets at Charles Schwab Corp are held by retail investors, up 16 percent in 2011 over the year before.

“ETFs are more transparent than actively managed mutual funds, but there are a lot of holes,” said Paul Justice, an ETF analyst at Morningstar. “And those holes could hurt investors.”

Thus far, regulators’ public concerns about transparency in the $1 trillion ETF industry have centered on the sale of more complex ETFs, like leveraged ETFs, which can be used to magnify returns, and inverse ETFs, which aim to deliver the opposite of the performance of the underlying index.

NOT SO REAL-TIME

Individual investors often do not have access to free, real-time information, which can result in overpaying for an ETF.

Professional traders have access to systems that show prices by the millisecond, but mainstream investors often rely on free websites such as Yahoo! Finance which post the price of last trade real-time for the Nasdaq exchange, and have a 15-minute delay on the bid-ask prices.

That could mean an investor may think he is buying an ETF at a discount, but he could actually be buying it at a premium.

“It’s the epitome of trading on poor information,” said Dave Nadig, director of research at IndexUniverse, which researches ETFs.

The worry, he said, is that an investor might call in to execute a trade based on what he sees on a free website and never double-check current stats via his brokerage website.

What’s more, ETFs that take short positions or invest in REITs can have added costs that investors can see only if they closely examine the discrepancy between the fund and its index.

For example, on Morningstar, the expense ratio of the AdvisorShares Accuvest Global Long Short ETF is 1.59 percent. Add in its shorting expenses and the fund’s real net expense ratio is 3.21 percent. But such information rarely filters down to third-party sites, industry experts said.

HIDDEN RISKS

Securities lending is a potential Pandora’s box of unseen risks or an unfair share of gains or losses for ETF investors. ETFs lend out shares and take bets with the collateral from the loans in an effort to spice up returns.

But despite the fact that ETF investors take on all the risk in securities lending, fund providers may keep a large share of any gains. At least one firm returns as little as 65 percent of gains to investors.

An astute investor could call the ETF provider to find out how much of the revenue it keeps, but they might not get an answer. It is nearly impossible to figure out what total revenues are, Nadig said.

BEHIND THE CURTAIN

ETF providers often say investors in the funds can see what they hold in real-time, but that is not always true.

Vanguard Group, for example, has $188 billion in ETF assets and discloses the holdings for its 64 ETFs at the same time as its mutual funds because the ETFs are structured as a share class of its mutual funds. But that means investors only get a window on holdings quarterly - and with a lag of up to 60 days on top of that.

This delay in disclosure could lead to overexposure to a specific security for a Vanguard sector ETF investor.

A fund, for instance, could be overweighted in certain securities as they are falling sharply or overlap with other investments they own. But a Vanguard ETF investor would not know that until months later, Nadig said.

“Big real estate investors who own Vanguard’s REIT ETF want to know which real estate investment trusts are in the fund because they don’t want to be double-dipping,” Nadig said.

Vanguard told Reuters that the U.S. Securities and Exchange Commission has said that providing real-time disclosures of its ETF holdings could hurt investors in its mutual funds by allowing outsiders to see fund holdings. Those outsiders could profit by making trades to front run Vanguard’s trades, said Joel Dickson, senior investment strategist at Vanguard.

Vanguard, like all ETF providers, must disclose daily what underlying securities an institional investor delivers to the ETF in exchange for shares. Those baskets usually represent the underlying holdings of the ETF, Dickson said.

But that is not always the case, and retail investors have no way of knowing if the baskets do not represent the underlying holdings, observers said. Professional traders, however, can access such information.

For an industry that prides itself on transparency, ETFs still have work to do, Justice said.

“Investors can’t assume they know every single thing about every ETF at a given time,” he said.

Reporting By Jessica Toonkel; Editing by Jennifer Merritt, Walden Siew and Matthew Lewis

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