Investing in Etfs

Are ETFs a good investment?  Well, as any other investment it has pros and cons.  ETFs have taken the investment world by storm and even though they are still a small player compared to mutual funds, their growth rates are astonishing.  It might be the case some time in the future ETFs will take over mutual funds as a diversified investment vehicle of choice.  This seems to be more likely as many investment managers enter the ETF arena and demand continues to grow.  It needs to be said that the growth of the ETF market was expected, since there are numerous benefits offered to investors of ETFs.  Those benefits include:

Diversification Lower fees Ability to trade (buy/sell) throughout the day Easier way to gain exposure to a specific asset class, geographical location.

However, investors also need to appreciate ETFs are not the answer to everything.  In some instances it does not really offer any differences, from let’s say investing in the index through a mutual fund.  Keep in mind that ETFs is just a diversified portfolio of certain investments, hence it is still likely to act as an index or a sector or an asset class.  It may exhibit the same degree of volatility, upside and downside.  However, there is one main thing that an investor needs to understand when investing in the ETF.  

Even though there is a NAV, which value is based on the price of underlying securities, the price that one would receive is dictated by the market.  It is dictated by the supply and demand.  If everyone decides to buy China ETF, therefore creating a huge demand, chances are the price will exceed the NAV, which is a true value of the ETF.  Hence, the pricing of the ETF might not be efficient.  A great example are two ETFs from Direxion, FAZ and FAS.  One is the financial bull ETF, the other is the financial bear ETF.  Since these funds offer two opposite investments, you would expect them to move similarly, meaning one goes up $1 the other falls $1.  Well, that has not been the case, primarily due to the demand.  

The two questions an investor should ask at this point are, ‘Do I want to invest in something that might not necessarily reflect the true value?  If so, can I actively monitor this investment to make sure that I will not get burned if the demand disappears and the price falls back to reflect the true value?’  Of course it needs to be said that this can actually work in investor’s favour.  That is if and ETF is bought at the discount to NAV, which is may not be the case historically, eventually at some point the price may catch up with the NAV and hence provide a nice return.

Eventually ETFs may evolve as it is a still relatively new investment vehicle, but until then an investor should understand what are the benefits, what are similarities and what are the downsides of this investment.