Too many investors and even their financial advisors are not paying enough attention to “what’s under the hood” of exchange-traded funds (ETFs) that have become so popular with investors in the past two or three years, according to S&P equity analyst Todd Rosenbluth.

Total ETF assets are now valued at more than $980 billion and more than 100 new ETFs were created this year alone, bringing the total number of ETFs available to investors to more than 1,000.  

"Many investors, and even financial advisors, are treating ETFs almost like stocks, buying and selling them without really bothering to do due diligence about what is actually in them and what the risks and volatility are," Rosenbluth said in an interview with Financial Planning.

While fraud is not likely to be a major problem with ETFs in the U.S. where counterparties that run and develop the synthetic indexes for some ETFs are barred from actually managing and marketing the ETFs, there can be major risks in ETFs that use derivatives -- an increasingly common practice.

Rosenbluth said to help advisors and investors do that due diligence, S&P Equity Research has developed a risk considerations ranking for ETFs.

Three of the risk measures are based upon assessing an ETF’s underlying holdings, while the fourth looks at the ETF’s standard deviation which measures its historical volatility. 

On that basis, he said the two ETFs with the lowest standard deviations were SPDR Global Dow ETF (DGT), and iShares S&P Global 100 Index Fund (IOO).  DGT’s top 10 holdings include Caterpillar and Siemens, while IOO’s top 10 holdings include Exxon Mobil and IBM.

While most financial advisors should have easy access to third-party research to allow them to learn about the inner workings and risks of an ETF, Rosenbluth said much of that due diligence work can also be done by an individual advisor or investor. 

“If the ETF manager has the ability to use derivatives, that has to be disclosed in the prospectus,” he explained. “That doesn’t tell you if they are actually investing in derivatives, but you should be able to find that out on a fund’s website.”

He said it is also easy to determine exactly what holdings are in an ETF and that it is important to evaluate those holdings in terms of risk, for example, whether the ETF holds actual stocks, or just futures tied to an index or a mix of the two. 

"The more investors understand the underlying holdings of an ETF, the more comfort they will likely have about selecting them for their portfolios," he said.



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