ETF risk, Management

The legal structures of unit investment trusts (UITs) and grantor trusts (GTs) don’t permit portfolio management, so there is only a small risk of management error.  By contrast, open-end investment companies (OEICs) and limited partnerships (LPs) have a managed portfolio with the associated risks of lending, borrowing, and rebalancing assets.

1. Managers can earn extra fees by lending portfolio assets, but at risk of delaying the redemption of ETF shares during times of high demand and acquiring undesired collateral assets.  Delayed redemption can result in the portfolio’s loss of net asset value and the systemic risk of failed trades.  UITs and GTs aren’t permitted to lend assets^1,2.
2. The supplemental use of derivatives (e.g., swaps) is a form of borrowing that can acquire undesired collateral assets with low liquidity.
3. The rebalancing of assets incurs operational costs that increase fund expenses and may inflate the tax burden of investors.  The annual “portfolio turnover” is a measure of rebalancing activity.  A 100% turnover means that the entire portfolio is replaced in one year, in which case any capital gains are classified as short-term and taxed at higher rate than long-term gains³.

copyright © 2012 Douglas R. Knight

References

1.   BIS Working Papers No 343: Market structures and systemic sisks of Exchange-traded funds. Srichander Ramaswamy, Monetary and Economic Department of the Bank for International Settlements, April, 2011.

2.  Exchange-Traded Funds: Too much of a good thing. The risks created by complicating a simple idea, June 23rd 2011, The Economist.

3.  Portfolio Turnover.  Richard Loth, Investopedia.com.