Although some other kinds of mutual funds, for instance traditional closed-end funds, are also trade on an exchange platform, introduction of the Exchange Traded Funds ETFs become different. In general, the Exchange Traded Funds disclose their holdings at the start of every trading day to allow potential buyers and sellers to evaluate the traded Exchange Traded Funds price versus the price of the underlying holdings. Professional investors can create and redeem shares at the end of the day for net asset value, a feature that helps keep Exchange Traded Funds market prices aligned with fair value. 

In a short period since its creation, there have been more than 1,570 Exchange Traded Funds listed in the United States exchange market, with a total of almost 1.74 trillion USD in assets under management. In 2014, Exchange Traded Funds represented more than 11 percent of all mutual fund assets, up from 2 percent a ten years earlier, and they continue to attract both individual and institutional investor assets. More impressive was that in the same year, Exchange Traded Funds typically represented between 25 percent and 40 percent of the total dollar volume traded on United States exchange markets.

Advantages of Investing in the ETF

The future of Exchange Traded Funds outlook for continued growth is strong. In each of the past years since 2014, the Exchange Traded Funds attracted more than 100 billion USD in net inflows, swamping the inflows to traditional and mostly actively managed mutual funds. 

To understand this growth and continued potential, investor needs to understand the fundamentals of Exchange Traded Funds, evolution of Exchange Traded Funds as products, and how they are used in investment strategies. Further this explains how Exchange Traded Funds work, their unique investment and trading features, their regulatory structure, how they are used in tactical and strategic portfolio management in a broad range of asset classes, and how to evaluate them individually. The following are broad advantages that Exchange Traded Funds provide compared with earlier investment vehicles: 

• Easy Access. Exchange Traded Funds are a true democratization of investment access and capabilities. With Exchange Traded Funds, an individual investor can construct sophisticated global strategic allocations in all asset classes in way that was previously available only to large institutional investors, such as pension funds. Furthermore, Exchange Traded Funds are available to all investors, even in areas that were barely accessible to institutional investors, such as frontier markets and emerging market local currency bonds. Both investors and their advisers can construct tactical allocation strategies that incorporate a wide range of approaches that combine disparate asset classes and sub-asset-class slices based on style, size, and sector. 
• Highly Transparence. For investors, Exchange Traded Funds provide a huge leap forward in transparency. Investors know what is in their portfolios, and even the naming of funds is greatly simplified. 
• Liquidity and Price Discovery. Price discovery is especially vital for the smaller, less-liquid segments of United States equities, foreign markets, especially when they are closed and many corners of the fixed-income market. For foreign stock markets, especially during times of financial crisis, knowing the right price can be challenging. Since the late 1990s, country Exchange Traded Funds have played a vital role in providing both liquidity and price discovery. The best example is Malaysia in 1997–98 during the Asian financial crisis, when capital controls were imposed on foreign investors. Institutions were locked into Malaysian stocks, repatriation was complex and at times impossible. The United States-traded Malaysia WEBS ETF, later known as iShares MSCI Malaysia, was the only freely trading investment vehicle for this market. It was used by virtually the entire United States investment community, such as custodians, asset managers, asset owners, and even some index providers, to value Malaysian equity holdings. 

Similarly, during the global financial crisis of 2007–2009, which featured wild volatility in both equity and debt markets, Exchange Traded Funds were often the most reliable price signals, especially for certain types of fixed-income securities. The price discovery role of Exchange Traded Funds has continued. 

• Tax Efficiency and Fairness. Exchange Traded Funds have revolutionized the efficiency and equity of tax treatment for investors. Generally, Exchange Traded Funds are able to provide in-kind redemptions by delivering a basket of securities and thus rarely need to make capital gains distributions. This feature allows most Exchange Traded Funds to avoid taxable events that arise from selling securities for cash within the fund. Not all Exchange Traded Funds are so tax-efficient, but overall, the record is exceptional. 

Disadvantages Of Investing In The ETFs

Expectation-Related Risk. Perhaps the greatest strength of Exchange Traded Funds is that they provide to a broad range of investors, large and small, access to asset classes and investment strategies that had previously been limited to the large institutional investors or investors that were familiar with derivative products. Some of these asset classes and strategies are sophisticated, however, many investors are not familiar with them. Proper use of these unfamiliar Exchange Traded Funds in a portfolio requires education of investors, if they are to fully understand the return and risk features. Therefore, the biggest risk of investing in Exchange Traded Funds may simply be one of misunderstanding what the Exchange Traded Funds is, how it works, and how it will perform. 

Structural Risk. Only one Exchange Traded Fund structure, the Exchange-Traded Note ETN, carries with it a different level of structural risk than other common investment products. The unique structure of Exchange-Traded Notes as unsubordinated, and unsecured debt opens them up to the risk of credit default by the note holder or issuer. Theoretically, the counterparty risk is 100 percent. An informed investor should have time to sell out of an Exchange-Traded Note investment before the underwriting bank defaults, but anything less than close monitoring introduces significant risk. Evaluating this counterparty risk can be difficult, and various measures are used. 

Holdings-Based Risk. Exchange Traded Funds are not the only products that take on counterparty risk. The type of holdings a fund has can open it up to some risk as well. A fund that uses derivatives, such as swaps, to gain exposure to a market has some level of counterparty risk. For example, the Market Vectors China A-Shares ETF (PEK) uses swaps to gain exposure to the Chinese market. Swaps are not as risky as an Exchange-Traded Note, but investors still need to understand what is going on in such an Exchange Traded Fund.

In a swap agreement, two parties agree to exchange a pattern of returns for a fee. For example, a major bank might agree to provide Van Eck with exposure to Chinese A-shares for a fee. In the beginning, no money changes hands. Instead, an account is created that must be balanced on the basis of movements in the referenced index. If the Chinese market goes up, the swap counterparty will have to put in cash to reflect that movement in value. If the market goes down, Van Eck will put money in. Accounts are typically settled frequently on a daily or weekly basis. This frequent settlement reduces the damage the swap partners face if a company goes bankrupt. 

The Exchange Traded Fund holder is exposed to the credit risk of the issuer of the swap only on the return of the index since the last time the swap reset or exchanged cash with the swap counterparty. Most swaps in Exchange Traded Funds reset daily, so this credit risk is only intraday. Also, the bulk of the funds invested in an Exchange Traded Funds are held in cash equivalents, such as United States T-bills at a custodian bank. Only the daily returns or returns between reset dates, on the swap are exposed to the counterparty risk. 

Although understanding the risks associated with swaps is important. Swap exposures are not unique to Exchange Traded Funds. Many mutual funds also use swaps and other derivatives to gain exposures. With Exchange Traded Funds, at least that exposure is transparent. 

Similarly, Exchange Traded Funds issuers, together with traditional mutual fund managers and institutions, commonly lend out their underlying securities to short sellers as a way of earning extra income for investors. Securities lent out are generally over-collateralized to 102 percent, and the risk from counterparty default is too small to be of concern. When funds are lost money in securities lending arrangements, the loss come from the way a fund reinvested that collateral. 

A well-run securities lending program can bring in money and offset the expenses of running the fund. Information about these lending programs tends to be scanty, however, and poorly disclosed. Investors should, at a minimum, be aware of how their funds are using their money. 

Fund-Closure Risk. As with a mutual fund, issuers can decide that an Exchange Traded Fund no longer makes sense and shut it down. Such a fund closing does not result in an outright loss for investors, funds simply sell off positions and return cash to investors. But the resulting activity can affect investors negatively through capital gains distributions and forced realized gains, because the closure of the fund creates a tax event for the shareholder and the hassle of finding a new investment vehicle. In a few cases, investors have been stuck with the fees and costs associated with a fund’s closure. 

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