ETFs: Look Beyond the Hype

If you understand the ETF structure, then you know when an ETF resembles a closed-end fund. If you own the more exotic or specialty ETFs or if you are considering owning one of these ETFs (ETFs that do not hold traditional individual securities such as stocks), then do yourself a favor and understand the potential pitfalls of the ETF structure --  such as when an ETF resembles a closed-end fund.

Why? Well, let's look at an example of an ETF that behaves like a closed-end fund.  Recently, the Powershares DB US Dollar Bullish (UUP) stopped issuing new shares (as of November 5^th).  UUP even stopped trading for a period during the day on November 5^th.

The fact that UUP stopped issuing new shares is not, unfortunately, a new problem for ETFs. Several commodity-based ETFs have had the same issue over the past year. Why is this a problem?

The problem is that many advocates of ETFs will tell us that ETFs are priced at or close to the value of the underlying holdings of the ETF. The creation-redemption feature of the ETF, in part, allows for this benefit.  If there is a dislocation in the market that disrupts the creation-redemption feature, then you have an ETF that resembles a closed-end fund, which defeats this espoused feature of the ETF and you are not getting what you pay for which are the underlying securities (a similar issue exists with closed-end funds).

Fortunately, for UUP investors, the problems were resolved by the end of the trading day.  But what this tells the ETF product manufactures is that the kinks of the ETF structure need some work.

Want to learn more? Read the basics:

ETFs Challenging Mutual Funds?

ETFs vs. Mutual Funds: An Active vs. Passive Debate

Read the more advanced:

New Challenges for Commodity ETFs

An Emerging Problem for this ETF