The Good ETF

What makes a good ETF in the long term?  My, what a question, driven by the ETFs challenging the limits of what is prudent.  Maybe it is easier to start with what makes a bad ETF, then:

  • Headline risk can be eclipsed by credit risk.  All ETNs, Currency ETFs, and ETFs that use non-exchange-traded swaps, sometimes for commodity funds, take credit risk.  Did you know you were taking credit risk?
  • Roll risk — for commodity funds, trying to replicate the returns of the spot market using the futures market works only when there aren’t a ton of funds trying to do so.  The flood of funds into front month futures contracts incites other funds to front-run the activity, capturing the profits that the commodity funds were trying to make.  (For storable commodities, better to take delivery and store.)
  • Market size risk — an ETF can become too large relative to liquidity or regulatory constraints of the market, and it no longer tracks its benchmark well — again, mainly a commodity fund problem.
  • Irreplication risk — This is mainly a bond market theme, but once the ETF defines the index, only index bonds can be bought in proportion to the index.  I ran into this personally in 2002, when I ask ed why a certain bond traded rich.  The answer came that it was in a common index, but it was a small bond issue in proportion to its weight in the index.  Many investment banks were short the note to provide liquidity, but could not source the bonds to cover the short because most were in index funds.  I would keep an eye out for those bonds, and would sell them to those short for a small markup when I found them.  For ETFs, the trouble is that arbitrage can’t take place, because bond buyers can’t find certain rare bonds in order to create new units in exchange for expensive ETF shares.  That is one reason whey NAVs get stretched versus market prices.
  • Abnormal or faddish theme — the risk is that they become too dominant in the trading of less liquid companies in their ETFs.  But away from structural risks is the faddish investment risk.  The ETF only gets created as the fad is about to go into decline.

In one sense, the market can reward non-consensus views, particularly when they are small compared to their relative advantage in their sub-markets.  In the same way, the market can punish those that become too large for the pond that they swim in.  Growth will be limited or negative.  Even the efforts to create more capacity, create it at the cost of credit risk.

Good ETFs are:

  • Small compared to the pool that they fish in
  • Follow broad themes
  • Do not rely on irreplicable assets
  • Storable, they do not require a “roll” or some replication strategy.
  • not affected by unexpected credit events.
  • Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.  There are many ETFs that are Closed-end funds in disguise.  An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.