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Beware the Flaws of Trading ETFs

Roger Nusbaum

According to the article, the iShares FTSE Xinhua China 25 Index Fund (FXI Quote) strayed more than 7% below its underlying net asset value on Feb. 27. The article then notes that most of that gap closed the following day -- a price within 0.5% of NAV is considered normal. Unfortunately, the data on the iShares Web site was not current enough for the discrepancy to be seen firsthand.

The article rightly points out that anyone selling FXI on the 27th was effectively short-changed, while buyers lucked out and got a small boost as the gap closed.

In a lot of the articles I write about new ETFs, I suggest giving a new fund a little time to season. That advice doesn't apply here, because FXI has already been trading for a while.

The fund strayed from its NAV at a time of elevated fear in the market, and this strikes me as the type of thing that might happen again. This decoupling also appears to have happened to some other Asian ETFs; the article notes similar behavior in iShares Malaysia (EWM Quote).

So if you own these ETFs or any others that might stray for a day or two, what should you do?

There is no absolutely correct answer. You need to assess why you own these funds and then decide if the flaws inherent in ETFs -- remember, anything you could invest in has some flaws -- outweigh the potential benefits.

Most ETF providers have data that shows how often the premium or discount to NAV strays beyond 0.5%. If you look at the data, you are likely to see that any ETF you care about spends the vast majority of the time within that so-called normal range. So if an ETF you care about spent 10 of the last 200 days outside of the normal range, would you care? If you would, perhaps you should sell.

If 10 days would not bother you, would 30 days out of 200? As I said above, there is no right answer; this can only be sorted out by the individual.

Anyone using ETFs as part of a diversified portfolio, as opposed to trading them in the short term, is trying to capture a certain segment of the market. Perhaps a given ETF has a tracking error issue, or perhaps the expense fee is on the high side, or maybe there is a composition issue that makes an ETF less than perfect. I would say that most ETFs have at least one characteristic that is less than ideal.

Choosing an individual stock poses a different set of potential risks that need to be weighed, such as picking the wrong stock in the right sector.

For example, an investor who wanted to buy a mega-cap domestic bank stock two years ago would have probably chosen between Citigroup(C Quote), Bank of America (BAC Quote) or Wells Fargo(WFC Quote). In the intervening period, Wells Fargo and Bank of America have each risen about 10%, while Citigroup has barely changed.

A more dramatic example might be picking a stock that falls because it loses market share to a competitor. For example, over the past two years, Pacific Sunwear(PSUN Quote) has fallen about 40%, while American Eagle Outfitters (AEO Quote) has risen 50%.

Picking the wrong stock is always a pitfall of investing in individual equities, just as trading quirks and fees are always pitfalls of picking ETFs.

Since the flaws inherent to these products are not going to go away, it comes back to how concerned you are by these issues and whether they outweigh the positives. The benefits to individual stocks include higher dividends (most of the time) and the potential for bigger gains. ETFs offer easier access to complicated markets and virtually no individual stock risk.

The way I look at it, I want access to what I believe will be the best tool to capture the effect, period. Most of the time, I prefer an individual stock. But for some things, such as foreign currency or the water theme, I use ETFs.

Remember: It is not about finding the best thing; it's about finding the best thing for you.