WILLIAMSTOWN, Mass. ( TheStreet) -- The two recent controversies over "long" and "short" ETFs and commodities ETFs are not unrelated. Investors must understand the connection between the two controversies to fully understand why these funds must be approached with caution.
First, a little history. ETFs entered the scene as transparent, low-cost and passive investment vehicles. Even before Bernie Madoff, investors wanted transparent alternatives to mutual funds that helped to mitigate the risk of investing in any single security.
Early ETFs were easy to understand. The SPDR S&P 500 ETF (SPY), widely credited as the first U.S. listed ETF in 1992, tracks a basket of 500 stocks in the S&P 500 index. Each morning fund issuer State Street (STT - Get Report) releases the holdings of the fund, making it possible to calculate exactly what the ETF is worth at any moment in the day, based on the prices of the stocks in its basket.
The underlying value of an ETF is available to investors as the fund's net asset value (NAV). On many trading platforms this number is available by simply typing the symbol for the ETF followed by ".IV". If an ETF's price is greater than the sum of its parts (NAV), the fund is said to be trading at a "premium"; if its price is less, it is called a "discount."As an ETF grows, the issuer creates additional shares of the fund to keep the fund's price close to its NAV. This process is relatively simple when it comes to ETFs like SPY. Bona fide market participants, essentially the fund's auctioneers, get more shares of an ETF by delivering the fund's ingredients, or shares of stock, to the issuer. Basically, market participants give yellow and blue, get back green and call it even.