Are ETF’s A Real Asset?

5 April 2006
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I’ve been participating in a comment thread with Canadian Capitalist about alternative investments. I mentioned an aversion towards ETFs because to what I understand, ETF’s are sort of like derivatives? Though I was hard pressed to find such a definition online.

Investopedia defines Exchange Traded Funds (ETFs) as:

A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange, thus experiencing price changes throughout the day as it is bought and sold.

Because it trades like a stock whose price fluctuates daily, an ETF does not have its net asset value (NAV) calculated every day like a mutual fund does.

Great, now we know what the public knows. Here’s what I don’t know. My question is “What’s the asset backing the ETF’s?” Are there underlying stock? And how can there be such frequent trading and movement of money in and out without triggering lots of buys and sells under these underlying securities? Are ETF’s a “bet tracker” of sorts?

Here’s A Counter-Point
I found an article titled ETF’s Are Not A Real Asset written by Christopher Laird. Now, usually I don’t quote such sources because I do not know who Chris Laird is or fully understand the concept in question. But I thought I’d refer to it in an attempt to gain some clarity. Please note that the article is really discussing ETF’s from a gold/silver (hard asset) ETF perspective.

Virtual Claims on Assets
In the article, my take-away thought is the idea that we are living in a world where virtual claims on assets are the norm. I can understand how it works with mutual funds, but am not clear on how ETF’s work. Just take a look at the currencies in your wallet. What asset are backing those up besides the government’s ability to collect taxes? The problem is drawing closer as the budget deficits keep growing in world superpower United States (another topic for the future)

Maybe I’m Crying Chicken Little
I’d appreciate if the ETF gurus enlighten me on what’s really going on. I’ve heard the tracker definition but would like a little more clarity than that. I stand humbled before you eagerly anticipating an enlightening discussion about ETFs.

  • Thanks CC. I almost thought I was crazy thinking that ETFs are sort of derivatives. This is an arena where I readily admit that I'm not familiar with.

    Well, the education I'm getting out of this has been great. So ETFs can be considered as derivatives? I've always had a "to each his own" attitude, if you like PPNs, or ETFs, or run-of-the mill mutual funds, stock-picking, options, currency trading... then all the more power to you, AS LONG AS you understand it.

    I've exposed my weakness in ETF's. Thanks guys!
  • Here is the comment I left on my site:

    It is true that some ETFs use derivatives. Examples include the old iUnits XSP and XIN.

    But most ETFs are real assets. A ETF does have the actual underlying securities backing it. Take the IVV, which tracks the S&P 500. If you have enough shares of IVV, you can exchange it for the underlying stocks that make the S&P 500. In fact that is how the issuer makes sure the ETF tracks the index. If it deviates too much, arbitrageurs will buy the ETF and exchange it for shares and vice-versa.

    I read the article you have linked and the author is talking mostly non-sense. Hard-core gold bugs want us to sell everything (they always rant about paper assets) and buy gold bullion and bury it in a hold in our backyard. Gold pays no interest, costs money to store and protect and gives a measure of inflation protection and nothing else.
  • Just wanted to add that I'm thinking ETF's are like stocks in that they have a set amount of units/shares available to the public and those units have underlying assets backing them. And trading activities occur on the secondary markets amongst investors. But that doesn't seem right either? Or are they more like closed mutual funds or open mutual funds? I'm so confused!
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