The ETF Derivative

ETF's, or exchange traded funds, have become increasingly popular investment products amongst US retail investors looking to cash on emerging market growth or niche aspects of the economy (such as technology). Broadly, these are funds which invest in a range of companies within the designated market and whose units trade as shares on the New York Stock Exchange.

In other words, NYSE-trading derivatives. Not many people often think of ETF's as derivatives, and this is a dangerous concept for many investors -- because they are derivatives with a kick. Think of a derivative as an investment product whose value is derived from an underlying (basket of) security(ies), and you have characterized an ETF perfectly; not even ETF investors themselves would disagree with that.

When a financial product has a "derivative value" -- i.e. a value derived from other product(s) -- it has two sets of prices: both a net asset value (NAV) price and a trading price. Often, there are disparities in the two, just as with any share in a company. However, in the case of derivatives, the trading value is not only built into the product's speculative value (the price which investors think these products are going to rise to), but also into the speculative value of the underlying instrument. Don't worry if you are confused: you are not alone. At least, however, you know you are confused.

A lot of investors often quiz me as to why when the underlying securities in an ETF have all traded up in say, Hong Kong, in the same trading day the ETF ends down. After all, it's a reasonable enough assumption: if the price of gold surges, you'd expect some kind of return on your gold call option. This is, however, where an ETF is somewhat misleadingly marketed. There is a net asset value of every ETF, usually available by Bloomberg though often available too by adding the symbols "nv" to the ETF's ticker. When you take a glance at this, you quickly know what you are looking at it is a highly volatile derivative instrument, and not a "fund" trading on the NYSE.

Like any derivative, an ETF's value corresponds to its relation to the net asset value of the commodity rather than the speculative value. What this means in the case of these funds is that even if the price of the shares the ETF has bought into has appreciated, the ETF itself might still trade down. It's a dangerous game, essentially fueling the fire of speculation in the area in which the ETF invests (e.g. the MSCI Emerging Market Fund has done very well this year as many investors try to get access to these securities "safely" and hence buy the fund, pushing MSCI EMF up).

With this in mind, if investors are required to have a certain level of sophistication before opening derivatives trading accounts, it seems nuts they don't have to in order to buy "shares" in an ETF.