Gen Z’s Biggest ETF Questions

November 12, 2018

Last week I had the honor of giving a guest lecture at Columbia University on one my favorite topics: how ETFs work. Though the discussion itself was supposed to be entry-level, the questions I got weren't. The students in the class asked such insightful, intriguing questions that I couldn't resist replicating them, as well as my answers, for readers:

Why do ETF share prices drift from their net asset value?

Because ETFs trade on exchanges, their share price will be subject to supply and demand pressures. If there are too few shares of an ETF on the market to meet investor demand, the price of that ETF will go up. If there are too many shares, the ETF price will go down.

Authorized participants (APs) exploit these pricing differentials when they arise through the process of arbitrage (read: "What Is The Creation/Redemption Mechanism?").

If an ETF is overpriced compared to its underlying securities, APs can swoop in, sell off ETF shares at the inflated price, then buy up the underlying securities—making a tidy profit on the difference. If the ETF is underpriced, the same thing happens in reverse: The APs buy up ETF shares on the cheap, then sell off the underlying securities. Ka-ching.

These arbitrage trades help keep the ETF's share price trading closely in line with its NAV. It doesn't always work, but for the vast majority of ETFs for the vast majority of the time, arbitrage works pretty well.

Are commodity ETFs riskier than other types of ETFs?

It depends on the commodity ETF, of course; but generally, I wouldn't say the risks are greater, per se. They're just different.

For example, for a commodity equity ETF—say, gold miners or oil refiners—you'll find the ETF behaves like a hybrid of a traditional equity ETF and the underlying commodity. Gold miners are equities, of course, and therefore they're exposed to the same sorts of risks as any other stock. But the business of gold miners is also intimately tied to the gold price; when gold goes up, mining activity subsequently increases.

That means gold miner ETFs are also exposed to shocks that impact the gold price, such as a flight to safety, or inflation. Commodity equity ETFs are somewhat riskier than your typical equity ETF, maybe, but they're also not your typical equity ETF, so it's also a little like comparing apples to kumquats.

A futures-based ETF, meanwhile, carries totally different risks than a commodity equity ETF, because futures are fundamentally a different instrument than equities. With futures contracts, you have to contend with expiry dates and position limits; contango and backwardation; and so forth and so on.

Futures—and futures-based ETFs—have a steep learning curve, for which reason I'd say that beginning investors probably should tread with care. But there's nothing about the futures contract that makes it inherently any riskier than, say, Chinese small-cap tech companies. Different, to be sure. But riskier? At least in the case of futures contracts, the Commodity Futures Trading Commission tightly regulates futures trading to make sure no blowups occur.

Is it illegal to trade marijuana stocks in the U.S.?

No. Even though marijuana is still federally illegal to use or possess, it's not illegal to trade marijuana stocks in the U.S. (A good thing too, for all you Tilray investors out there!)

However, lots of big custodian banks are loath to hold these stocks on behalf of an ETF specifically designed to cover the marijuana space. Doing so could run them afoul of federal banking laws, putting at risk their banking license or FDIC insurance (read: "Promise & Peril Of Marijuana ETFs").

This is the primary reason we haven't seen any direct competitors to the ETFMG Alternative Harvest ETF (MJ) hit the U.S. market yet. Will we see the tides shift, now that noted anti-pot crusader Jeff Sessions is out at the Department of Justice? Who knows? I'm not holding my breath.

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