6 Things You Need to Know About ETFs

Sal Gilbertie is the president and chief investment officer of Teucrium Trading, a Santa Fe, N.M., firm that specializes in futures-based commodity exchange-traded products (ETPs). Last week, we met to discuss the launch of the Teucrium Agricultural Fund (NYSE Arca: TAGS), the first ETP that offers exposure to agricultural commodities in a single fund of ETP funds. (See: Teucrium Grows Another Grain ETF.)

But since commodities aren't for everyone, it seemed like a good time to get Gilbertie's take on something a little more generic. So here's his list of the most important things to know before you invest in any exchange-traded product.

Know what you're buying. "The terms ETP and ETF are often used interchangeably by the public, although regulators make distinctions between them. Essentially, though, the concept is the same. But ETNs are a whole different animal," Gilbertie said.

• Exchange-traded funds (ETFs) are generally used to provide traditional index exposure. When you buy an ETF, you own a single security that represents a basket of other securities. It generally tracks an index and fluctuates with the underlying assets.
• Commodity ETPs that use futures contracts are structured as limited partnerships, while those that hold the physical commodity are structured as grantor trusts. As with an ETF, when you buy an ETP, you own a single security that represents a basket of a something else -- in this case, a basket of commodities.
• Exchange-traded notes (ETNs) are technically debt obligations from a backing bank. They do not necessarily hold the index's underlying constituents. They can be used to provide traditional index exposure similar to what an ETF offers, but they can also provide two and three times leveraged and inverse and commodity strategies.

"Both ETFs and ETPs own an underlying basket that's what you're buying, and someone is going to arbitrage. When someone sells you a share of an ETF, they've bought something in relation to that to hedge that. So if they sell you the S&P 500 ETF, they've bought the S&P 500 stocks. If they buy a share of the S&P 500 ETF from you, they sell the S&P 500 stocks. It's instantaneous. It provides liquidity and price visibility constantly to investors.

"But investors should not confuse ETNs with an ETF, an ETP, or, by the way, an ETV -- an exchange-traded vehicle. There are legal nuances between the latter three, but basically they are the same. ETNs, however, are generally unsecured debt obligations of the issuer. So you can buy oil ETNs, but all you're really getting is the promise of the issuer to pay you based on some oil index. The issuer doesn't have to own that oil index. ETNs are not visible. They are not transparent. they are unsecured debt obligations.

"The issuer of an ETN tells you what the ETN is based off of so you know what you're buying, but you have no idea if they're hedging that. They don't have to hedge it. It's basically a credit exposure. If that bank or issuer goes bankrupt, you stand in line with the other unsecured creditors. You have substantial risk there. "

Just last week, the VelocityShares Daily 2X VIX Short-Term ETN (NYSE Arca: TVIX), a Credit Suisse-managed ETN designed to track stock market volatility, lost 60 percent of its value. Reuters reports that the Financial Industry Regulatory Authority now is investigating not just TVIX, but a host of issues relating to ETNs and other complex products.

Know what your ETF or ETP holds. Or, as Gilbertie put it, "What is the underlying benchmark?" The level and type of risk may vary significantly from one ETF to another. It is important to understand the underlying benchmark or portfolio of securities the ETF is designed to replicate in order to evaluate the risks of investing in it.

Know the liquidity of the underlying benchmark and when it trades. "For an ETF like the S&P 500, this is simple, because if you trade it between 9:30 a.m. and 4:00 p.m. Eastern Time, New York Stock Exchange hours, all those stocks are trading. If you buy the S&P 500 ETF, there's a market maker who is able to hedge his position with you, so you always have a very tight bid-ask spread and almost infinite liquidity, because no one is going to put in a big enough order on an ETF to nuke the underlying market.

"But there are some ETFs that trade things that aren't that visible or aren't that liquid, like an ETF on a foreign security. It might be a great ETF. But if it's in a different time zone and you're trading during New York Stock Exchange hours, the person hedging his buy or sell to you, which is usually a market professional, authorized purchaser, or arbitrager, may not have as efficient a hedge, because the markets in that location are closed," Gilbertie said. "So the price and liquidity may not be as good as if you traded that ETF when its underlying markets were open."

Understand that liquidity and price are at their best when the underlying markets are open. "Trade when the markets are open! Trade your ETF, ETP, or ETV when those underlying markets are open, because that's when you're going to get the best pricing and liquidity. Now, this matters less to retail investors than institutional investors, but it is still worth noting."

Never trade a market order on any ETF. Ever. "Every ETF is priced by these professionals. There's a bid and an ask. When the markets are open, that professional will sell you your ETF and buy the underlying to hedge. Machines do that work. There aren't people anymore. There aren't floor specialists. It all happens lightning fast on multiple exchanges with machines, and those machines do a two-step process to give you that bid or ask on your ETF," Gilbertie said.

"If they're offering some shares of an ETF, they are simultaneously bidding in the underlying market. It's a two-step process. So when you buy an ETF from them, they simultaneously sell to you -- step one -- and buy the underlying -- step two. If you hit a market order, simple little 100-lot eTrade order, the machine lifts that order.

"It's a one-step process. The machine knows someone just looked at what it was offering. It is instantly programmed to now back up its offer a little bit, No. 1, for safety, because you can't ask them to lose money, and No. 2, it knows when you're bargaining with it. And if you're not bargaining with it and just coming at it, it's going to back away from you. It's programmed to do that. And it's basically like a circuit breaker programmed by these computer specialists. It keeps backing up, and the market order keeps chasing. Investors should never, ever, ever use a market order."

Use a limit order on stops, regular buys and sells, and anything you do. "Put a price limit if you are trading an ETF, because ETFs are all run electronically by necessity. I don't mean anything disparaging by that. But machines don't understand market orders. They just know they are under attack, and they back up, unless you are trading all but the most liquid ETFs. My suggestion: If you're buying, just go to the ask price. If your selling, go to the offer price. And just let the order sit there. The machine knows its value and will keep buying or selling to you at those levels."