Supposedly Simple ETFs Not So Simple to Understand

"Overly dense and/or overly generic prospectuses render an investment product that should be relatively easy to understand too complicated for most investors," reports the WSJ in a Nov. 27 article.

What Are Exchange-Traded Funds?

The products, exchange-traded funds (ETFs), generally involve investment strategies that should be simple for the lay investor to understand. ETFs are mutual funds that trade on listed exchanges (such as the NYSE) in the same manner as traditional stocks. Unfortunately, according to the WSJ, "while they would seem to be transparent, their trading sometimes doesn't reflect their underlying value."

On May 6, for example, the market experienced a "flash crash" during which many ETFs seemed to become almost entirely worthless in a few brief seconds, only to rebound moments later. A look through many of the funds' prospectuses would not indicate that level of risk to most readers.

What Makes ETFs Difficult to Understand?

As reported in the article, many of the prospectuses contain overly generic and vague language, which makes it difficult for potential investors to understand both the risks of the funds and how one ETF may differ from another. In addition, ETFs often have complicated fee structures that are explained in terminology that is too complex for most investors to follow.

These problems mean that most prospectuses do not do a very good job of explaining the risks and benefits of a particular ETF to potential investors. While the firms that offer the funds often believe the documents disclose all necessary information, financial advisers and investors do not always agree. One adviser quoted in the article suggests basing the appraisal of a fund on its past performance history rather than on the information in the prospectus. "Show me the returns," he says. "Am I getting what I thought I would?"

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