Tuesday, November 2, 2010

Is an Exchange Traded Fund Considered Equity? Is A Coffee Mug Considered Coffee?

Is an exchange traded fund equity? It seems like a basic question with an obvious answer. But it is question that confuses some of our largest financial institutions?  As an example on my investment statement the asset mix summary classifies all ETFs as equity even though some are commodity based and some are bond ETFs. If I had a 100% of my portfolio in commodity ETFs, or 100% in a T-bill ETF, or 100% in a bond ETF or 100% in a leverage ETF or 100% in an inverse ETF, it all shows up as 100% equity.

I was pondering the question is an Exchange Traded Fund equity? - as I was walking my dog Kobe on one cold, dark, damp,  early morning on the deserted streets of Toronto. As I was approaching the corner of Yonge and St. Clair, lease in one hand, and a mug of Tim Horton’s coffee in the other, it came to me in a flash.  An Exchange Traded Fund is just like a coffee mug – they are both merely a vessel – i.e. an object used as a container.

A coffee mug, originally designed to hold hot coffee can be used as a vessel for other things, like tea, hot chocolate, orange juice, water, beer, wine etc. I also use a coffee mug as a measuring cup for flour, sugar, rice, milk, and Kobe’s kibble. A coffee mug is very versatile and can be used for many things besides holding hot coffee. Although, originally designed to hold coffee, a mug is not coffee!!!

ETFs were originally designed to hold the stocks of indexes, like the S&P500, Dow Jones Industrials, or the S&P/TSX Composite. ETFs are like mutual funds except they trade on stock exchanges. Now, ETFs are used as vessels for all kinds of investments like equity, bonds, commodities, currencies, futures and even other ETFs. Like a Swiss army knife they have many uses and applications. They can give an exposure to different assets classes, used for hedging or can be combined with other investments. There are even ETFS that will go up in value when the underlying investments go down. Although, originally designed to hold equity, an ETF is not equity!!!

Equity is defined as the ownership in a corporation in the form of common stock or preferred shares. Therefore if an ETF does not contain equity or positively track an equity index then from an asset mix perspective it is not equity.  If an ETF contains bonds , it should be considered fixed income. If the ETF contains gold then it should be considered commodities or precious metals from an asset mix perspective. If an ETF is designed to increase in value if the market goes down it should be considered a short position not a long position.

The Bottom Line

An ETF is only considered equity if the underlying investments are equities. If you own ETFS, do not assume that your asset mix summary properly classifies your ETFs. Therefore you might have to calculate it yourself. Although a child knows the difference between a coffee mug and coffee you cannot assume that our large financial institutions know the difference between an ETF and equity.


  1. I love the analogy, funny and well presented, and presents an interesting point.

    Adjusting the asset mix reported on the statement to be truly reflective of the underlying investments is time consuming and inconvienent (esp. if you own many ETFs), and some investors may not know how to do it properly or be aware of the need to do it.

  2. The issue from a compliance perspective is the firm will say that an ETF is equity because it says so on the statement. They can then justify unsuitable investments as perfectly all right.
    As an example assume I had 50% in bonds and 50% of my portfolio in a double inverse gold etf and my portfolio was supposed to be 50% equity and 50% bonds according to the investment policy statement. According to the firm then my portfolio was manged properly because it was 50/50. However it had no equity and had the equivalent of being net short 100% gold.

    They would then say that according to them the portfolio was appropriate for my investment policy statement and they would take no responsibility for any loss.