When you have very narrow and specific mutual funds, such as tech funds, they tend to enter a downward spiral when their markets turn down. Prices fall, fund prices fall, people redeem, funds have to sell holdings into a falling market, exacerbating the decline in the market. A classic domino affect.

Our reader offers an interesting and timely question, because investors know or ought to know, the link between hot markets and mutual fund marketing machines. The mutual fund marketing model follows the same theme time and time again. It all comes down to performance or performance expectations.

When you are about to launch a new fund with no track record, you generate excitement by selling into a hot sector. In the current environment, that leads directly to sector funds focusing on natural resources, flow throughs and precious metals.

The risk of course is that investors jump into a hot market and quickly learn why the phrase “there is no guarantee that past performance will be repeated” accompanies all mutual fund marketing material. The risk for the broader market as our reader has so adeptly quantified, is that a surge of redemptions on narrowly focused open ended funds could spark a domino affect.

Having said that, we note that most of the new commodity based products are being manufactured as exchange traded funds. And because of their structure, ETFs are not subjected to the same push and pull affect that a typical open ended fund faces.

To understand why, you need to recognize that traditional mutual funds are open ended, while exchange traded funds are closed end. When we talk about buying an open ended mutual fund, you are really buying units directly from the fund company.

For example, if you buy the Altamira Equity fund, you are buying new units of this fund directly from Altamira. The price paid for the units is based on the net asset value of the fund, which is simply the value of all the holdings in the fund divided by the number of unitholders. Once the purchase is made, the money is deposited into the Altamira Equity Fund, and the manager of that fund, invests it based on the fund’s guidelines.

Same when you redeem units of an open ended mutual fund. You are selling units back to the fund company and you will receive the net asset value per share for your units. In that situation, the fund company may have to sell securities in order to raise capital to meet new redemption requests, and if enough redemption requests hit at the same time, that could have an effect on the market.

Obviously, if it is a broadly based open ended mutual fund holding quantities of very liquid stocks or government bonds, meeting redemptions is usually not a major problem. However, if you have an open ended mutual fund whose performance is tied to an underlying commodity, a sell-off in the commodity could cause a run on the fund, which would cause the manager to sell commodities to raise cash.

All of this points to another issue that is often overlooked in the market. Managers of open ended mutual funds usually hold a portion of their portfolio – sometimes 3% to 5% of the portfolio – in cash. That is to provide the manager with a cushion should unexpected redemptions hit the fund. Having some cash on hand, the manager can meet the redemption request without having to sell securities. The problem with that approach is that cash holdings can be a drag on performance.

Problems related to redemptions do not apply in the same way to the closed end ETFs. In a closed end structure, the fund company issues a certain number of units in the fund, no more no less.

When an investor wants to sell units, they do not redeem from the fund company at the net asset value per share, but rather they sell them to other investors in the market. The price is based on what the market believes is reasonable, just as the market determines what a share of IBM, GM or CIBC is worth.

In all cases the price of an ETF is loosely related to the net asset value of the fund. Having said that, it is not unusual for any closed end fund to trade at a premium or discount to its net asset value.

Because redemptions are typically not an issue, the manager of an ETF can always be fully invested. That’s why index funds are usually structured as ETFs, and without the cash drag, is probably why index funds typically outperform traditional actively managed open ended funds.

On the flip side, when an ETFs wishes to tie its performance to an underlying commodity, the ETF must own the commodity. And knowing that a new commodity linked ETF is coming to the market can influence the value of the underlying commodity prior to the listing of the ETF. Recall the run up in silver that was related, in large part, to a new silver ETF that was coming to market (FYI, that new silver ETF began trading in the US on Friday). The market bid up the price of silver knowing that the silver ETF would have to buy sufficient quantities of silver in order to securitize the fund.

Given that, we think commodity or sector ETFs may have more influence on the underlying commodity or sector price when it initially comes to the market, then when it has been trading for a period of time.

One final point that we have noticed in recent years, which under the right – or wrong – circumstances could change our view on whether ETFs are likely to influence the underlying market.

Because ETFs will trade at a discount to their net asset value, some companies have been offering to redeem shares of the ETF at the true net asset value per share, during certain times of the year. Usually on the anniversary date of when the ETF came to the market. By doing this, it helps keep the price of the ETF close to its net asset value during the year. Good for unitholders, but under the tail-wagging-the-dog scenario that concerns our reader, annual redemptions could force downward pressure on an underlying commodity if the manager were forced to sell at certain points during the year in order to meet redemptions.