Lifting the Veil on ETFs

Even with ETFs' phenomenal growth, there is still a number of them that stay on the opaque side

Ben Johnson 29 October, 2010 | 9:49AM
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The proliferation of exchange-traded products in recent years have made asset classes and investment strategies that were once the realm of only the largest and most sophisticated institutional investors available to the masses.

The democratisation of previously exclusive corners of the investment universe began simply enough when iShares launched an exchange-traded fund tracking the FTSE 100 in the UK in April of 2000.

Offering the UK’s blue-chip benchmark in exchange-traded form and at institutional-level pricing was an important first step in making the institutional available to the adviser and the individual investor. Ten years on, there have been over 1200 new ETPs launched across Europe's major exchanges. These products have provided investors with increasingly narrow market exposures and access to ever more complicated strategies. While many of the more esoteric products available on the market have their uses, a deeper understanding of their investment methods and place in a portfolio is critical.

Simply because ETPs have made select segments of the financial markets available to all, does not mean that they are all worthwhile investments.

A handful of ETFs offering access to hedge fund strategies have been launched in the past two years. Institutional investors that faced redemption restrictions on their hedge fund investments during the recent financial crisis place - and pay - a premium on the intra-day liquidity offered by the ETF wrapper. But these funds are a far cry from their FTSE 100-following grandfather.

First, their costs are substantially higher. Investors in most ETFs following hedge fund strategies are subject to not only the total expense ratio on the ETF wrapper, but also the fees levied by the underlying hedge funds’ managers, which typically adhere to the industry-standard “two-and-twenty” structure.

These strategies are also extremely opaque. For instance, no one outside Marshall Wace can possibly claim to know the secret formula behind the firm’s Tops strategy - made available in ETF form in January. Meanwhile, anyone with an internet connection can quickly find a complete list of the components of the FTSE 100 and their relevant weightings. So while hedge fund strategies have become investable to a larger number of investors and more liquid for the institutions already invested, those that value the low costs and transparency that are the hallmarks of the ETF wrapper may not find them to be worth their investment.

ETPs have also opened commodity markets to a broader swath of investors. While the democratisation of this asset class could potentially benefit all market participants, returns on these first ETPs have resulted in a good deal of confusion among those new to the sector. Investors should be wary of commodity-focused ETPs.

Anyone looking for spot price exposure must recognise that spot prices on oil, wheat, and many other benchmark commodities do not represent an investable return. The closest proxy for spot price performance comes through physical holdings - which are presently limited to precious metals funds. Outside physical holdings, ETP investors can only purchase exposure to the movement in commodity futures prices. Investing in commodities through futures strategies introduces unique sources of return (both positive and negative) - most notably roll returns.

Persistent contango across many commodity futures markets have led negative roll returns to overpower spot price movements in recent years. As a result, ETPs tracking passive long-only commodity futures strategies have frequently grossly underperformed spot prices. For a long-term position in commodities, some of the best ETF options in the category include precious metals products or funds like db x-trackers’ DBLCI-OY Balanced ETF, which offer exposure to a broad, well-diversified basket of commodities in tandem with a tested strategy for optimising roll returns.

Leveraged and inverse funds represent more “innovations” of the ETP industry that have limited usefulness and led to adverse investor experiences. There are occasions when leveraged and inverse ETFs are useful: they can provide a (very) short-term hedge for investors looking to protect a portfolio with heavy exposure to a particular sector or asset class. They can also be used for speculating on a given index or asset’s near-term (again, very near-term) prospects.

The phrase “near-term” is emphasised because investors must understand the risks involved in leveraged and inverse funds, most notably the effects of daily compounding and volatility on their returns. As a result of their daily rebalancing and the arithmetic of compounding, investors are not guaranteed to get X times the index’s leveraged or inverse return for any holding period longer than one day.

This issue is generally amplified in periods of high market volatility and can lead to greater losses than anticipated. These funds will only provide returns approximating X times the return on their underlying index or asset over longer time periods if the index or asset’s value trends consistently upwards or downwards (that is, exhibits very low volatility during a given holding period).

Currencies are another fairly exotic investment that has recently been brought into the realm of investable opportunities for advisers and individuals through an ETP wrapper. While these products may be suitable for hedging long-term consumption risk or removing currency risk from an existing investment denominated in a foreign currency, the temptation may be to use them for outright currency speculation. In the long-term, currency speculation is a zero-sum game, perhaps best left to no one. Additionally, those looking for currency diversification are often unaware that it already exists within other portions of their portfolio. For instance, over 70 per cent of the FTSE 100’s earnings are generated outside the UK, in currencies other than sterling. That said, it may be best to leave currency speculation to the professionals.

ETFs tracking emerging markets benchmarks have proven immensely popular. Investors can gain broad exposure to developing economies through an ETF tracking the MSCI Emerging Markets Index, narrow it down a bit by tracking just the Brics, or slice even more thinly with ETFs tracking the individual equity benchmarks in Brazil, Russia, India, and China.

While these funds fall much closer to the plain-vanilla end of the spectrum than those products offering hedge fund strategies, commodities, or currencies, there are still important considerations to make before diving in head first. More specifically, it is important to understand the composition of these various indices and the true fundamental drivers of their value.

For instance, one may think that an ETF tracking the MSCI Brazil would be a good way to play an investment thesis based on the increasing purchasing power of the country’s emerging middle class. However, upon further examination, one would find that 48 per cent of the index is comprised of firms in the materials and energy sectors - with its top two constituents being oil giant Petrobras and mega-miner Vale.

As such, an investment in this large-capitalisation Brazilian benchmark may be a better play on China’s voracious appetite for commodities than upwardly mobile Brazilians’ growing taste for automobiles and nice clothes. Fortunately, where there is a need for a better tool there have been index and ETF providers to build it, and ETFs tracking small-capitalisation emerging market equities offer a more finely tuned implement for acting on an investment thesis related to fatter consumer wallets in the developing world.

While rapid innovation in the ETP space has expanded the investor toolkit, most ETP investors have foregone many of the more nuanced and exotic vehicles and stuck to the basics. The vast majority of existing ETP assets and new flows into ETPs continue to reside with the most basic products on the markets - those tracking regional and country-level equity benchmarks, broad fixed income indices, and precious metals. These funds tend to represent all that is good about bringing the institutional to the adviser and individual investor. They have extremely low carrying costs, remarkable portfolio transparency, and offer intra-day liquidity.

There is little doubt that ETP innovation will continue in coming years. Some new products will continue to stray towards the more opaque and expensive end of the spectrum, and could potentially tarnish the image of the industry despite their relatively small size. Meanwhile, other innovations, like pre-packaged asset allocation products, will continue to advance the investor-friendly aspects of ETFs by creating ever more diversified and inexpensive investments. Regardless of where new products might lie on this continuum, it is important to keep in mind that just because ETPs are making new strategies and asset classes investable, it does not necessarily mean they are worth an investment. In ETPs, as with any investment vehicle, education and suitable caution are essential.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.

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