The Problem with ETFs

An important bit of ETF education. Here is an extract from an article by James Kirby in The Australian about the risks of some exchange traded funds. The article highlights one of the major risks of ETFs: “A coalition of the world’s biggest fund managers is pressing for consumer protection reforms in the booming Exchange Traded Fund market, where a rush of exotic products is putting new investors at risk. With speculative products bunched together with traditional index funds under the ETF banner there are mounting concerns that investors need much clearer “labelling”, so distinctions can be made between conservative funds that simply aim to mirror an index and funds that may be leveraged (based on borrowed money) or funds that act as derivatives. “We need to see some warnings out in the market on new style ETFs, where consumers may not realise what they are buying. The sector has evolved a long way from the original idea of a fund that simply reflects an index,” says Robin Bowerman, the head of market strategy and communications at Vanguard Australia. There are particular concerns that the swarm of new investors that have entered the sharemarket since March are particularly vulnerable to products that offer upside from falling share prices, or the promise of “sharemarket protection”. Vanguard, along with key global players including BlackRock, Fidelity Investments, Invesco and State Street, have recently urged regulators in the world’s biggest sharemarkets to “support implementing more consistent identifications and categorisations of Exchange Traded Products”. In the local market the Australian Securities and Investments Commission is understood to be examining the issue in consultation with local ETF managers, while in the US the coalition of major ETF players has put a submission to each of the three leading exchanges that list the products.” This has always been the case. As passive investments that represent an underlying index ETFs are great. Access to the passive replication of something that would be very hard for individual investors to do is a real service. Where they go wrong is when an ETF issuer creates an “active” ETFs that more often than not is created because of some fad-like, and often momentary, demand for one particular investment theme. These are particularly dangerous because the general impression of many investors is that ETFs are all passive, and by implication....safe. But they are not. Many are simply managed funds (actively manged funds) in an ETF structure, and they are not the same. The most obvious ones to me are the capital destroying income focused ETFs many of which simply add no value and return your capital to you pretending it is some miraculous income generator when the share price of the ETF is simply deteriorating every year as they return your capital to you. The goal of the Betashares Dividend Harvester ETF for instance (not bagging it...see below) is to offer a franked income stream which is 1.5x the yield of the broad Australian stock-market paid monthly. Here is the chart of HVST: This is the performance, which they rather cheekily don’t put up against an index, the excuse being “HVST does not aim to track an index”. It’s all alright advertising 1.5 times the broad return on the Australian stock-market - which implies a yield of around 6.75% (4.5% times 1.5) plus franking (9.64% - if it was fully franked) but not when the return pre-franking is -1.09%pa since inception and after franking is 2.17%. I use this example to drive home to anyone the folly of investing in anything that appears to pay more than an average yield - If you give me a dollar I can guarantee you a 100% yield. I can, Guaranteed. Would you invest? Some of you would. But the reality is that at the end of one year, I would simply pay you your dollar back and all that has happened is that I have effectively borrowed and returned your dollar after 12 months. There would be no capital lef of course, my ETF would be priced at zero and we'd have to close it. But it made a great marketing line. There is nothing for nothing in the stock-market. These are the performance numbers of HVST. Now let me get this straight before Betashares arc up. You could have predicted this performance if you had read the HVST PDS. Betashares are not hiding anything, bamboozling anyone, or being ‘bad’ fund managers. The HVST product does exactly what it says on the box. In the HVST PDS for instance it has a line that says this – “During periods when the share market (as measured by the S&P/ASX 200 Index) is rising, the Fund can be expected to make losses on its futures positions and, to that extent, the Fund’s capital growth will be lower than it would have been without the futures positions.” The performance is in line with the structure of the fund. Spending money on options to reduce volatility (options cost money - they are not 'clever', bought routinely they are simply a constant cost that eats away at returns). Then there is all the 'action' buying and selling stocks coming up to an ex-dividend date. Then of course there's the fees (0.9%) for management of the fund. So of course the returns do no relate to the ASX 200 return, the ASX 200 isn't chasing around dealing in stocks as they come up to an ex-dividend date and isn't buying options. Take off the costs and you were never going to get an average return. Then to fulfill the 1.5x the broad market yield, of course you you are simply going to get a regular return of capital and the total return will be what's left of the market return if any, less all the costs and activity. The point is that investors should be aware of the detail, but you won’t be if you just fall for the marketing line and the marketing line, as it is here, is always at the top of the documentation not in the middle. This is the HVST marketing line: It’s not hard to read beyond the front page. The disclosure requirements in a Product Disclosure Statement (PDS) mean all these ETF products are very upfront, honest, even if the structure is flawed and the marketing line emphasised above the detail. Point being that it’s all there for you to read but you do have to read it to understand what you’re getting into. And this is only the tip of the iceberg. A lot of ETF’s attempt to promise you something that is above and beyond what is a ‘normal’ return. As I say, there is nothing for nothing and anyone promising you something for nothing has got their fingers crossed behind their back. You might have noticed this Ad turn up in the middle of reading the financial press today for instance. You can't earn 11% reurn pa from anywhere - it has to come from somewhere. Its just not available. And I could go on a rant about "Sophisticated Investors" - its an oxymoron sometimes. "Fixed Income" is also a marketing line - it implies Gilt Edged Bonds, reliable, safe, capital loss free. Anyway. In the end the ETF’s that very efficiently, at low cost, without any bells and whistles, replicate something like an index, without brains, without active management, coming from a major issuer, can be easily understood, trusted and invested in. So ask yourself with every ETF, is this plain vanilla, or has this been created for marketing purposes, because there is a demand for it at the moment, we are in the middle of a fad. An easy filter is to ask, does it have some discretionary/active/non-passive element to it. The joke in the industry is that by the time the ETF industry gets around to creating an ETF to provide an exposure to a fad....thats the end of the fad. You also need to look at whether its construction is straightforward - does it represent physical gold for instance - or is it synthetic - created out of or including some smart-arse options or futures positions that are designed to somehow replicate the real thing or hedge something or make something safer (which usually does the opposite). Does it use derivatives - You need to understand that whenever a fund uses options or futures, those contracts cost money, they detract constantly from the return, and over the years can do vastly more damage to the returns than they do good to the investors. And the other one is leverage. Does the ETF use leverage. You can write a lot of fabulous marketing lines about leveraged products using examples of when it goes in the right direction, but when it doesn’t…they don’t write about that bit. Bottom line there are ETFs and then there are ETFs. It’s not hard to spot the safe ones…just make sure you go past the first page of the marketing document. [activecampaign form=64]