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Home > Funds > ETFs > All you need to know about exchange-traded funds

All you need to know about exchange-traded

funds
27/11/2009

The transparency and liquidity of exchange-traded funds make them

popular with investors, but there are still a few things you should
know before you sink your money into them, writes Paul Amery,
editor of www.IndexUniverse.eu.

The financial crisis was a nightmare for most asset classes, with money pulled
out of investments left, right and centre. But not for exchange-traded funds
(ETFs). Money actually flowed into the sector more rapidly between 2007 and
2009 than ever before. From modest beginnings in the mid- 1990s, global ETFs
now hold nearly $1trn in assets.

Why are ETFs – which ‘passively’ track an underlying asset class, be that a stock
market index or the price of gold or wheat – so popular? Some of their key
characteristics, such as transparency and liquidity, have become even more
attractive amid rising concerns over counter-party risk (as investors in
structured products backed by Lehman Brothers, for example, have learned to
their cost) and widespread lock-ups of investor funds in hedge funds or
commercial property funds, for example.

But the main reason is cost. ETFs are just plain cheap. The average annual fee in
Europe for a stock-market ETF is 0.37%, says Barclays Global Investors. That
compares to 0.87% for an index (tracker) fund and 1.75% for an actively
managed fund (whereby a fund manager picks and chooses stocks in the hope of
beating the market). Bond ETFs are even cheaper, often costing only 0.10%-
0.15% a year. In other words, the average City fund manager has nearly 1.5% a
year in performance to make up before breaking even with an ETF. That’s
without factoring in trading costs (bid-offer spreads and broker charges), which
can easily add another% percent or two.

That 2%-3% a year may not sound much, but long-term it matters, says John
Bogle, pioneer of index investing in the US. Assume an average investment gain
of 8% a year over 30 years. If this is cut to 5% via fund expenses of 3% a year,
then you lose more than half your money over the 30-year term (you end up
with £4.32 for each pound initially invested, compared to £10.06 before costs).

But ETFs are not without their detractors. Some unpleasant surprises,
particularly from funds tracking more esoteric indices or asset classes, have
caused sceptics to wonder if these funds aren’t just the latest addition to the
bankers’ long list of marketing gimmicks. Is this true? And what risks do
investors need to be aware of?

Know your tracker types

There are several different types of index tracker – ETFs, ETCs (exchange-
traded commodities/currencies) and ETNs (exchange-traded notes). Almost all
European ETFs comply with the EU’s “UCITS III” directive. Without getting too
technical, this is a set of Europe-wide rules that set minimum standards for
things such as a fund’s diversification, the way it’s priced, and which underlying
financial instruments (such as derivatives) it can use.
European ETFs fall into two broad categories. First, you have funds which
replicate their underlying indices by simply buying the underlying index
securities, or a representative sample of them. So a FTSE 100 tracker would
hold the stocks making up the FTSE 100 index, for example. This method is
used by most of the iShares funds, as well as ETFs from HSBC, German issuer
ETFlab and some of the French issuer EasyETF’s range. This is usually known
as ‘physical’, ‘in-kind’, or ‘in specie’.

Swap-based ETFs, on the other hand (which include funds issued by Lyxor, db
x-trackers, Source, ETF Exchange and the majority of European issuers) –
replicate their indices by buying a performance “swap” from a bank, and holding
a basket of collateral. The bank guarantees the index return (before the bank’s
fees) via the swap. The collateral is there to provide backing for investors’ funds
in case the bank fails to deliver. Under UCITS rules, at least 90% of the fund’s
value must be backed like this at all times.

Since Lehman Brothers went bust last September, investors have certainly
looked more closely at the security of swap-based ETFs. But it’s worth
remembering that, in theory, a maximum 10% loss should result, even if a
counter-party fails. And in practice, many swap-based ETF issuers have reduced
their uncollateralised exposure to less than 10%, and in some cases 0%. And as
swap-based ETF issuers point out, ETFs that physically replicate their indices
are not free of counter-party risk either; they often lend out the index securities
in return for extra revenue (although these transactions are also backed by
collateral).

It’s certainly worth being aware of which replication technique an ETF issuer
uses, what their collateral policy is, the identity of any counter-party, and to
what extent securities are lent out. This information should be readily accessible
on the issuer’s website. But we wouldn’t favour one breed of ETF over another.

What about ETCs and ETNs?

ETCs – exchange-traded commodities and currencies – are debt securities, not
funds. They offer exposure to the price of one or more commodities or to
individual currency rates. Most ETCs have collateral backing, meaning that if
the issuer defaults, investors should be protected.
Initially, only a few ETCs tracking precious metals were collateralised and last
September, the market in many of these commodity trackers was paralysed for a
short time following the blow-up at AIG – a key counter-party at the time.
Investor protection has improved since then, but you should make sure that you
know the counter-party status before you invest, which should be on issuers’
websites and in the ETC prospectus.

We’re less comfortable with ETNs (exchange-traded notes). These are popular
in the US market for tax reasons, but incur full counter-party exposure to their
issuer. In other words, if the issuer disappears, so will your cash. While bank
risk, as measured by the cost of default insurance, is much lower now than a
year ago (if only because of the various Government-funded safety nets), it
would be foolish to assume that concerns over bank failure couldn’t surface
again. So where possible, we’d avoid ETNs. The good news is that the vast
majority of asset classes can be accessed via ETFs or ETCs, so there’s rarely any
need for a UK-based investor to go down the ETN route.

What does it really do?

Counter-party risk is something to be aware of, but it shouldn’t put you off
ETFs. A more common problem is that the more exotic the asset class or
investment style, the harder an ETF becomes to understand. And that means
they may not always perform as you might expect.

For example, how can it be possible that both the US-listed Direxion Daily
Financial Bull and Bear ETFs (which offer three times and minus three times
the return on the Russell 1000 Financials index respectively) have managed to
lose money for investors in 2009 so far? The Russell index is up 15%; three
times that is 45%. Yet the bull fund has lost 34%, while the bear fund is down
94%.

And why have the European-listed ETCs which track the oil price risen by
between 5% and 33% in the year to the end of October, when the underlying
spot oil price was up 73% (NYMEX West Texas Intermediate front month
contract) or 83% (ICE Brent Oil Future) over the same period?

The answer lies in the way the tracker products’ indices are constructed. There’s
a huge difference between a plain vanilla ETF tracking a broad, capitalisation-
weighted stock index (where constituents’ weights are determined by the
companies’ market sizes) and more esoteric indices involving leverage, or
indices that are based on futures or forward contracts.

Leveraged ETFs – those which offer plus or minus two or three times an index’s
performance – are rebalanced daily. This ensures a constant leverage ratio. But
in practical terms, it also guarantees that over time, performance will differ
from what an unwary investor might expect. Inverse (or short) ETFs, which
provide a daily return of minus one times the underlying index, are also prone
to drift over time.

Here’s why. Imagine that an index rises over a day by 10%, from 100 to 110. A
two-times leveraged daily long index will rise by 20%, from 100 to 120. Fine.
But on day two, the market falls by 5%. The underlying index declines from 110
to 104.5. But the doubleleveraged index will fall by 10%, taking it from 120 to
108. As you can see, after two days the leveraged index (+8%) is up by less than
double the underlying index (+4.5%).

Repeat this over many daily periods and the drift will grow. All other things
being equal, the greater the leverage factor and the more volatile the underlying
index, the more drift you’ll get. And, as you can see, this ‘index drift’ begins as
soon as you hold them overnight. So highly leveraged ETFs are suitable for very
short-term traders only.

You could consider holding simple inverse ETFs (those offering minus one
times an index’s return on a daily basis) over longer periods, but bear in mind
that even these will be subject to drift over time, so you must monitor their
performance.

How ‘contango’ can catch you out

ETFs and ETCs which follow indices based on futures markets (this includes
most commodities, currencies, and credit trackers) face tracking ‘problems’ of a
different type. Futures have to be ‘rolled’ on a regular basis (usually monthly or
quarterly) from the expiring contract into a longer-dated one. In many
commodities markets, the further out in time you go along the futures ‘curve’,
the higher-priced the relevant contract will be.
This ‘upward-sloping’ futures curve is known as a ‘contango’. Any passive
strategy of rolling from one contract to the next will incur a cost, as the longer-
dated contract is more expensive than the shorter-dated one. That’s exactly
what’s been happening in the oil market this year, and it’s the reason why oil
trackers have not copied the performance of spot crude.

It’s not always like this – if futures prices are below spot (a price structure
known as ‘backwardation’) – you’ll earn money when rolling contracts rather
than losing it. However, contango is the norm for a non-perishable commodity
which incurs storage costs (because people expect to be paid more in the future
for a commodity which costs them money to hold on to).

There is one exception: gold and other precious metals. These typically have
little in the way of a forward curve, meaning trackers can follow the spot price
quite closely. Most gold ETCs are backed by holdings of the metal itself, rather
than futures contracts, and directly track the spot price after a deduction for
fees.

So what should you buy?

As regular readers will know, MoneyWeek prefers plain vanilla investments by
and large. The more complex ETFs become, the further they move from their
core remit, which is to offer investors simple, cheap exposure to the market of
their choice. So unless you’re a trader, we’d avoid leveraged products.

As for ETFs tracking commodity prices, they have their place (particularly
precious-metals trackers), but longer-term investors interested in playing soft or
industrial commodities are probably best off finding stocks with exposure to
rising prices, rather than betting directly on specific commodities. But that still
leaves plenty of uses for ETFs, not least in playing more exotic stock markets.
Below, we pick out some of the ETFs we favour to play markets we like.

• Paul Amery is editor of www.indexuniverse.eu , the leading source of news

and analysis on the fast-growing European exchange-traded fund market.

Some potential golden opportunities…

Most of MoneyWeek’s favourite asset classes can be followed using ETFs.
Gold

Starting with gold, we’d suggest investors hold some physical bullion. But a
convenient way to get exposure is via the London-listed ETF Securities Gold
Bullion Securities (LSE: GBS).The ETF is backed with physical gold stored in
London, so it tracks the spot price.The management fee is 0.4% a year. As for
gold miners, our precious metals writer Dominic Frisby favours the US-
listed MarketVectors Gold Miners ETF (NYSE: GDX) that tracks the HUI,
which is the index of US-listed unhedged gold stocks (those gold producers who
have full exposure to the gold price).

Japan

Among developed markets, we still favour Japan, which Andrew Smithers of

Smithers & Co believes may be “the only significant market in the world which is
not seriously overvalued”. One of the least expensive London-listed ETFs
is Lyxor’s Topix ETF (LSE: LTPX), which simply tracks the Topix index. It
has an annual management fee of 0.5%. Those more interested in getting
specific exposure to Japanese small caps – which are even cheaper than the
broader market and more exposed to the domestic consumer – the iShares
Japan Smallcap ETF (LSE: ISJP), with an annual fee of 0.59%, gives you
exposure to more than 400 small-cap Japanese stocks.

Emerging markets

Emerging markets (EM) in general are looking more expensive these days, but
investors should have exposure to these regions for the long run. There are too
many individual country ETFs to list in detail here, but if you’re looking for a
general EM fund, Cris Heaton, who writes the free MoneyWeek Asia email,
suggests buying an ETF that tracks the MSCI Emerging Markets index, which
has Brazil, South Korea, China, Taiwan and South Africa as its five biggest
holdings; the biggest issue (a common problem with EM funds in general) is
that it’s biased towards sectors such as financials and energy, with relatively
little direct exposure to consumer themes. There are London-listed ETFs
tracking the index from iShares (LSE: IEEM), db x-trackers (LSE: XMEM)
and Lyxor (LSE: LEME). Fees are in the 0.65%-0.75% range, so the choice is
down to how often you want dividends paid or whether you want them
reinvested. iShares also offers an MSCI Emerging Market Smallcap
ETF (LSE: SEMS). The geographical focus is similar, but there’s a heavier
weighting in consumer stocks.

Regional funds

On regional funds, Asia has the best choice. The broadest large-cap funds are
the db x-trackers MSCI AC Asia Ex Japan (LSE: XAXJ) and MSCI EM
Asia (LSE: XMAS). The second is more of a pure EM fund; it doesn’t have Hong
Kong or Singapore (but does include South Korea and Taiwan, which,
confusingly, are developed countries whose stock markets are still classed as
emerging). Latin American trackers such as the iShares MSCI Latin
America (LSE: LTAM) are dominated by Brazil, with a lesser weighting in
Mexico.

What about value stocks?

There are fundamental ETFs that track stocks based on metrics such as
dividends and book value, rather than their market capitalisation. This is meant
to cure the main problem with trackers, which is that they end up investing
more and more in sectors and companies as they become increasingly
overvalued (such as during the tech boom). With fundamental ETFs you get to
track the best companies without overweighting the latest fad in the stock
market. Sounds great – but while we like the idea, fundamental ETFs have yet to
take off in a big way. Invesco closed down 19 fundamentally weighted ETFs in
May.

Top dividend payers

And while an ETF that tracks the FTSE’s top dividend payers sounds a good
idea, the trouble with mechanically tracking such stocks is that a high yield
often signals a dividend is about to be cut. For now, this is one area where we’d
buy an investment trust – such as Neil Woodford’s Edinburgh Investment
Trust (LSE: EDIN). Or, as the number of secure dividend-paying blue-chip
FTSE stocks is relatively low, just buy the shares yourself.

• This article was originally published in MoneyWeek magazine issue number

463 on 27 November 2009, and was available exclusively to magazine
subscribers. To read more articles like this, ensure you don’t miss a thing, and
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