Exchange-Traded Funds (ETFs): Proceed with Caution

Tuesday, 26 July 2011 Posted in SpringReef Insights

Last week, securities regulators for the state of Massachusetts issued a formal complaint against RBC Capital Markets and one of its former financial advisors over the sale of leveraged and inverse-leveraged exchange-traded funds (ETFs), citing the use of dishonest practices to sell the investments to clients who did not fully understand their unique complexities or risks.

While not the first of its kind and likely not the last, the complaint against RBC Capital Markets is timely given the growing popularity of ETFs in investment portfolios today. Originally developed in 1993 as a way to emulate the S&P 500, ETFs have since drawn a tremendous amount of interest in the investor community – over the last twenty-four months alone, close to 1,300 exchange-traded funds and products have come to the market, raising approximately $470 billion in investor assets. These new arrivals have brought the global total of such products to 3,987 and the corresponding asset levels to $1.6 trillion1.

The reason behind this boom can be easily rationalized. ETFs, originally designed to offer the diversification of a mutual fund and the liquidity and transparency of a stock, often have lower expense ratios than traditional mutual funds and can offer investors easy, inexpensive access to the markets. And armed with these benefits, investment firms and financial advisors have encountered little difficulty in selling the products to their clients.

Of course, as can be deduced from the complaints against RBC, not all ETFs are as simple as they seem. As with many investment vehicles, their simplicity often gives way to underlying, often misunderstood complexities, blindsiding many investors who think they know exactly what they’re getting.

Given the increasing popularity of these investments, the propensity of firms to find more complicated ways to sell into that demand, and the likely pitfalls associated with unabated growth, this month’s SpringReef Insights focuses on five lessons to remember when investing in ETFs.


1. Size Does Matter

Generally, an ETF needs to have $100 million in invested assets to be profitable for its sponsor. Unfortunately, almost half of the ETFs on the market today have less than $50 million in assets and roughly half of those have under $10 million.

What are the potential effects of smaller funds on client portfolios? To start, they can create problems with high expense ratios and larger than average bid-ask spreads. They can also create liquidity issues if they decide to close and investors are backed into either selling at a discount or waiting for a liquidation check.

For additional insight on these types of funds, readers can browse through the “ETF Deathwatch” section of Invest with an Edge – it currently lists 155 ETFs on life support.

The rule here? Be wary of ETFs with assets under $100 million.


2. The Importance of Order Type

To the surprise of many investors, ETF prices are not immune to wild swings, particularly during volatile market conditions. Consider the “Flash Crash” that took place on May 6th, 2010. Instead of performing like broadly-diversified baskets of stocks, many clients were shocked to see that ETFs functioned like single stocks subject to the whims of panicked traders. For some of these funds, prices plunged over 60% while the underlying net asset value fell only around 8%. About 210 of the 980 ETFs that traded on this day did so at less than half of their ultimate closing price.

There are countless stories of people who entered “market” or “stop-loss” orders during the crash and received execution prices that were dollars lower than what they expected.

Our advice for averting this situation – avoid “market” and “stop-loss” orders in favor of “limit” orders, particularly on volatile days.


3. Watch Out for Leverage

As the good folks of Massachusetts have discovered, leveraged and inverse-leveraged ETFs lose money over time. For those who want additional evidence, Balaji Viswanathan, a writer at Seeking Alpha brings forth an example involving the DIG (ProShares ETF that corresponds to twice the daily performance of the Dow Jones U.S. Oil & Gas Index) and the DUG (ProShares ETF that corresponds to twice the inverse of the Dow Jones U.S. Oil & Gas Index).

Since the DIG and DUG are leveraged, opposite bets on the oil and gas industry, logic dictates that one of them should always be on the winning side of the market, right?

Guess again. Over a period of twenty months, both ETFs lost 45% of their value.

In another example, J. Alex Tarquino of SmartMoney Magazine notes that in October of 2010, “…all 52 leveraged ETFs that had been operating since January 1st, 2008 lost money…even those whose index had risen over time.”

The lesson to take away? Avoid leveraged funds.


4. It’s What’s Inside that Counts

Traditional ETFs are pretty straightforward, consisting of stocks or bonds that typically move in line with their respective indices and can be traded intraday for liquidity.

Conversely, synthetic ETFs, which use derivatives such as swaps, present a whole series of additional risks. Aside from regular market or investment risk, there's also credit risk or counterparty risk of the instrument intended to track the market. Not to mention the risk that the synthetics inside the ETF will gap away from the asset class or index.

Jim Wiandt, founder and CEO of IndexUniverse offered a great analogy in a recent issue of Barron’s. He thinks of classic ETFs as "cotton" and synthetic ETFs as its more complicated, man-made substitute, "polyester."

Our advice – always wear cotton. Avoid ETFs that use derivatives or futures.


5. Watch for Premiums and Discounts

ETFs trade on an exchange and represent a portfolio of underlying securities. Generally, the price of the ETF and the net asset value of the underlying securities stay pretty close to one another. However, in volatile times and thinly-traded markets, strange things can happen and the spread can increase dramatically.

As an example, many investors seeking to participate financially in the recent market turmoil in Japan or Egypt wound up sorely disappointed. While markets moved significantly upward following the well-known events, investors who leapt to buy ETFs paid historically high premiums of approximately 25%, and while markets advanced as the situations settled, the premiums contracted leaving the ETF price essentially unchanged.

The lesson here – purchase or sell within historical premiums. For those interested in studying current and historical premiums / discounts, information can be found on the ETF pages at Morningstar.


Conclusion

In a recent article in The Wall Street Journal, reporter Emma Dunkley sums up our theme perfectly. “Innovation in the financial markets is often viewed as a double-edge sword,” she says. “On one side, cutting edge products like ETFs can offer a more efficient way of investing. Yet on the other side, there is a danger of over exuberance leading to even more complex variations on a once simple idea, which can lead to misunderstanding and potential market failure2.”

Before taking advantage of the potential benefits of ETFs, be sure you and your financial advisor fully understand the complexities and potential risks involved. Only then can you truly decide the suitability of the product for your portfolio.

 

1 Willoughby, Jack. “ETFs Carry More Risks.” Barron’s (Barrons.com). 16 July 2011.
2 Dunkley, Emma. "Don't Lose Your Grip." The Wall Street Journal (WSJ.com). 22 June 2011.

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