ETF flaws

Exchange Traded Funds (ETFs) are shares traded on a stock exchange that track a stock or bond index, a commodity, or even a portfolio combining all those assets. The ETF market has gained lot of traction over the last decade thanks to low fees and good performance compared to actively managed funds. In this article we highlight the key risks and problems that ETF investors should consider.

Size is a problem: five trillion dollars and rising

ETFs have grown from $450 million in assets under management in 2005 to more than $4.9 trillion last month. This growth rate is expected to continue in the near future, and according to a study by EY the ETF market will continue to grow 15-20% over the next five years. The size of the ETF market has already exceeded that of the high-fee actively managed hedge fund industry and forced all funds to lower their fees to compete. But size could become a problem, particularly for smaller markets like high yield bonds, the volatility market and some commodities. ETF investors are fickle, and tend to stampede in and out of popular trades and for small markets this could cause instability and detach prices from their fundamental drivers. This has worried some regulators like the Securities and Exchange Commission in the US and the Banks of England in the UK, but has so far stopped short of capping the size of ETF funds.

Source: ETFGI

What makes ETFs attractive?

The main drivers behind the large inflows into the ETF market are its low cost compared to actively managed funds combined with growing evidence that few active funds generate outperformance net of fees. This has been highlighted by Warren Buffett's Million Dollar Bet but also by S&P's SPIVA website that tracks active equity fund performance. Familiarity with the indices that ETFs track also gives them a marketing edge. For example the performance of a FTSE 100 tracker can be followed in any newspaper. Of all the benefits, low fees are probably the primary factor drawing investors into passive ETFs. For example, according to data provider Eurekahedge a hedge fund charges on average 1.39% every year on the amount invested while passive ETFs charge just 0.4% per year, with the cheapest funds charging as little as 0.07%.

What are the Problems?

So much for the benefits. Here we highlight the top five problems with ETFs which you need to be aware of as an investor:

  • Cost: The management fee for ETFs is often very low, however there are other hidden costs involved
    • Rebalancing: ETFs that track an equity or bond index get re-balanced. The ETF manager has to sell the stocks or bonds which have dropped out of the index and buy new securities which have entered the index. Also as prices fluctuate they push the ETF out of sync with the weights in an index and securities have to be bought and sold to bring the ETF back into line. This continual buying and selling incurs trading costs because to buy any stock or bond two prices are quoted: one is the bid price at which you buy and the other is the offer price at which you can sell. For a frequently traded share the difference between these two prices, the bid-offer spread, is tiny but for less frequently traded stocks it can be very large. If your ETF has these stocks then continual buying and selling could lead to losses.
    • Bond ETFs One of the great things about bonds is you don't have to sell them: if the bond issuer doesn't go bankrupt you get your principal back without facing the market ever again. Not so with funds. As investors buy and sell the fund the manager has to keep in step by buying and selling bonds. Combine this with the fact that investors sell funds when markets fall and buy funds when markets rise and you can see that the fund manager will be forced to sell into falling markets and buy into rising markets.
  • ETFs Shut Down: A lot of ETFs fail to attract enough investors which eventually leads to their closure as they cannot generate enough revenue to cover their costs. This problem is widespread and causes inconvenience to investors. According to ETF.com in 2016 128 ETFs, a record number, closed down. If you are worried about your fund a useful resource is ETF deathwatch. Once the ETF manager decides to close a fund it issues a notice giving the last trading day for the fund and you have the choice of selling before that date or waiting until the fund liquidates its assets after the last trading date. Your choice may also be affected by differing tax treatment of waiting or selling. Also if the closure occurs during a wider market crisis the liquidation could lead to distressed sales of the fund's assets into a market with no buyer which would lead to large losses. For examples have a look at ETFdb.com's "ETF Hall Of Shame: Nine Exchange-Traded Debacles".
  • Foreign Exchange Risk: Foreign exchange can be an invisible source of risk if you are buying an ETF linked to an index containing assets which do not trade in your home currency. In such ETFs your risk is twofold: one you are aware of, which is how your index has performed in the local currency and secondly how that currency performs relative to your home currency. So despite the underlying index generating high returns the ETF returns could be curtailed or even negative if your home currency has appreciated. Japanese ETFs are a good example because Japanese stocks perform well when the currency weakens but this also erodes the value in foreign currencies. One of the options to negate this foreign exchange exposure is to go for a currency hedged ETFs but be aware that the cost of the hedge can add to the management fee.
  • Liquidity Mismatch: For some ETFs liquidity of the assets bought by the ETF is very low. Liquidity refers to the ease and speed with which an investor can sell their assets. This problem is more evident in the corporate debt ETFs and property funds. In corporate debt most of the bond holders hold their bonds until maturity which leaves little liquidity in the market and makes it difficult to match buyers and sellers. The ETF itself may be highly liquid while the corporate bonds it owns are not so easily tradable. This could lead to a sudden fall in the fund's total asset value when the market is selling off. So as an investor you need to understand the liquidity of a fund's underlying assets.
  • Leverage: Some ETFs use borrowed money or financial derivatives to provide higher returns than a non-leveraged ETF tracking the same underlying index. A financial derivative such as a swap or future can be used to multiply your return. For example the ProShares Ultra S&P 500 fund provides 2 times the return of the US benchmark index the S&P 500 while the more popular S&P 500 SPDR ETF simply tracks the underlying index returns. Though multiplying returns might sound tempting one should be aware of the associated risks.
    • Leverage increases risk: Leverage works both ways so if the index shoots up by 10% your returns would be doubled to 20% while a fall of 10% would lead to 20% losses.
    • Fees: Leverage funds generate management costs so fees are often higher than comparable non-leveraged funds.
    • Not tracking: Another problem with the leveraged ETFs is that they no longer track an index, instead they multiply daily returns. You can't track and match levered daily returns. If the S&P 500 rises by 10% over a year a 2x levered S&P 500 fund will not rise by 20%. To see why the levered fund can't track accurately say the index falls 10% then rises 10% it will fall 1% overall (0.9 times 1.1 = 0.99). The 2x levered fund is designed to match 2x the daily return. It must therefore lose 4% not 1% (0.8 times 1.2 = 0.96) and this "leakage" increases over time. Levered funds are more suited to short-term investment and should be left to experts.
March 23, 2017