ETFs: Not so simple

By now most investors will have heard of ETFs or Exchange Traded Funds. These securities have mushroomed to hundreds of billions of dollars in assets in a relatively short time. Catchy names like Spider, ishares, Qubes, Vipers etc lead us to believe that ETFs are some new, simplified art of investing. However, just like all investments, there are complexities that indicate ETF’s are not what they may seem. An investor will be wise to learn a few facts, or even be prepared to pay for professional help, to build a risk-relevant portfolio of ETF’s.

Briefly, ETFs are baskets of securities which trade just like any other stock. The objective of these baskets is often to track well known indices. A common misinterpretation is that the ETFs hold the exact same securities as the index. Whilst possible, this is seldom the case. Some ETFs hold large positions in mutual funds or use derivatives and other highly correlated securities (albeit passively) to try to outperform the index. There are now at least 160 ETFs tracking every major asset class, broad market and sector/country specific index’s. In other words, “ETF” has become another investment category name all of its own, just like “bonds”. In fact, one ETF has as much in common with another as one AAA bond has to a junk bond.

Another common misunderstanding is that ETFs are always “low cost” when compared to mutual funds. Whereas at the management fee level this is usually the case by a large margin, from the investor’s perspective there is the brokerage cost, as the ETF has to be purchased through a broker-dealer just like any other stock. This is particularly relevant for small, short term and frequent traders as the increased brokerage will quickly negate the saving on the management fee. There is no doubt, however that long term ETF investors will benefit more from their low cost structure when compared to the average mutual fund. As a general guideline, brokerage costs will cause average investors with typically less than $20,000 to favour mutual funds, however longer-term investors, say +/-10 years, can reap benefits from ETF’s over mutual funds at investment levels of only $13,000*.

Compared to mutual funds, ETF investors generally have the benefits of greater liquidity, including intraday trading, the ability to short sell and buy on margin, and in general have greater tax efficiency. This liquidity benefit needs to be looked at closely as there are some ET’s that do not trade as regularly as others. Unlike regular mutual funds, ETF’s do not necessarily trade at the net asset value (NAV) of their underlying holdings, instead, the market price of an ETF is determined by forces of supply and demand. Whilst this is in part driven by the value of the underlying assets, liquidity is an issue and may cause ETF’s to trade above or below their NAV. The extent to which these discounts and premiums are considered to be temporary depends on the ETF.

Currency and country risks are other risk considerations often ignored in building a portfolio of ETFs. It is all too easy too assume a US listed “equity” will not be exposed to currency or political risks, but that is in fact the case and investors again need to be cautioned.

Another misconception is that ETFs are pure surrogates for passive investment. Whilst their index tracking nature can be passive, the ETFs are still stocks and stocks need to be managed and monitored in line with an investor’s risk tolerance. Further to this, ETFs are an excellent transition tool while an investor re-aligns between asset classes or other structures. Within an overall risk range, ETFs can maintain portfolio exposure whilst securities are shuffled. A practical example of this is if for instance an investor holds Cisco and wants to buy Microsoft, he needs to find a day when he is happy to sell the one and buy the other. Since there are few days both prices are right, he/she may sell the Cisco and buy a technology ETF and remain exposed to the systematic returns of the sector.

ETFs for fixed income can also be preferred options for investors. Fixed income ETFs can potentially provide an efficient vehicle for investors to hedge interest rate fluctuations. Also, fixed income ETFs are understood to give much greater transparency of spreads on bonds purchased through a bond dealer. Transactions in the bond market are not known for their transparency as investors don’t always know what the true bid/offer spread is. In addition, a fixed income ETF, like iShares Lehman TIPS Bond Fund, which invests in a basket of treasury inflation protected securities (TIPS), can help investors protect the purchasing power of their dollars. However, TIPS do carry risk as they will lose money in a deflationary environment, where the TIPS' yield falls short of Treasury’s or when interest rates rise but inflation remains subdued**.

The structure of an ETF can also influence its returns, especially when it comes to dividends that companies pass on to shareholders. For example, SPDR 500, by far the largest ETF, is a unit investment trust and distributes dividends on its portfolio to shareholders quarterly, net of fees and expenses associated with operation of the trust, and taxes, if applicable. Because of such fees and expenses, the dividend yield for SPDRs is ordinarily less than that of the S&P 500 Index. Investors should consult their tax advisors regarding tax consequences associated with Trust dividends, as well as those associated with SPDR sales or redemptions. With some ETF’s, the dividends must be held and cannot be reinvested in the underlying securities. This leads to further negative index tracking error or "dividend drag." All of the above mentioned factors could lead to underperformance vs. the target index and this may vary from a few basis points to substantial differences, which could have a dramatic effect over longer time periods.

To conclude, ETFs do have a lot to offer. They allow an investor to easily access all major asset classes and geographical regions without being exposed to non-systematic “stock picking” risks. However, as explained above ETFs are not as simple as the press leads investors to believe and investors should therefore approach ETFs with caution. With the help of their financial advisor, a suitable investor can build a portfolio of ETFs that are suitable to their investment needs, their risk tolerances and their existing portfolio.

The author is CFO of Pioneer International.