Are ETFs suitable for all investors?

YES

Lars Kalbreier, Global head of investment funds & ETFs, Credit Suisse Private Banking

Exchange traded funds (ETFs) have most probably been the biggest success story in financial markets over the last five years. Despite the difficult market environment, the total assets under management of global ETFs have almost tripled since 2006 to close to $1,500bn (€1,042bn).

Over recent years, investors woke up to the many advantages that ETFs offer. Firstly, as ETFs replicate a specific index, they provide immediate diversification benefits with little need for regular rebalancing by the investor. Secondly, they allow implementing market views without taking the specific risk associated with single stock investments. Thirdly, their passive management style achieves much lower operational costs, thus allowing for lower fees than traditional mutual funds. And finally, major ETFs can generally be easily traded on exchanges as they tend to have narrow bid-ask spreads.

These facts make them interesting not only for long-term investors, but also for investors who want to implement sector rotation strategies, hedging parts of their portfolio (eg with inverse ETFs) or even for short-term trading.

So, are ETFs the philosopher’s stone for investing? Stellar successes always call for critical review. Are ETFs better than mutual funds and are there systemic and counterparty risks hidden in them that are likely to lead to a major disappointment for investors?

The first question can be drilled down to: is active management dead? Our belief is that both ETFs and mutual funds fit very well into a holistic investment strategy.

Fees certainly are an important point when investing as they can heavily dent into long-term compounded returns. Therefore, if investors pay a fee, they should get alpha in return. In many efficient markets, such as US large caps, however, it is unlikely that an active manager can consistently outperform a low-cost ETF solution. Hence the case for ETFs is much stronger than the case for mutual funds in these markets.

In less efficient markets where manager skills have more potential to produce alpha, the additional fees for active management can well be justified, and a mutual fund with strong track record in generating alpha is likely to be the better choice than an ETF.

In our view, ETFs are clearly part of a holistic investment approach. A clear process has to define market segments which should be implemented with ETFs, and in which case mutual funds with active management should be preferred.

The second set of questions points more to the structure of the ETF. While the first generation of ETFs (so-called physical ETFs) is holding the stocks of the index it tracks, later generation ETFs sometimes deviate from this strategy and hold a collateral portfolio of assets that is potentially completely different from the index it intends to track. A total return swap then achieves the tracking of the index (so-called synthetic ETFs).

Under normal circumstances, the latter type of fund exhibits a relatively small tracking error. Under stress scenarios, however, this type of ETF indeed could entail some adverse behavior such as counterparty risk and liquidity issues. Conducting profound analysis of stress scenarios is therefore important before investing in ETFs.

The success of ETFs is certainly reflective of the advantages of this investment vehicle. It allows for an easy implementation of tactical and strategic views by different type of investors (ranging from retail to ultra high net worth and institutionals) at low costs. The fact that some new risks can arise from new ETF structures makes a proper due diligence and advisory process necessary.

Nevertheless, with the proper processes and checks in place, ETFs can add value for every investor if integrated in a holistic investment process.

Terry Smith, Fundsmith

NO

Terry Smith, Chief Executive of Fundsmith

When I first started looking at the problems of ETFs and discussed them with people in the investment industry, they said “they’re just index funds”.

If only they were, then there wouldn’t be a problem. In most circumstances I think investors would be better off investing in an index fund. They are low cost and most active managers underperform them. Why should you pay higher fees for worse performance?

But many ETFs are not index funds. An index fund owns the constituent securities in an index in the same weighting as the index. Some ETFs do this, but some do not own the index constituents at all. They are “synthetic”. They own derivative instruments or swaps in which a counterparty agrees to match the movements of the securities or commodities the ETF is trying to track. The credit crisis should have taught investors that there is no such thing as an undoubted counterparty, so who knows if a synthetic ETF will deliver the performance of the securities it is alleged to track in periods of financial stress?

ETF proponents claim that this problem of counterparty risk is negated by the fact that synthetic ETFs obtain collateral which they hold to ensure that if the counterparty providing the swaps on which they rely fails, they will have the wherewithal to ensure that the ETF investors will be able to realise the value they should have obtained from the swaps. But here’s the rub: the collateral can be held in instruments which bear no relation to the ETF. So your FTSE 100 synthetic ETF may hold collateral in Japanese yen bonds. When the moment comes to realise these because the swap counterparties have failed, who knows what their value will be?

Then there is the matter of leveraged ETFs and so-called inverse ETFs. Leveraged ETFs use debt to provide a return which magnifies the performance of the underlying index or assets. So a 2x leverage FTSE 100 ETF should go up or down at twice the rate of the FTSE 100 index. But the 2x leveraged FTSE 100 ETF is re-balanced daily to match the weighting of shares in the FTSE. As a result of this it is possible to own a leveraged ETF for a period of time over which the index goes up, but which includes days when there are sharp falls, and overall the investor can lose money.

Similarly, an inverse ETF allows an investor to profit from a fall in the underlying index, sector or commodity. But again because of the daily rebalancing, you can own an inverse ETF during a period when the index on which it is based goes down, but with some sharp rallies, and still lose money.

The final problem with ETFs is caused by short selling. ETFs are, as the name implies, traded on exchanges. This allows hedge funds and banks to use them to take short positions in the indices, sectors and commodities in the ETFs. When someone sells short in a security they have to borrow that security from a holder in order to effect delivery on their sale, hoping to buy it back later at a lower price. In normal companies, short sellers could not borrow more than the issued share capital, which places a limit on how much can be borrowed and sold.

But in an ETF you can seemingly rely upon the ability to create new units if necessary. So a short seller may borrow an ETF share from a holder and sell it to another holder and then borrow it again and sell it again ad infinitum. In these circumstances the short sellers may not always be able to obtain the creation of ETF units in order to close their shorts. They may not realise it, but the ETF may not have created any units for holders who purchased units from the short sellers and there are therefore too few assets in the ETF to cover their investment.

If all this seems confusing that in itself is telling – if investors cannot understand them, they are being mis-sold them by financial advisers.