One of the most important investment principles you can follow is to sidestep investments you don’t understand.
It’s a principle that some of the most successful, well-known investors, such as Warren Buffett and former mutual-fund star manager Peter Lynch, have followed.
It’s also a principle that formed the basis for exchange-traded funds, or ETFs, when they were first launched two decades ago.
In fact, the first ETF was started here in Canada in 1989. At that time it was known as the Toronto Index Participation Fund, or TIP 35. It was the forerunner of today’s iShares S&P/TSX 60 Index Fund.
The early ETFs were simple in conception. They sought to imitate the performance of an underlying market index by holding in their portfolios the same securities in the same proportion as occurred in the index.
Investors, therefore, always had a clear idea of what was in their ETF from one day to the next.
With a simple and transparent product like TIP 35, they knew that they were assured the same performance as the index. That’s because back then, TIPs charged no management expenses.
Changing Landscape
Fast forward to today and the ETF landscape looks considerably different. In recent years, the number of these products has ballooned to nearly 4,000 worldwide. And with the proliferation of ETFs has come greater complexity.
Many of these new investment vehicles track obscure indexes and engage in difficult-to understand trading activities through such securities as swaps and derivatives. The result is that lots of retail investors don’t realize the potential risks they face with these products.
Indeed, potential problems can arise when so called “swap-based” ETFs use derivative agreements to simulate the performance of an index instead of actually holding the physical securities that make up the index. Commonly known as “synthetic” ETFs, these funds’ derivative agreements are backed by a counter party such as an investment bank. But if a counter party were to fail to meets its obligations to an ETF, then the derivative contracts could become worthless.
That’s what happened in 2008, when financial services firm Lehman Brothers went bankrupt, playing a pivotal role in the global financial crisis of that year.
The firm was the sponsor of the Opta Lehman Brothers Commodity Pure Beta Total Return exchange-traded note, or ETN. Needless to say, this ETN failed along with Lehman Brothers.
Keep in mind, though, that a synthetic ETF is less likely to completely fail than an ETN. The latter is a type of debt security designed to track the performance of a market index. The collateral rules of these investments are not as tightly regulated as those of ETFs. Hence, you could potentially lose all your money with an ETN.
With ETFs, however, counter party exposure is limited to 10 per cent of the fund’s net asset value. So you can only loose a maximum of 10 per cent of your money if the counter party folds.
But that’s still a measure of risk you’ll have keep in mind with synthetic funds.
The growing complexity of exchange-traded funds, which is a theme of this article on ETFs, is a global phenomenon. Fortunately, it’s less of a problem here in North America than elsewhere.
In 2011, the Financial Stability Board, or FSB, an international super-regulator, produced a report in which it examined recent ETF trends. It found that so-called physical, or “plain-vanilla,” ETFs are still the dominant form of ETF, especially in the U.S., where regulations are more conservative.
In Europe, however, the newer, more complicated synthetic ETFs now comprise 45 per cent of the market.
The FSB also noted synthetic funds are growing in some Asian markets. It’s a trend, the Board says, that warrants “closer scrutiny.”
It’s a far better fund strategy to stick with ETFs that track more transparent, straightforward indices
By contrast, ETFs that actually hold the real assets of an index are far less of a concern. These so-called “physical” ETFs are the types of funds that make up my “Best ETFs For You” (discussed in February/First Report ).
Mind you, some of the funds on my list do use derivatives agreements for the purpose of neutralizing foreign currency fluctuations.
Though this does introduce a small measure of risk, these funds still hold real assets and are, therefore, safer than synthetic funds in my view.
Obscure Indices
Another potential drawback of synthetic ETFs you should keep in mind comes from the sheer numbers of new offerings that have flooded the market in recent years. After all, the more mainstream and transparent market indexes already have one or more ETFs that track their performance.
New offerings, therefore, have had to go elsewhere to compete for investors’ money. And many of these offerings attempt to mimic the performance of obscure indices that typical retail investors just don’t understand.
Some of them that use leverage to magnify the rise or fall of a market index, or that let investors short-sell indices, may have special appeal for the inexperienced speculator. But these offerings entail even more risk than those that use derivatives to simulate an index’s performance.
That’s because they’ll often perform in ways that can’t be easily anticipated, producing long-term results that simply don’t resemble those of their underlying index.
These investments, then, are not easy to understand. And if you don’t understand them, you run an increased risk with them that they simply won’t perform to your expectations.
It’s far better to stick with ETFs that track more transparent, straightforward indices. These are the types of funds you’ll find in my “Best ETFs For You” list.
Because they’re easier to understand, they’re more likely to meet up to your investment expectations while posing less risk to you than do synthetic offerings. I think they’re among your best ETF choices for income or long-term growth.
* My advice: Stick to ‘physical’ ETFs, (such as the ones I recommend in the February 1st report of The MoneyLetter).
– James Kedzierski
The MoneyLetter •3/25/14 •