There are two types of ETFs you should be wary of if you want to avoid risks. We’ve sidestepped these risks with our 13 “Best Exchange-Traded Funds For You”.
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-know investors, such as Warren Buffett and former mutual-fund star manager Peter Lynch followed.
It’s also a principle that formed the basis for exchange-traded funds, or ETFs, when they were first launched a few decades ago. In fact, the first ever ETF was started here in Canada in 1989. At that time it was known as the Toronto Index Participation Shares, or TIPS 35. It was the forerunner of today’s iShares S&P/TSX 60 Index Fund.
Early ETFs were simpler, more transparent
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, then, always had a clear idea of what was in their ETF from one day to the next. With a simple and transparent product like TIPS 35, they knew they were assured the same performance as the index. That’s because back then, TIPS charged no management expenses.
Fast forward to today and the ETF landscape looks considerably different. Today, the number of these products has ballooned to just over 5,000 worldwide. And with the proliferation of ETFs has come greater complexity.
Many of these new investment vehicles track obscure indices 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.
Beware synthetic ETFs
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 failed to meet its obligations to an ETF, then the derivative contracts would 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.
We favor ETFs that hold ‘real’ assets
With ETFs, however, counter-party exposure is limited to 10 per cent of the fund’s net asset value. So, generally, you can only lose a maximum of 10 per cent of your money if the counter-party folds. But that’s still a risk you might not want to incur when you invest in an ETF. In Canada, a greater concern is the concentration of counter-party risk, as most swap-based ETFs rely on just one counter-party.
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 our “Best Exchange-Traded Funds For You” list in the Money Reporter.
Mind you, some of the funds on our list do use derivative 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 our view.
Beware obscure index ETFs
Another drawback of synthetic ETFs you should keep in mind comes from the sheer numbers of new offerings that have flooded the markets in recent years. After all, the more mainstream and transparent market indices 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 a mainstream 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 their benchmark. In fact, such inverse and leveraged ETFs like the Horizons Beta Pro S&P/TSX 60 2X Daily Bull ETF, are best held for no more than a day.
Stick with transparent, straight-forward ETFs
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 our “Best Exchange-Traded Funds For You” list. Because they’re easier to understand, they’re more likely to stand up to your investment expectations while posing less risk to you than do the more exotic synthetic offerings. We think they’re among your best ETF choices for income or long-term growth.
This is an edited version of an article that was originally published for subscribers in the August 2, 2019, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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