How to check whether ETFs are right for your portfolio

Last week’s column noted the phenomenal rise of exchange-traded funds (ETFs) and the concept of passive investment. This is best exemplified by data from independent consultant ETFGI which shows that $197 billion flowed into ETFs worldwide in the first quarter of 2017. That compared to inflows of $70 billion in the same period in 2016 and was enough to take total assets under management to $3.9 trillion.

Low costs, transparency, simplicity and liquidity are four key drivers of this surge in assets, as explained last week.

Powerful and welcome as these four faces are, they do not mean investors can avoid doing the necessary research into what they are buying.

Such analysis will help them understand ETFs and better assess how (or whether) they can be used to construct a balanced portfolio designed to satisfy their overall investment strategy, target returns, time horizon and appetite for risk.

There are four issues which are worthy of note and consideration when assessing ETFs. All four represent the flip-side of the potential advantages discussed above.

1. Not all ETFs are the same

Not all ETFs are the same. This is where the research begins.

ETFs can use synthetic (indirect) or physical (direct) replication to generate performance. They can track different indices to access a specific asset class or geography or sector. Some lend out their stock holdings (usually to hedge funds who then short-sell the stock) to enhance performance with the lending fees.

Some ETFs now track their own custom-built indices, rather than the mainstream ones, with the result that according to work from Eric Balchunas of Bloomberg Intelligence there are now more stock indices in the USA than there are quoted stocks.

Over the past decade the number of ETFs quoted in the USA has soared from just over 200 to over 1,500. There are now 6,771 exchange-traded products with 12,750 stock market listings from 305 providers on 67 stock exchanges, according to data from ETFGI.

Looking at it dispassionately, it is hard to see how such index or product proliferation is helpful to anyone other than the ETF providers. Investment banks abhor a vacuum and if there is potential demand for something they will provide it – for a fee.

Some even argue that the rash of new indices and products tracking them is even creating demand for stocks and pushing their valuation into bubble territory as the ETF ‘tail’ wags the broader market ‘dog’.

This may have happened in the USA, where the VanEck Vectors Junior Gold Miners ETF has become too big for many of the stocks that it tracks. It now has stakes of 18% in ten Canadian gold miners – and if that figure reaches 20% then Canadian market rules require a takeover offer to all investors.

One solution has been to buy into the US-listed VanEck Vectors Gold Miners ETF, but that it taking the tracker into big-cap stocks and away from its mandate. Another has been to widen its underlying index to include larger-cap stocks, but again the changes the tool’s mandate. Holders then have to decide whether the ETF still fits with their strategy or not.

A US gold miner ETF has begun to outgrow its underlying index (and invest in another ETF to help it out)

Source: Thomson Reuters Datastream

2. Complexity

ETFs can therefore be more complex than they look.

Even if talk of the tracker tail wagging the market dog seems a little apocalyptic, investors do not need to investigate, let alone buy, an ETF simply because it is there.

A pungent example of this is the US-quoted Barclays iPath S&P 500 VIX Short-Term Futures ETN. This tool is designed to allow investors to ‘buy’ volatility and profit if the America’s VIX index, or fear index, goes up.

No-one perhaps could have predicted how the VIX has plunged by more than 75% to all-time lows since the launch of the product, as volatility has collapsed and markets have been soothed by central bank intervention.

But this trend has been exacerbated by how the product works. It is not possible to invest directly in the VIX so the tracker follows index futures. And futures lose value over time owing to time decay, so the futures are down over 90% and the ETN down by more than 99% since inception.

This shows how a simple concept rapidly becomes very complex with potentially serious financial consequences. Buyer beware.

This particularly applies to ‘short’ or ‘leveraged’ ETFs.

‘Short’ ETFs rise in value as the underlying falls (enabling investors to profit, or protect) themselves from market drops while ‘leveraged‘ ETFs do not move on a one-to-one basis with the underlying, but rise or fall by two, three or even four times as much.

On balance such products work well in ‘trending’ markets but deliver poor returns in choppy ones, owing to how they are priced, which is at the end of each day, rather than intra-day.

Some ETFs use futures to track an underlying rather than assets themselves

Source: Thomson Reuters Datastream

3. Opacity

The example above, and the use of futures, means ETFs may not be quite as transparent as they seem.

This particularly applies to some ETCs (exchange-traded commodities) which also use futures instead of owning the underlying in cases where storage is impractical or expensive (oil, live cattle, live hogs and even oil, for example).

The providers are quite clear about this, but investors need to think about the implications.

The manner in which futures contracts ‘roll’ over at regular intervals can affect the value of the ETC, relatively to the asset it is tracking, as we can see here from the well-established ETFS Brent Crude ETC.

The ‘roll’ in futures markets can affect how an ETC tracks an underlying commodity

Source: Thomson Reuters Datastream

Investors also need to check the small print when it comes to costs, as not all ETF providers include all of the ownership costs in the ongoing charge figure (OCF). Index licence fees and the cost of the derivative or swap transactions used by synthetic or indirect ETFs may sometimes be excluded.

4. Liquidity

Liquidity is always helpful, as hopefully investors can buy the ETF they want, when they want, in the volume they want and do so at the price they want.

But the temptation to over-trade should be avoided, as this brings with it unnecessary dealing costs and commissions which help to erode long-term portfolio returns. Just because it is now possible to access Russia or baskets or robotics or oil pipeline stocks does not mean investors should be doing so every five minutes (or at all).

It is worrying to see figures calculated by Bloomberg Intelligence’s Balchunas that two leading US ETFs turn over their entire market value roughly once a week, for an annual turnover ratio in excess of 3,500%. That is not long-term investing, in this column’s book, but wild punting.

Conclusion

At a time when many stock markets in particular are rising it is understandable that ETFs are becoming ever more popular. There is no scope for fund manager error and fees are kept low to allow investors to keep as much of this upside as possible.

Yet as with any tool, care must be taken when using them. No-one should ever forget that the bulk of ETFs are so-called ‘delta one’ products, so they will fall in value in lockstep with their underlying index just as methodically as they will rise with them.

This is easy to forget after an eight-year run in stocks and a 30-plus-year one in bonds – but we all know that markets can go down as well as up.

Even if we are entering a period where markets consolidate, ETFs may then look less attractive, as some fascinating research from fund management giant Fidelity attests.

Granted, the bulk of Fidelity’s funds are actively run so there may be an agenda here but the statistics look interesting.

According to the research, there are still a large number of stocks which rise by more than 75% even when markets are going sideways overall, on one- or three-year view.

Sideways markets could (in theory) favour active managers

Source: Fidelity International, Legg Mason Global Asset Management for US market

Skilled fund managers and stock-pickers will argue they can identify enough of these winners to outperform and provide value for money. They will also argue that their disciplines will lead them away from the biggest, the most popular and the, most expensive stocks before any smash – the very stocks which will be most heavily represented in an ETFs portfolio of holdings owing to the mechanics of index construction.

It may therefore only be the next market downturn that really provides fresh data for the active versus passive fund management debate.

But one final point must be considered. Asset allocation is still vitally important. Chasing performance can be costly. As Warren Buffett, himself a proponent of ETFs, put it: “You cannot buy what it popular and do well.”

The cost benefits of using an ETF relative to an active equivalent will be lost if investors find themselves overweight the wrong asset class, or country or sector and underweight the right one at the wrong time, no matter how cheap the instrument used.

Active and passive funds are just tools. Cost management is indeed critical, to ensure any investment product provides value for money and the best risk-adjusted returns. But it is the strategy they are used to implement that matters the most when it comes to dictating total returns.

Russ Mould, AJ Bell Investment Director