There are risks, but I’ll stay with ETFs for my money: ETF concerns- Has anything changed?
In a nutshell
Yes there are risks everywhere, but I am sticking with ETFs so long as they are used as they were intended to be. Broad/diversified asset classes (except where accessing in a limited application otherwise inaccessible asset classes), low cost, high liquidity, reputable sponsor, primarily to construct a portfolio to meet long-term objectives, limited trading, no leveraged or inverse ETFs and special care on use of market/limit/stop-loss orders especially in volatile markets.
Only low-cost ETFs can battle the relentless erosion of one’s portfolio by high fees associated with mutual funds and ‘financially engineered’ investment and insurance products in general, and Canada in particular.
While I don’t advocate the exclusive use of Vanguard ETFs just because they are a (possibly the only) ‘mutual’ (customer owned) rather than ‘public’ (stockholder owned) investment company; however in a manner analogous to the insurance company discussion (in my recent blog entitled Insurance: To insure or self-insure? Public or mutual insurance company?) it is impossible to simultaneously serve two masters, and the management of a ‘public’ fund company has fiduciary responsibility to its shareholders rather than customers.
Generally speaking when there is a significant pool of assets to be allocated to an asset class you might consider splitting implementation between two different sponsors (e.g. Vanguard and iShares).
I’ve been meaning to collect some thoughts about concerns that might occur to the growing number of investors who (like me) are relying partly or completely on ETFs in building their portfolios. (Some of these are comments from previous Hot Off the Web blogs while others are new perspectives on ETF risks.) These concerns might have intensified last month when on May 6th some broadly diversified ETFs (like many individual stocks) have dropped in price dramatically in a matter of minutes. In fact for those few minutes there also was a total disconnect between the ETFs’ market value and their NAV based on the underlying securities. (E.g. see Eleanor Laise in the WSJ’s “Danger: Falling ETFs”)
Then there are a growing number of articles which suggest that there are significant unknowns (individuals are not aware or there are perhaps significant unknowns in general about ETFs). No doubt that this is true, but I suspect no more or less than in other similar financial products. For example there was a short article I came across in the Journal of Financial Planning last week entitled “3 things you don’t know about ETFs”in which Carly Shulaka writes that the three things you don’t know about ETFs are: (1) liquidity is not about daily trading volume of the ETF itself, but more about the liquidity of the underlying securities (i.e. large cap developed country underlying is more liquid than small cap stocks, developing country, real estate, or non-sovereign fixed income) because authorized participants (or market makers) are responsible for creation of ETF units (and hedging their exposure by buying the equivalent underlying securities), (2) “not all ETFs are created equal”- in fact you really need to understand the objectives of the ETFs and the mechanisms used to implement them; common recent examples of surprises were associated with leveraged ETFs, or ETNs (which are not ETFs but a completely different construct which is like an obligation (bond) of the issuer), and (3) the source of tax efficiency of ETFs is only partly due to the fact that it is based on an index, most of the tax efficiency results “because its structure enables it to meet investor redemptions without having to sell securities”. (Yes, but mutual funds often take advantage of tax efficiencies by strategies/timing of securities sales.) At least the first item on Ms. Shulaka’s list was violated during those key 20 minutes, when some ETFs had a total disconnect between the market value and the NAV based on the underlying securities, so it isn’t just about the liquidity of the underlying securities. In a crisis situation it is also about the liquidity of the ETF itself.
The final trigger to write some thoughts on ETFs was when Globe and Mail’s Rob Carrick referred to in the past week to a couple of recent opposing articles on ETFs: against ETFs was the legendary John Bogle in “Bogle: Investors are getting killed in ETFs” and a rebuttal in support of ETFs in “ETFs better than mutual funds for long-term investors”. Bogle’s issue with ETFs is reported to be based on investor behaviour potentially induced by the ease of trading ETFs (intra-day rather than just end of day trading of mutual funds) resulting in more frequent trading; this often ends up in buying high and selling low, thus actual ETF investors receiving worse returns that those offered by the ETFs. He found that investors in comparable mutual funds traded less frequently and ended up lagging returns of the same funds by less. (Is there a cause and effect relationship here, that people trade more because they own ETFs rather than mutual funds or did some buy ETFs because they want to trade more, for example?) The article taking the opposing side argues that ETFs are the best for long-term investors because of: Bogle’s analysis is based on imprecise data, but more importantly because there are cost and tax advantages of ETFs in case a large fund investor sells a significant holding (resulting in capital gains distributions). (Frankly, with all due respect to John Bogle and the other author, I am not particularly impressed with either argument; the ETF investor can be a long-term investor as well if she so chooses and the mutual fund can have tax advantages as well, such as harvesting losses when gains are realized. As far as Canadian investors are concerned, ETFs are their only option when they want to access low-cost U.S. originated funds, as U.S. mutual funds are not permitted to be sold to Canadians due to some unfathomable reason.)
Let’s look at things that you might be worried about and perhaps some thoughts on what you might be able to do about your concerns.
Not sure how many investors read the prospectus of the ETFs that they buy, but if you read for example the December 1, 2009 iShares MSCI EAFE Index Fund (EAF) you can find “Summary of principal risks” starting on p.S-2, where 16 are listed. A little further on starting on p.1 there is “Further discussion of principal risks” and 24 risks (and further sub-risks) are discussed. You may (or may not) want to read the whole prospectus, though I doubt that it is significantly different than what you may find if you read your mutual fund prospectus covering a similar asset class (e.g. Vanguard Developed Markets Index Fund which by the way is not available to Canadian investors.)
I won’t bother to discuss all the risks mentioned in a typical prospectus, but I would like to discuss a few of some of the more unusual ones or some of the unusual aspects of some of the common risks.
Conflict of interest
Starting on page 15 of iShares MSCI EAFE Index Fund (EAF)prospectus a long list of potential conflicts of interest is identified due to dealings of and with affiliated companies. “…their interests or the interests of their clients may conflict with those of the Fund. One or more of the Entities act or may act as an investor, investment banker, research provider, investment manager, financier, advisor, market maker, trader, prime broker, lender, agent and principal, and have other direct and indirect interests, in securities, currencies and other instruments in which the Fund directly and indirectly invest.”
Further on page 16 the Prospectus indicates that “The Fund may also make brokerage and other payments to (related) Entities in connection with the Fund’s portfolio investment transactions. “
So some/many of the affiliates may earn fees, and/or may be on the other side of trades performed on behalf of the fund, and may thus expose the fund to excessive trading or other costs.
Counter-party risk in security lending
Also from iShares MSCI EAFE Index Fund (EAF)“Under a securities lending program approved by the Fund’s Board of Trustees, the Fund has retained an Affiliate of BFA to serve as the securities lending agent for the Fund to the extent that the Fund participates in the securities lending program. For these services, the lending agent may receive a fee from the Fund, including a fee based on the returns earned on the Fund’s investment of the cash received as collateral for the loaned securities. In addition, one or more Affiliates may be among the entities to which the Fund may lend its portfolio securities under the securities lending program.”
While securities lending is mentioned in the conflict of interest section (i.e. potential self-dealing in high fees or other conflicts), I have not noticed it discussed in the risks sections; e.g. what about counter-party risk should the collateral provided in the securities lending process turns out to be inadequate/insufficient and the borrower of the securities is unable to return them.
In the Financial Times’ “Cautious approach to lending out stocks” Sophia Grene writes that “Index tracking funds and pension funds often seek to earn extra revenue by lending out the stocks they hold to traders wishing to sell them short”. With the collapse of Lehman Brothers counter-party risk (adequate collateral) suddenly became an area of concern, specifically when say an index fund manager lends a security to hedge funds which wants to short those securities. The risk is that if the borrower will be unable to return the securities, is the collateral adequate? When cash is used as collateral, the lender (the index fund) will invest the cash to generate returns and if they invest it aggressively they may incur losses.
This is the case where the ETF sponsor undertakes securities lending to generate additional income for either off-setting investor costs or perhaps to generate income for its own account, by introducing risk which is ultimately borne by the investor. In effect the securities lending may expose the ETF (or mutual fund, I suspect) owner to this counter-party risk without necessarily benefiting the ETF holder.
As mentioned above, ETF liquidity is supposedly not about daily ETF volume but a function of the liquidity of the underlying securities. However on May 6, 2010 there was what appears to be a different phenomenon at play; specifically, unresponsive market-makers. Eleanor Laise in the WSJ’s “Danger: Falling ETFs” discusses the complexity (and risk if not handled with care) that come with ETFs, which otherwise should be the picture of transparency, liquidity and simplicity. So while on May 6th over about 20 minute interval when the Dow fell almost 10%, some ETFs dropped by 50% or more (some even to pennies), though the exchanges cancelled “any trades executed at prices 60% or more away from pre-crash levels”. “Many ETFs didn’t behave like broadly diversified baskets of stocks—they performed like single stocks subject to the whims of panicked traders. For some ETFs, the “net asset value,” or the value of underlying holdings, fell only 8% or so even as the market prices of the ETFs plunged 60% or more.“ Investors who placed stop loss orders (which are in effect market orders once the trigger price is hit) on their ETFs ended up selling some of their holdings at 50% or even less than the pre-crash prices. Laise then weighs in with some rules that ETF investors should consider such as: (minimize or) don’t trade on very volatile days, use limit rather than market orders, consider trading costs resulting from wide bid-ask spreads in your choice of ETFs (try to limit yourself to very broad market and highest liquidity ETFs), and look at underlying market value of the ETF before trading. In a related article Jason Zweig looks at a eerily similar plunge in “Back to the future: Lessons from the ‘Flash crash’ of 1962”; both events resulted from sudden evaporation of liquidity when key market participants (‘specialists’ in 1962 and ‘high frequency traders’ in 2010) withdrew from the market in the face of ‘rapid’ price drops. In the Financial Times article “’Flash Crash’ delivers clear messages” Duncan Niederauer argues that the ‘flash crash’ was caused by “weaknesses in the structure and mechanics of our market system rather than any particular piece of economic news”. While he is encouraged that the SEC has quickly enacted single-stock ‘circuit breakers’, he feels that confidence in the system has been shaken and further steps are required like: increased transparency (30% of all stock transactions in the US do not occur on regulated exchanges”) and insufficient transparency in ‘price discovery’. (The SEC has introduced circuit breakers, though further changes are expected.)
In the Barron’s article “ETFs get an “F” for May 6 liquidity”Tom Sullivan reports that as a result of the May 6, 2010 20 minute stock drop “some ETFs lost almost all their value and couldn’t be traded at all” and “ETFs represented 70%, or 227, of the 326 securities for which trades were cancelled by the exchanges, owing to a price drop of 60% or more”. “The SEC is also probing the role of market makers, the effect of institutional investors, who often trade rapidly, plus the impact of stop-loss market orders — those placed in advance with a broker to sell a security when it falls to a certain price, limiting an investor’s loss.” Sullivan asks: How bad is the damage to the reputation of exchange-traded funds?” It seems based on May’s net positive inflows into ETFs that confidence was not damaged significantly. Of course those who did not have stop loss orders and/or were not panicked into selling during those frenzied few minutes, were not affected more than corresponding mutual funds.
Tracking of stated ETF objectives
Steve Johnson writes in the Financial Times’ “Alarm over commodity ETP returns”that relatively recent, and increasingly popular, commodity-based exchange traded products’ performance “can dramatically undershoot that of underlying spot commodity prices, a factor not all investors may understand… The discrepancy arises because most of these ETPs, with the exception of some precious metal funds, invest in futures contracts that are rolled over before expiry. When the forward curve is upward sloping, known as contango, investors lose money every time the contract is rolled forward.” “Investors really shouldn’t be buying into ETPs when the market is in contango. Many commodity ETPs are short-term trading vehicles and investors should avoid them if they want long-term exposure to commodities.”
Different mechanisms result in similar mis-tracking which is observed with leveraged, inverse ETFs, and other derivatives based implementations (e.g. ETNs which are primarily ‘futures’ based implementations).
In “ETFs: Maximizing the opportunities for institutional investors”it is reported that “SEC Chairman Mary Schapiro has indicated that an additional regulatory review may be complete by year’s end. The reason: While ETFs are held predominantly by institutional investors, retail investors constitute the majority of owners for the top-three inverse and leveraged products. However, according to the Financial Industry Regulatory Authority, the largest independent regulator for US securities companies, inverse and leveraged ETFs are not typically suitable for longer-term retail investors. Inverse and leveraged ETF products reset daily. With the effect of compounding, this can produce returns that diverge widely from benchmarks”.
Increasing costs/fees due to changes in business model or ownership of ETF sponsor
Further on page 16 the Prospectus iShares MSCI EAFE Index Fund (EAF) indicates that “The Fund may also make brokerage and other payments to (related) Entities in connection with the Fund’s portfolio investment transactions. “ This may result in changes in costs associated with ETFs which may get worse or better when there is a change in sponsor objectives or business model or change in ownership structure of sponsor could result in rising management fees and other costs. If you bought XIU or SPY many years ago and you have a large unrealized capital gain associated with these ETFs, you might be effectively locked into these ETFs, as selling them will result in significant taxes resulting from the accumulated gains.
Some of the ETFs have enormous capitalizations; for example iShares S&P 500 IVV ($21B expense ratio of 0.09%), iShares MSCI EAFE EFA ($31B expense ratio of 0.35%), iShares Emerging Markets EEM ($33B with expense ratio of 0.72%) Vanguard Total Stock Market Index VTI ($135B with expense ratio of 0.07%), State Street S&P 500 SPY($72B with expense ratio of 0.10%) or State Street Gold GLD ($50B with expense ratio of 0.40%). For every $10B of assets held each basis point (bp) or 0.01% increase of fees generates $1M extra profit. So for the iShares group of ETFs, which were recently bought by BlackRock from Barclays, with close to $400B in ETFs capitalization under management, a 1bp increase in fees adds $40M in profit or 10 bp or 0.1% increase in fees adds $400M. And don’t forget that many of the fund issuers get paid for other services which they perform in-house for the funds under management such as custodianship (hopefully not done by an affiliate), creation/redemption fees/charges security lending, etc which generate significant additional revenue/profits which are deducted from fund assets as they are incurred and not as readily visible as the management fees/expenses.
The temptation to increase the costs associated with in-house services provided or management fees charged must be pretty significant, and the financial industry is not famous for a competitive pricing environment especially for retail customers. As an example I received a few weeks ago a notice from iShares that they’ll start charging HST (the new Canadian Harmonized Sales Tax), which was also mentioned in Shirley Won’s article “iShares Canada ETFs poised to charge HST”; previously iShares absorbed the predecessor GST taxes.
In the rebuttal to John Bogle’s above mentioned article, “ETFs better than mutual funds for long-term investors”, the author hints at tax management disadvantages of Vanguard ETFs because, unlike other ETFs, they are co-managed with the corresponding asset class Vanguard mutual fund. Vanguard however argues that this approach potentially offers increased tax benefits, since ETFs get the tax advantages of both the ETF and mutual fund constructs, as described at the Vanguard ETF webpage:
“Because Vanguard ETFs are shares of conventional Vanguard index funds, they can take full advantage of tax-management strategies available to conventional funds and to ETFs. Conventional index funds can manage tax liabilities by selling high-cost securities to realize losses to offset realized gains. Vanguard ETFs can also limit a fund’s potential capital gains exposure by using in-kind redemptions to eliminate stocks with high built-in capital gains from the portfolio. This advantage gives our Vanguard ETFs management team more flexibility in implementing tax-management strategies.”
There are risks, but it is not obvious that these are any more significant as compared mutual funds, and there are advantages over mutual funds available for the taking. ETFs continue to remain my primary portfolio implementation mechanism.