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Why you should beware of ETFs

Exchange traded funds (ETFs) have become increasingly popular in recent years.

That’s because they’re cheap, simple and easily traded. They combine some of the best features of shares and investment funds.

However, ETFs can be more dangerous than many people realise. In this video I explain how ETFs work and highlight the types of ETF that are especially risky.

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Transcript

In this video, I'm going to look at ETFs, or exchange traded funds. They're a really simple way to invest in the stock market, and also a lot of commodities, and I know they're very popular with a lot of MoneyWeek readers.

So in this video I'm going to look at what ETFs are, but I'm also going to highlight some of the dangers and risks that come with ETFs. ETFs are great, but they're not perfect. They can be risky, so I want to give you all the information, so you can avoid the pitfalls.

So what exactly is an ETF? Well it's basically a kind of passive investment – we touched on them before in a video called The lowdown on passive investing.

What I mean by passive investment is this: if you have an ETF fund that tracks the FTSE 100, then if the FTSE 100 goes up by roughly 10%, the ETF should go up by roughly 10% too. The ETF does that normally by buying all the underlying shares in the FTSE 100. And as I say, they're great, because they're cheap; the trading charges are really low, and you're charged a really low annual charge. They're really nice and simple, and they're easily traded.

ETFs are a kind of a hybrid between a normal investment fund like a unit trust or OEIC, and a share that you trade on the stock market. So the beauty of an ETF is you can sell or buy this fund on the stock market, you can do it at any particular point, and the trading costs are really nice and low.

Another big plus point for an ETF is that there is such wide range of assets you can invest in. ETFs don't just follow the FTSE 100 or the S&P in the U.S. You could buy an ETF that tracks the Brazilian stock market, or the Japanese stock market – pretty much any stock market around the world has an ETF. You can also use them to track different assets, commodities like coal, gold, or silver.

I've actually used an ETF myself. I made my first investment in gold just recently, and I used a physical gold ETF to make that investment. The ETF owns big chunks of gold that it's got in vaults in Switzerland, or New York, or wherever, and as the gold price goes up, my physical ETF goes up in line with it.

So it all sounds great so far, but there are potential problems with ETFs too.

If you want to track a stock market, some stock market ETFs don't buy all the shares in the underlying index. So you've if got a FTSE 100 ETF some don't buy all 100 shares, they just buy some of the shares, and hope that their performance will still move roughly in line with the index. Or they might use other investment products such as derivatives to achieve the same aim.

I'd rather have an ETF that owns all the shares in the index, because that means it's more likely to follow the performance of that index. Now, fine, if the index has 3,000 shares, maybe you can't buy all 3,000, but the basic principle is that you want an ETF that buys most or all of the shares in that index. If the ETF doesn't do that, it's a ‘synthetic’ ETF, and I'd rather avoid them.

You also have synthetic ETFs if you're trying to invest in commodities like gold or silver. As I said my gold ETF is a physical gold ETF – it's got gold in a vault. But there will be other gold ETFs that don't buy any gold whatsoever. Instead, they aim to track the gold price by investing in futures, or options, or other financial products. (An option gives you the right to buy some gold at a certain price in the future.)

If you buy and trade these products you could hope to replicate the performance of gold, but the risk is higher, and things can go wrong. I'd say you should only invest in an ETF using futures or options if you've got a really good understanding of how these markets work.

So if you don't know, to use some jargon, what ‘backwardation’ http://moneyweek.com/glossary/backwardation/ means for example, you really don't understand the futures and options market. And that's fine, it's not a crime, most of us don't understand what backwardation means. Same for another term: ‘contango’, http://moneyweek.com/glossary/contango/ if those terms make no sense, you need to stick with a physical ETF where the risks are lower.

The only downside here is that for some commodities you can only get synthetic ETFs. If you wanted to invest in corn, there are no ETFs that buy a lot of corn and leave it in a barn for a year or two, for obvious reasons. So you can only invest in a corn ETF that's synthetic, using a futures and options. And that's a shame. As I say if you don't understand the futures market, I'd say just stay clear of corn ETFs, there are loads of other potential investment opportunities out there.

Another kind of funky, or ‘sexed up’ ETFs are ‘short’ ETFs, or ‘leveraged’ ETFs. With a short ETF, if you're very sure that the FTSE 100 is going to fall, you might want to bet on that market fully. So with a short ETF, in theory, as the FTSE falls 10%, your ETF should gain, and deliver you a 10% profit. Very nice.

With a leveraged ETF, the size of your profit should be boosted. So you could buy a ‘two times’ FTSE 100 tracker. So if the FTSE 100 index goes up by 10%, the leveraged ETF should go up by 20%, so you're doubling your profit. Essentially, you double your loss if things go wrong, too, but you can double your profit.

So that sounds great, short leveraged ETFs another option to play in the market. But there's actually a big danger, a big risk here, because of the way these ETFs work, and it's all connected to the fact that all these ETFs are re-balanced at the end of trading.

So let's imagine we're investing in a two times leveraged ETF that's following a particular index. So if the index goes up 10%, the two times leveraged ETF goes up by 20%. We make our investment on day one, the index starts at 100, it closes at the end of the day at 110, it's gone up 10%, nice. The leveraged ETF has done even better, it's gone up 20% from 100 to 120, fantastic. You've doubled your potential profit.

But what happens on day two? On day two the index falls 5%, so it goes from 110 to 104.5, that's what's happened to the index. What happens to the ETF? It falls by 10%, double the 5% fall. So it goes from 120 to 108, sounds fine.

Then when you think about it actually, over the two days the index has risen 4.5%. Started at 100, and at the end of day two it's risen 4.5% to 104.5. So the leveraged ETF double that rise should give you a 9% rise. It doesn't, it gives you an 8% rise, because of the re-balancing at the end of every day.

So the point with short and leveraged ETFs is that very quickly the performance can divert very substantially from the underlying index. So you should only invest in short or leveraged ETFs if you're very confident about a market move, and if you're going to do it over the really short term. I'm talking weeks here. You really shouldn't invest for longer than weeks, and you should be also have a good understanding of how futures, and options work as well, because of course these leveraged ETFs are using those kinds of investment contracts.

So in summary, I really like ETFs. I like nice simple ones. A nice, cheap, good way to invest in stock market indices, as long as they own all the shares in their index. A simple way to invest in gold or silver as long as they have physical holdings in the metal. But the funky ones, the synthetic ones with the futures, and the shorts with the leverage, for most of us it's best to steer clear.

So that's a quick overview of ETFs, and the potential dangers. I'll be back with another video soon. Until then, good luck with your investing.

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  • quark

    Ed. thanks for the video. I have used ETF’s for Bonds in the past. Black Rock i shares in all cases. I have also learned to beware the spreads and wait for them to narrow before buying.

    I have been interested in SPDR ETF’s run by State Street. I use Barclays stockbrokers and I have noticed that there is virtually no trading on the ETF’s that interest me. In fact, trading via Barclays Stockbrokers shows zero trading.

    The spreads are narrow but because of zero trading, I am inclined to ignore them – do you have an opinion on rarely traded ETF’s? Do you think that rarely traded ETF’s are likely to be withdrawn eventually, leaving a unwanted Capital Gains Tax liability if they go up in price.

  • Investa

    Excellent video as always thanks

    Do you have anything on CFD’s? This would be very helpful

  • Sue Rudd

    Hi Ed,

    A request please.

    Really enjoy the videos as I am new to investing.

    Could you give some tips on managing investments and the terminology used please. For instance how do you ‘take profits’ and what does ‘lock in profits’ mean. I haven’t seen much profit yet, but would like to know what to do, when I do…. Thanks Sue

  • Ed I agree with the leveraged synthetic ETF comments, but don’t think the comments on needing to understand Swaps etc is correct.

    Hi Ed
    I agree with your comments on leveraged ETF’s but really think you are overstating the risks of synthetic ETF’s, in particular that they are only suitable for individuals with a comprehensive knowledge of Swaps etc.
    At the end of the day, all ETF’s are derivatives i.e. they are a entitlement to something, not the thing itself, and only as safe as the UCITS rules protections can make them… If the issuer dissapears, so does the ETF.
    Synthetic ETF’s are minimally different – the issuer ‘buys’ the return by means of a Swap with a Swap provider. Again the scary risk is if the Swap provider disappears, but that risk is collateralised (UCITS only insists that 90% of credit exposure is collateralised and that collateral is held with one of the four global collateral management firms and they include the strongest financial institutions in the world).
    I’m not saying there is no risk, but it is substantially the same and any investor requires no knowledge whatsoever of the workings of the Swap market, they won’t even know it’s there unless they read the prospectus..