All you need to know about exchange-traded funds

Exchange-traded funds (ETFs) are funds that “passively” track an underlying asset class, be that a stockmarket index or the price of gold or wheat. Their transparency and liquidity make them attractive – but their main attraction is cost. ETFs are just plain cheap. The average fee charged by a UK active fund is about 0.85% per year, says Interactive Investor. ETFs come in at around 0.23%, but can be as low as 0.07% for a fund that tracks a large index such as the S&P 500 or FTSE 100.

That may not sound much, but it matters in the long term. Over 30 years with a 5% return, the difference between paying 0.85% in fees and 0.23% on a £100,000 investment would be £66,000.

But ETFs are not without their detractors. Some unpleasant surprises, particularly from funds tracking more esoteric indices or asset classes, have caused sceptics to wonder if these funds aren’t just the latest addition to the bankers’ long list of marketing gimmicks. Is this true? And what risks do investors need to be aware of?

Know your tracker types

There are several different types of index tracker ETFs, ETCs (exchange-traded commodities/currencies) and ETNs (exchange-traded notes). Almost all European ETFs comply with the EU’s “UCITS III” directive. Without getting too technical, this is a set of Europe-wide rules that set minimum standards for things such as a fund’s diversification, the way it’s priced, and which underlying financial instruments (such as derivatives) it can use.

European ETFs fall into two broad categories. First, you have funds which replicate their underlying indices by simply buying the underlying index securities, or a representative sample of them. So a FTSE 100 tracker would hold the stocks making up the FTSE 100 index, for example. This method is used by most of the iShares funds, as well as ETFs from HSBC. This is usually known as “physical”, “in-kind”, or “in specie”.

Swap-based ETFs, on the other hand (which include funds issued by Lyxor, db x-trackers, Source, ETF Exchange and the majority of European issuers) replicate their indices by buying a performance “swap” from a bank, and holding a basket of collateral. The bank guarantees the index return (before the bank’s fees) via the swap. The collateral is there to provide backing for investors’ funds in case the bank fails to deliver. Under UCITS rules, at least 90% of the fund’s value must be backed like this at all times.

Since the financial crisis, investors have looked more closely at the security of swap-based ETFs. But it’s worth remembering that, in theory, a maximum 10% loss should result, even if a counter-party fails. And in practice, many swap-based ETF issuers have reduced their uncollateralised exposure to less than 10%, and in some cases 0%. And as swap-based ETF issuers point out, ETFs that physically replicate their indices are not free of counter-party risk either; they often lend out the index securities in return for extra revenue (although these transactions are also backed by collateral).

It’s certainly worth being aware of which replication technique an ETF issuer uses, what their collateral policy is, the identity of any counter-party, and to what extent securities are lent out. This information should be readily accessible on the issuer’s website. But we wouldn’t favour one breed of ETF over another.

What about ETCs and ETNs?

ETCs – exchange-traded commodities and currencies – are debt securities, not funds. They offer exposure to the price of one or more commodities or to individual currency rates. Most ETCs have collateral backing, meaning that if the issuer defaults, investors should be protected. But you should make sure that you know the counter-party status before you invest, which should be on issuers’ websites and in the ETC prospectus.

We’re less comfortable with ETNs (exchange-traded notes). These are popular in the US market for tax reasons, but incur full counter-party exposure to their issuer. In other words, if the issuer disappears, so will your cash. While bank risk, as measured by the cost of default insurance, is much lower now than ten years ago, it would be foolish to assume that concerns over bank failure couldn’t surface again. So where possible, we’d avoid ETNs. The good news is that the vast majority of asset classes can be accessed via ETFs or ETCs, so there’s rarely any need for a UK-based investor to go down the ETN route.

What does it really do?

Counter-party risk is something to be aware of, but it shouldn’t put you off ETFs. A more common problem is that the more exotic the asset class or investment style, the harder an ETF becomes to understand. And that means they may not always perform as you might expect.

This is because of the way the tracker products’ indices are constructed. There’s a huge difference between a plain vanilla ETF tracking a broad, capitalisation-weighted stock index (where constituents’ weights are determined by the companies’ market sizes) and more esoteric indices involving leverage, or indices that are based on futures or forward contracts.

Leveraged ETFs those which offer plus or minus two or three times an index’s performance are rebalanced daily. This ensures a constant leverage ratio. But in practical terms, it also guarantees that over time, performance will differ from what an unwary investor might expect. Inverse (or short) ETFs, which provide a daily return of minus one times the underlying index, are also prone to drift over time.

Imagine that an index rises over a day by 10%, from 100 to 110. A two-times leveraged daily long index will rise by 20%, from 100 to 120. Fine. But on day two, the market falls by 5%. The underlying index declines from 110 to 104.5. But the double-leveraged index will fall by 10%, taking it from 120 to 108. As you can see, after two days the leveraged index (+8%) is up by less than double the underlying index (+4.5%).

Repeat this over many daily periods and the drift will grow. All other things being equal, the greater the leverage factor and the more volatile the underlying index, the more drift you’ll get. And, as you can see, this ’index drift’ begins as soon as you hold them overnight. So highly leveraged ETFs are suitable for very short-term traders only.

You could consider holding simple inverse ETFs (those offering minus one times an index’s return on a daily basis) over longer periods, but bear in mind that even these will be subject to drift over time, so you must monitor their performance.

How “contango” can catch you out

ETFs and ETCs which follow indices based on futures markets (this includes most commodities, currencies, and credit trackers) face tracking “problems” of a different type. Futures have to be “rolled” on a regular basis (usually monthly or quarterly) from the expiring contract into a longer-dated one. In many commodities markets, the further out in time you go along the futures “curve”, the higher-priced the relevant contract will be.

This “upward-sloping” futures curve is known as a “contango”. Any passive strategy of rolling from one contract to the next will incur a cost, as the longer-dated contract is more expensive than the shorter-dated one. 

It’s not always like this if futures prices are below spot (a price structure known as “backwardation”) you’ll earn money when rolling contracts rather than losing it. However, contango is the norm for a non-perishable commodity which incurs storage costs (because people expect to be paid more in the future for a commodity which costs them money to hold on to).

There is one exception: gold and other precious metals. These typically have little in the way of a forward curve, meaning trackers can follow the spot price quite closely. Most gold ETCs are backed by holdings of the metal itself, rather than futures contracts, and directly track the spot price after a deduction for fees.

So what should you buy?

As regular readers will know, MoneyWeek prefers plain vanilla investments by and large. The more complex ETFs become, the further they move from their core remit, which is to offer investors simple, cheap exposure to the market of their choice. So unless you’re a trader, we’d avoid leveraged products.

As for ETFs tracking commodity prices, they have their place (particularly precious-metals trackers), but longer-term investors interested in playing soft or industrial commodities are probably best off finding stocks with exposure to rising prices, rather than betting directly on specific commodities. But that still leaves plenty of uses for ETFs, not least in playing more exotic stock markets. 

Paul Amery is editor of www.indexuniverse.eu , the leading source of news and analysis on the fast-growing European exchange-traded fund market.