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ETF risk – a personal action plan

Global regulators lining up to beat on Exchange Traded Funds (ETFs) has been an unnerving experience for passive investors, not least yours truly. A number of potential risks have been highlighted and – given the shortage of decent passive investing alternatives available in the UK – it would be a grievous blow if ETFs prove to be about safe as a cluster bomb in a playschool.

While warnings about the counterparty risks and conflicts of interest that bedevil synthetic ETFs sired by investment banks are not exactly new, it did come as a jolt to learn that physical ETFs share many of the same problems.

What’s more, the reports are long on scary ‘what if’ scenarios but short on suggestions for practical action that retail investors might take.

So while the wheels of global regulation grind into gear, here’s my action plan. Bear in mind, this is a personal response that suits my investment needs and attitudes. I offer it purely as a discussion point, not as fail-safe, portfolio bomb-proofing.

Who knows whether the current clouds of uncertainty will drift away, turn more threatening, or eventually transform into golden rays of investor-friendly enlightenment? Until then I’m going to…

Favour index funds

I'd choose synthetic funds last of all trackers

Index funds are like the slower country cousins of ETFs. They’re simpler, and only like to trade once a day in the afternoons. The expectation of intra-day liquidity does not burden these investment bumpkins, and they’re sturdy physical, security-holding folk, not synthetic replicants fresh from the lab.

True, index funds can lend securities but, crucially, they’ve been around since 1975 without blowing up. Sure, the past is not a guide to future performance, but it’s the best clue we’ve got.

The basic asset classes can all be held very cheaply in index funds without worrying about trading costs and a passive investor can create a well-diversified portfolio without recourse to ETFs, especially if you use Vanguard funds.

Use physical ETFs rather than synthetics

I will still use ETFs to access broad asset classes that are not catered for by index funds.

In the UK, that means I need to buy ETFs to cover commodities, property, value, and UK small cap.

Where I have a choice, and the cost differential isn’t too great, I’ll choose physical ETFs over synthetics.

With most of my assets in index funds, I can accept the potential risk of using a more complex vehicle to gain exposure to a few extra asset classes – especially as the main risk highlighted for physical ETFs is the potential fallout from security lending during a market apocalypse. The world and his financial services’ mother lends securities, so it’s difficult to protect myself from this particular spectre by choosing some other type of investment vehicle.

You can check how the ETF is structured on its factsheet or web page. Variations on physical replication are:

  • Physical
  • Full
  • Sample
  • Optimised

If it says ‘synthetic’ or ‘swap-based’, then it’s not a physical ETF.

  • Major physical ETF providers include iShares and HSBC. Credit Suisse also offers a reasonable scattering.
  • Db X-trackers, Lyxor and ETF Securities generally, if not always, stock synthetics.

iShares currently discloses the most information by far about its security lending activities, although it hardly arrives in easy-to-digest form. In the future, investor-friendly presentation of the facts will be my tie-breaker for individual ETF selection.

An alternative approach favoured by Monevator co-author The Investor is to use fairly low-cost investment trusts. If you’re looking for reliability borne out by history, then investment trusts have been around since 1868. They’re actively managed but some have relatively reasonable TERs, and The Investor has done an excellent job of explaining the foibles to watch out for.

The last resort: Synthetic ETFs

Synthetic ETFs could be a flashpoint for global financial contagion in extreme market conditions, according to those regulator warnings.

It’s important to stress the reports cited potential risks rather than cast-iron certainties. They called for further investigation, they didn’t pass a damning verdict. All the same, the regulators are clearly unhappy at the current level of ETF operational transparency.

My attitude to synthetics is a trickle-down version of my physical ETF outlook. In the index tracker food-chain, synthetic ETFs are:

  1. More complex
  2. Therefore more risky

However they are useful for reaching otherwise inaccessible asset classes cheaply. Therefore I’ll buy them as long as I:

  1. Have no other suitable choice
  2. Keep their use to a minimum
  3. Diversify among providers

I currently hold one synthetic ETF, which is worth less than 10% of my portfolio. I’m comfortable with that as there’s no other way for me to track that asset class.

I also console myself that it will have to be a pretty cold day in hell before the envisaged nightmare scenario occurs. It’s not impossible, but my exposure to a malfunctioning ETF is minuscule in comparison to the damage plunging markets would do.

What’s in the basket?

The G20’s Financial Stability Board (FSB) report proposes:

In particular [ETF providers] should make publicly available detailed frequent information about product composition and risk characteristics, including on collateral baskets and arrangements for synthetic ETFs.

Due diligence for investors would then include checking the counterparty viability and collateral quality that underwrites the synthetic ETF.

The swifter industry operators already post some of this information about individual ETFs on their websites:

Those that do:

  • db X-trackers
  • iShares
  • Credit Suisse

Those that don’t:

  • Lyxor ETF
  • ETF Securities

I’d rate the information they provide as nigh on useless to the average punter in its current form. Even if you can competently analyse the quality of potentially hundreds of securities held as collateral, it changes on a daily basis.

Frankly disclosure is not the answer here. Only a tightening of regulations that govern the quality of collateral will do.

We can’t spend our days squinting at a spreadsheet of Japanese small caps, or whatever else the investment bank has put up behind its synthetic ETF. What we need is the assurance that the ETF is backed by an adequate amount of high-quality, liquid collateral that can be shifted sharpish in an emergency.

Reputation counts

Conflicts of interest are a major theme within the recent ETF risk reports. They raise the question of whether investment banks use their synthetic ETFs as a dumpster for illiquid collateral, and as a source of cheap funding.

In the conflict of interest stakes, private investors versus investment banks equals easy meat for the banks.

In the shadow of the credit crunch, I’d argue trusting big banks is like trusting a python to babysit your pet mouse. If I can choose an ETF from anyone other than a big bank then I will. That’s easier said than done, though, as subsidiaries of the banks dominate the synthetic ETF market.

Tried and tested

So that is how I plan to deal with the situation for now, until the industry and/or the regulators make the risks of ETFs plainer.

In truth, this has always been my tracker selection policy anyway. But the regulators’ warnings have helped to ram home how carefully I should tread in the face of rampant financial innovation.

It’s best to stick to the tried and tested, and when it comes to asset classes, to the broadest, deepest end of the pool. There’s no real need to go sticking my nose in the glowing sludge that collects at the fringes.

Take it steady,

The Accumulator

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{ 9 comments… add one }
  • 1 Alex May 10, 2011, 3:00 pm

    1. I think it’d be useful to say that there is another source of ETF risks, actual and potential – something you haven’t hitherto mentioned. It relates to a particular class of ETFs: the leveraged ones.

    2. Leveraged ETFs, as you know, have a number of issues.

    3. I’m assuming you haven’t discussed them here so far because they’re not really suitable for buy-and-hold investors (for a number of reasons).

    4. However, I think us long-term investors need to be aware of them if only because various parties attempt to trash all ETFs on the basis of the leveraged subset.

  • 2 The Investor May 10, 2011, 5:11 pm

    @Alex — One reason why we don’t mention every last thing in every article is because we already publish amongst the longest articles out there. They need to be broken down for digestibility, as well as our need to sleep now and then… 🙂

    Articles can be endless, as the Internet has proven only too well. If leveraged in here then why not sector etfs? Why not illiquid country ones (the new Peru one?) etc etc.


  • 3 Alex May 10, 2011, 6:34 pm

    1. Hi TI, I’m really sorry. I wasn’t intending to be critical in any way – rather the opposite (as I’ve said many times). I was only trying to add to the discussion.

    2. I was referring to TA’s superb series of posts to date – not just the current article. I was only surprised by the lack of reference to leveraged ETFs to date because they seem to be potentially so problematic. They really are a quite different beast, I feel.

  • 4 The Investor May 10, 2011, 7:01 pm

    Hi Alex, no worries and sorry if I came over as a bit snappy — I’m moderating comments on the iPhone which is a bit laborious.

    I totally agree almost nobody has any need for leveraged ETFs, and that they’re risky. Was just pointing out articles need boundaries.

    Sure TA will get to leveraged etfs in time.

  • 5 The Accumulator May 10, 2011, 7:42 pm

    @ Alex – you’re right to bring this up – leveraged and inverse ETFs were cited by the reports as examples of complex products that are are potentially being bought by investors unaware of their ‘special’ features.

    I did skip them on the basis that most passive investors are surely giving them the same kind of berth they’d give a foaming pit bull.

    I think a line or two in this piece saying ‘don’t touch ’em, unless you really know what you’re doing’ would have been a good idea. I personally don’t use ’em and don’t see why I would in a passive portfolio.

  • 6 Newbie investor May 16, 2011, 2:32 am


    I understand that you don’t like financial advisors. Is there any circumstances that you feel one would warrant the services of these folk?

    I have an advisor…. I have come into more cash than I am used to since starting my own business a few years ago. He helped me arrange a investment which has increased by about 45% in 2 years. Even I know this is good! My own attempts have been poor in comparison. So was he lucky? Is he a genius? Probably lucky. I dont know. Would you be able to write an article on your feelings towards FA’s?

    Many thanks
    Newbie investor

  • 7 The Investor May 16, 2011, 8:34 pm

    @Newbie – Hi there! 🙂 The Accumulator (the author) may have a slightly different view to me, but I am no fan of financial advisers at all, as I have written before in arguably hyperbolic terms, though at least some deserve it.

    I’ve created a Google Finance graph that shows you the FTSE 100 in the UK returned 40% over the past two years, and the S&P 500 returned 50%. You can add another 5% for dividends, too. So your adviser has not beaten the market.

    That said, 42% over two years is a great return and he may have done it by taking on less risk, so I’m not making any specific judgement. Just pointing out that you always need to look at returns in the context of the market’s return.

    Anyway, the article above gives my views. Not sure if you’re in the UK or the US, but in the UK at least fee-based advisers who don’t charge commission are far far far better than typical ones, since the latter, while they may seem cheaper, frequently steer you to products that pay them the most commission.

    A fee-based adviser isn’t a panacea and there are still potential conflicts of interest, but they’re much less blatant. Realistically, many people need some sort of professional advice.

    The best idea is to become hugely informed about investing yourself, either way.

    Your decision, and I can take no responsibility for whatever you choose to do. Good luck!

  • 8 The Accumulator May 17, 2011, 7:19 pm

    @ Newbie – I don’t have a problem with professional advice. My personal story is:

    1. Took on an advisor (commission-based).
    2. Felt something fishy was going on.
    3. Something fishy was going on.
    4. Decided to learn about investing so I could smell the fishiness earlier next time. Or at least tell the fishy from the dishy.
    5. Got hooked on it and decided to do it myself.

    Most people will need professional advice, if for no other reason than there aren’t enough hours in the day for everyone to DIY. Everything I’ve read and learned says make sure you get a fee-based advisor. Commission-based leaves you too exposed to conflict of interest.
    I have no doubt there are IFAs of every hue who are well-trained, knowledgeable, ethical and diligent. The question is, how do you make sure you get one? There are a few books out there with chapters detailing the questions you need to ask a prospective IFA. Doubtless a quick google search would throw up something similar. I’d personally want an advisor who subscribed to my investing philosophy, so I’d seek out IFA’s of the passive kind.

  • 9 The Accumulator May 21, 2011, 9:25 am

    Came across this as a starting point for questions to ask a prospective financial advisor: http://www.osc.gov.on.ca/documents/en/Investors/res_choosing-adviser_en.pdf

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