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

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

Some reading for the weekend.

Anyone who still believes that markets are ultra-rational got yet another rude awakening this week, when a huge sell-off in commodities sent prices for everything from silver to oil tumbling.

In a superb column for Reuters, John Kemp writes:

Front-month Brent crude futures sank almost $12 per barrel (well over 9%) in a series of vertiginous declines that took the market down from over $120 at the start of the day to under $110.

The price change was more than 4 standard deviations — which is something that should be seen on average only once in every 63 years — if the market was well-behaved and changes followed a normal or Gaussian distribution.

At times the move has approached 5 standard deviations — which should only occur once every 7,000 years.

Yet again, the markets are proving academic theories about Gaussian returns absolutely wrong. This is why you must read The Black Swan even though the book has become a trite buzzword, and is far less easy on the eye then the bonkers Portman movie of the same name.

Once every 7,000 years – either investors of 20,000AD are going to find the markets a millpond, or the theories are absolutely bunk.

However, realizing that markets are not rational is not the same thing as being able to profit from it. In fact, most market timers lose money, as academic studies have shown. The difficulty, basically, is that the bubble of tomorrow is the rational re-valuation of today.

Call time on market folly too soon, and you risk missing the gains that make investing profitable over the long-term. Or, even more commonly, you fail to get back in again because you expect more falls to come.

On that score, it’s worth noting that Goldman Sachs expects this fall in oil to be temporary. Central bankers will hope the squid is wrong, given how lower oil prices would take the edge off inflation, as Stephanie Flanders points out:

If the global price of oil averages, say $110 a barrel over the next year or two, and not the $120 forecasters had been pencilling in, that could take about 0.2 percentage points off the rate of inflation in 2011 and 2012, relative to what was previously thought. If you’re the ECB or the Bank of England, or the Federal Reserve, every little helps.

The perma-bullish investors in oil companies who plague the bulletin boards (and the boardrooms of hedge funds!) will be backing Sachs over Stephanie, of course. They’ve been doing so all year, to the chagrin of those of us invested in companies that dare to do something other than dig stuff up:

(Via Business Insider).

I am not going to predict the bursting of the commodity bubble, even if silver’s 30% price fall in a week looks suspiciously like the top (and confounds those who say the price of precious metals is driven by fundamentals).

But I think it’s worth heeding these thoughts from Larry Swedroe:

There are two […] reasons to be cautious and to avoid being caught up in the speculative hype:

• The prices of both gold and silver are now way above the marginal cost of production. When that happens, you get new supply (though it may take some time for production to come on line).

• Unlike oil, which is a depleting asset, all the gold and silver ever mined is still around and is available to be sold. That means supply can quickly swamp demand as those family heirlooms that have been sitting in attics become prime material for melting down.

Having some money in commodities as part of diversification is very sensible, if you can find a way that fits into your overall investing strategy.

[continue reading…]

Early on in the life of Monevator, I wrote a series of posts explaining how to pick high yielding shares for long term diversified dividend income, and why you might want to do so.

The series culminated with a example portfolio, which I reviewed for the last time in April 2011.

As promised, I am now going to create a new high yield portfolio (HYP). What’s more, I’m going to do the sensible thing this time, and track the dividend income.

Income is, after all, the entire point of a HYP. And while I’m fairly pleased with how well the capital value of that last HYP withstood the carnage of the credit crunch, I haven’t really got a Scooby as to how the income fared. This time I want to be sure.

Having weighed up various tools to enable me to track both the portfolio and its income – and taking into account the entire Monevator research department seems to have absconded, together with all our interns AND the hapless but dependable jobsworth who might otherwise have been lumbered with tracking the portfolio – I’ve decided to simply buy the shares in real-life to do it.

Yes, I am investing my own hard-earned money to buy and track this HYP here on Monevator.

As a fan of Airfix in my childhood, I can’t really resist having another mini-model portfolio to play with. More importantly, this way is guaranteed to be correct, if rather expensive, unlike the online tools which all have downsides. Also, buying and holding the shares will give us a better idea of how much faff it takes to run even a largely hands-off portfolio, as companies are acquired, go bust, do an Enron, and so on.

I’ll give the exact details, such as prices paid and initial costs next week. For the rest of this post, I’ll tell you what shares I’ve chosen and why.

Important: I’m not recommending you buy these shares, and take no responsibility if you do so. I’m just a private investor, not your personal adviser nor Warren Buffett. Also, if you’re going to hold shares directly, you need to learn about, choose and follow your own shares, not just blindly copy someone else’s picks. There’s no shame in going for an index tracker instead!

Let’s do it like we did last year

There’s no point in repeating what I’ve previously written about selecting shares for a HYP. Please follow the various links in the first paragraph of this article for the specifics (or else see this archive of all my HYP posts).

I think the original strategy stood up fairly well last time, and steered me away from indebted disasters like Yell or from buying too many housebuilders or banks – even if it didn’t avoid banks altogether. (I did note yields on bank shares were high because of fears of a credit crunch, but I said it could go either way and so bought a couple of banks anyway!)

The importance put on diversification and avoiding excessive debt proved itself in the bear market, too.

All that said, my HYP thinking has evolved a little bit since 2007, in that I now think the sustainability of the yield is also worth an extra moment of guesswork thought.

It won’t pay to try to be too much smarter than the market here; let’s be honest, our 20-minute evaluation won’t beat a full-time analyst’s efforts. Our edge, if we have one, comes through buying a basket of higher yielders, not by second guessing the earnings forecasts for every company in the FTSE.

Put simply, I’d now pick a hugely dependable cash generator on a slightly lower yield like Unilever – which only just made my 2007 portfolio – over the average engineering firm or cyclical, unless its yield is stupidly low. (Still no room for ARM then).

The 2011 high yield portfolio

Again, please see my 2007 post for a step-by-step walkthrough of how you can pick your own portfolio of high yield shares using a combination of a screener, further research, and gut feel.

Needless to say, that old portfolio is wildly out of date. Yet I think reading the previous post is arguably more demonstrative than detailing every step today. Truth is, making pronouncements about share A versus share B as commentators and fund managers do gives an illusion of exactitude. By looking at that four year old post, you can see the warts and all, in the harsh light of what happened next.

Here’s my final chosen portfolio for this year, followed by a few brief notes on what’s in it and why:

Company	Size (m)	Sector	Cover	Yield
Aviva	£12,440	Life assurance	2.2	6.0%
BAE Systems	£11,065	Aerospace	2.2	5.6%
AstraZeneca	£42,670	Drugs	2.5	5.6%
Scottish & Southern Energy	£12,461	Utilities	1.5	5.5%
GlaxoSmithKline	£67,632	Drugs	1.7	5.3%
Vodafone	£87,075	Telecoms	1.9	5.2%
Admiral	£4,468	Insurance	1.1	4.7%
Centrica	£16,181	Gas supplier	1.8	4.7%
Royal Dutch Shell	£60,467	Oil	1.8	4.6%
British Land	£5,253	Property	1.1	4.3%
Balfour Beatty	£2,231	Construction	2.7	4.1%
HSBC	£115,135	Banking	2.2	4.0%
Tesco	£32,857	Retail	2.3	3.9%
Tate & Lyle	£2,831	Food	1.8	3.9%
Unilever	£25,561	Household	1.8	3.8%
Aberdeen Asset Management	£2,661	Funds	2.0	3.5%
Pearson	£9,149	Media	1.9	3.5%
Diageo	£30,787	Beverages	1.9	3.4%
Halma	£1,383	Engineering	2.2	2.5%
BHP Billiton	£51,522	Mining	4.3	2.4%
				———
Overall yield				4.3%

Note: The forward yield is rounded to one decimal place.

While I’m not going to run through every company I’ve picked – or indeed the ones that got away or were pushed overboard – a few points are worth noting.

First off, I’ve not included British American Tobacco. I’ve never bought tobacco shares – it’s a mental weakness of mine but I just can’t bear to profit from a habit I loathe, especially given how such companies’ future growth is predicated on selling cigarettes to less well-educated parts of the world.

If you’re made of sterner stuff, then grab the diversity and swap them in for either Glaxo or AstraZeneca. Doubling up on healthcare instead of cigarettes is my idea of share humour, but it’s also a chance to buy an out-of-favour sector that finally looks cheap.

I’ve included two utilities, both of which have a fair bit of debt. As I explained in the original series, utilities always come with debt, which is considered sustainable due to their long-term pricing arrangements.

Vodafone’s debt is horrible, too, but it’s a monster utility-like company. BAE’s pension deficit isn’t great, but it’s debt looks sustainable, provided the US military’s recent coup doesn’t mean the end of defense spending.

Aviva’s high yield is a bit of a mystery. I suspect it’s because it holds a lot of European government bonds. I’m sanguine, given the 6% reward for the risk.

Admiral and British Land both have lower dividend cover than the strategy looks for, but they’re special cases. Admiral has a superb record of paying out nearly all its income as a dividend, but that does make for low cover (and the potential for some lean years in the future). British Land is a REIT, which means it has to pass through most of its income, by law. It’s also got a fair bit of debt, albeit it backed by a great portfolio of commercial property.

The two lowest yielding shares at the end are in for diversification. Halma has one of the very best dividend records on the London market. I first bought it years ago on a near-4% yield, and I don’t deny it looks pricey now, but it’s a super business. As for BHP Billiton, I’m not comfortable setting up a long-term portfolio without a mining company in it, and BLT is as good as it gets today. Again, I can remember a 5%+ yield less than a decade ago on this share.

A purchaser could skip these last two and take the yield up to 4.5%; I’d rather have their proven prowess in the portfolio.

Incidentally, the ability to focus on whatever sector is down in the dumps and thus get higher yields is an advantage of buying your HYP over a period of years, instead of all in one go like this. If you’ve got the cash and you need to buy an income now, it’s better to get the diversification and lose some yield, I say.

I’m happier with the quality of shares in this portfolio than the 2007 version. True, the starting yield is lower, but the quality of companies seems overall higher. Of course, that might just be because we haven’t had the car crashes yet!

This HYP versus cash, trusts, and annuity

Our final yield of 4.3% is much higher than the FTSE All-Share’s yield of roughly 3%. It’s also much higher than cash.

But the HYP yield only just matches the current forward yield on my favourite income investment trust, City of London, which is slightly disappointing. The latter is trading on a 2% premium, but owning it (or better a basket of such income trusts) will be a lot less hassle for most investors. I’ll probably use the trust as a benchmark comparison against this HYP in the years to come.

HYPs were originally conceived as an alternative to an annuity, and the income compares well here, only a little below the £4,583 starting level a 65-year old man might get from the best single life annuity with 3% escalation and a 5-year guarantee. It’s much lower than the £6,491 he’d start with if he skipped the 3% escalation and the guarantee, though. (These quotes come via the Hargreaves Lansdown best buy table).

Of course, a HYP has a big advantage over an annuity in that you don’t lose it just because you’ve done the indecent thing and died. A portfolio of shares can be left to your heirs.

The other key advantage is that both the income and the capital value of our shares will, hopefully, grow ahead of inflation in perpetuity.

The downside of the HYP route – aside from the extra work in buying and monitoring a portfolio – is that either through poor share picking or a market meltdown, your income is hit and you get less than the guaranteed payment of an annuity. I’m decades away from retiring, but if I was I’d probably split a pension pot 50/50 between shares and annuity, to hedge against this risk.

In terms of expectations, I don’t expect fireworks from my mini-portfolio. A HYP shouldn’t beat the wider market, according to the boffins, as that higher starting yield will be paid for by lower capital growth. Over 20 years or so, a FTSE tracker’s income might well have overtaken it, too, due to faster dividend growth. But a HYP is about a higher income now, not some day in the future – a pensioner hasn’t got 20 years to wait!

While it may not beat the market, I’d certainly hope the income will rise ahead of inflation, though, and it’d be nice if the capital value does, too.

We’ll see.

There’ll be more details of the benchmarks I’ll be tracking this HYP against in next week’s post, so if you’ve not done so already please subscribe to make sure you get it.