The risks of Exchange Traded Fund (ETF) investing have been brought into stark relief by a volley of warning shots from the G20’s Financial Stability Board (FSB), The International Monetary Fund (IMF), and the Bank for International Settlements (BIS).

While much of the alarm has centred around exotic synthetic ETFs, physical ETF risks could also be storing up a shock for the financial system, according to the FSB and IMF.

Often described as plain, vanilla funds, physical ETFs are so-called because they physically own the bulk of the securities of the index they aim to track.

The problem is what they do with those securities next.

Many physical ETFs run security lending programmes, renting out securities to hedge funds et al, who like to make short-selling mischief with them.

Securities are lent for a fee which, if we’re lucky, is split between the ETF manager and the fund shareholders (you and me).

ETF risk alert

The short-sellers get a ready supply of securities to bet against the markets and the ETF makes some easy money that can offset its tracking error.

Everybody’s happy? Everybody except the FSB which warns:

Thin margins on plain-vanilla physical ETFs create incentives for providers to engage in extensive securities lending in order to boost returns… Securities lending… may create similar counterparty and collateral risks to [those incurred by] synthetic ETFs. In addition, it could make the liquidity position of the ETF fragile, by challenging the ability of ETF providers to meet unexpected liquidity demands from investors, particularly if outflows from ETFs become significant under severe stress.

So supposedly simple, original flavour ETFs potentially expose investors to the same unpalatable dangers as those tutti frutti synthetic ETFs. Specifically:

Counterparty risk – In this case the chance that you’ll never see your borrowed security again, because the borrower goes under before they give it back.

Collateral risk – The danger that the collateral the borrower posted to lend your security (to cover the counterparty risk) turns out to be worth a lot less than the value of the original security. Alternatively, perhaps you can’t get your hands on the collateral at all, due to a bankruptcy bunfight with the counterparty’s administrators.

The nightmare scenario envisaged by the BIS and FSB is that – in the midst of a market panic – doubts about counterparty viability and collateral value trigger a run on the ETF. (I explored that chain reaction more fully in last week’s synthetic ETF piece).

Don’t touch physical ETFs with a bargepole?

Completely avoiding physical ETFs would be an over reaction, to say the least.

Firstly, we’re compensated for the risk through the securities lending income returned to the ETF, in much the same way that we’re compensated for the heightened risk of investing in emerging markets by the expectation of greater returns.

The key question is are we’re compensated enough? You can only answer that question by knowing how much of the bunce is going into your pocket. I’ll return to this in a sec.

Also, securities lending isn’t unique to ETFs. Almost everyone is at it. Index funds, active funds, pension funds – securities lending has been going on for decades without major disaster.

Neither do these reports suggest that their apocalyptic visions will come to pass. The authors stress that they are highlighting concerns over the unintended consequences of rampant ETF growth, the mutation of the product, and possible interactions with contemporary trading developments.

By highlighting these physical ETF risks, they’re pointing out potential weaknesses and flashpoints in the system. Flaws to be addressed now by regulators, investors and the industry, rather than by blackened survivors raking through the rubble.

It is the work of regulators keen not to be caught napping again quite so soon after the credit crunch.

What should happen next?

If the security lenders have us surrounded, then we need to know what they’re up to. And we need to be able to compare those activities in a meaningful way: Apples with apples – rotten or otherwise.

The ETF industry has barely moved a muscle on the issue so far. A fund’s factsheet and website page should contain the following information, in my view:

1. Does the ETF actually lend securities?

Not all do. You can check which iShares ETFs lend out securities on the individual fund’s page in the latest annual report (but not the interims). If no securities lending income is reported then you’re in the clear. Although that doesn’t mean that fund can’t lend in the future.

Credit Suisse’s latest semi-annual report says they didn’t indulge in any securities lending, although they’re perfectly entitled to according to their prospectus.

If you’re in any doubt about the position then contact your ETF’s provider and ask them.

2. Are we being well rewarded for the risk?

iShares split securities lending income 60:40 in favour of the investor. They dine out on 40% of the income. The other 60% takes the edge off an ETF’s costs.

What I’d like to know is would anyone else give me a 70:30 deal, or better, to compensate me for the risk that is all mine, not iShares.

Investors certainly aren’t getting any love from HSBC’s growing range of physical ETFs. Their latest annual report baldly states:

The Investment Manager is entitled to retain any fee received for such [stock-lending] services for its own benefit and not for the benefit of the relevant Sub-Fund.

As we’ve seen, Credit Suisse’s ETF securities lending programme is on hold. They don’t mention what the revenue split would be if they cranked it up.

3. How much income is being generated?

I’d like to see securities lending income presented as a clear benefit to the investor. For example, what percentage did it knock off the TER?

iShares is the only provider I know of that coughs up details on security lending income for individual ETFs. As mentioned, you can find the info buried deep in the annual report (though not the interims) which reveals:

• Lending income generated in pounds.

• The value of securities each ETF has on loan.

• How much collateral is covering the loan.

You can compare these figures with the ETF’s Net Asset Value (NAV) to work out how exposed the fund is.

It would be much more investor-friendly if iShares (and everyone else) provided the information for every ETF as per this snapshot (choose the institutional settings to view) of selected funds:

This info gives you an instant gut-feel for how hawked around the ETF is as the loans are presented as a percentage of the fund’s NAV. The average on-loan percentage is crucial, too.

We passive investors don’t want to fritter away our lives checking this stuff daily.

4. Basket case

There’s been plenty of woolly calls for more ‘transparency’ regarding the actual collateral basket holdings of ETFs. The idea is that a rummage in the basket enables investors to perform ‘due diligence’ on their collateral risk exposure.

That’s all very well, but the information has got to be readily useable by retail investors. Too often transparency or disclosure means a provider pumping out a spreadsheet containing hundreds of listings that defy analysis by the average punter.

I’d like to see a simple rating system devised that would enable the collateral basket and the credit worthiness of counterparties to be easily assessed. Perhaps using the rating agency methodology of AAA and so on down the food chain.

No doubt this would be proclaimed expensive, but it’s not as if the ETF providers’ risk managers don’t already know what they’re getting themselves into. (I hope!)

These reporting requirements should be consistently presented for ease of comparison across providers. They should also apply equally to other UCITS funds marketed to retail investors, too. Why single out ETFs when my pension fund is merrily renting out my shares too?

Where’s my risk analysis department?

My biggest fear is not that physical ETFs have suddenly become radioactive and I’ve lost my asbestos gloves. Risk abounds, so I just need to know what I’m getting myself into.

My biggest fear is that the reports prompt a raft of new regulation, or the ETF industry makes pre-emptive moves to put their house in order, but in such a way that the little guy is still left none-the-wiser.

Given that we’re all increasingly thrown onto our own mettle to provide for our future, we need the risks of investable vehicles, including physical ETF risks, to be fully understood by the average Joe.

Take it steady,

The Accumulator

Some great reading on money and investing.

When you’re young, half the classic books you read seem to apply to you. For example, like many a nerdy teenage bookworm without a girlfriend, a driving licence, or even a favourite tipple, I managed to see myself in Jack Kerouac’s literary tale of drop-out debauchery, On The Road.

Yet simultaneously my favourite poet was John Keats, the prototypical Smiths-ian hero – and a Romantic who possibly died a virgin.

As you get older, you start to get a better sense of who you are. As the English dandy Quentin Crisp once quipped:

“It’s no good running a pig farm badly for 30 years while saying, ‘Really, I was meant to be a ballet dancer.’ By then, pigs will be your style.”

Something similar has happened to me with my investing, and the investment books I enjoy. In my earliest days of investing (and even in writing with this blog) I toed the sensible line of putting away a bit of your earnings every month, investing it entirely passively, and waiting for the pay off 30 years down the line.

But in reality I’ve grown more drawn to biographies of Warren Buffett or even profiles of hedge fund managers, and I’ve invested my money ever more actively and aggressively.

Let me stress as usual that I don’t say this is the right thing for you to do. Most people are statistically best off following the passive approach outlined by The Accumulator here on Monevator. A good chunk of my money is in various index funds that are periodically rebalanced, too.

But it’s a case of do as I say, not as I do, with the rest of it, and I’m sure that’s what makes Free Capital, a just-released profile of a dozen super-successful UK private investors, such a compelling read for me.

Pre-release copies of this new book by Guy Thomas have been floating about the UK investment scene for a several weeks now, and I was very glad to get my hands on one. Extra frisson comes from the fact that – in online form at least – I know who a few of the purportedly anonymous investors really are. Long-time denizens of bulletin boards like The Motley Fool, ADVFN, and Stockopedia will have fun trying to guess the usernames behind the biographies and strategies.

Actually, there’s very little pure strategy discussion in the book. Thomas also resists the urge to say that just because these 12 investors made themselves millions by investing in the stock market, “you can to”. In fact, he’s downright frank, discussing in some depth the role that luck undoubtedly played in their success.

But he also writes:

A reasonable observation put to me by one of the interviewees is that there are two types of luck. The first type, ‘lottery luck’, is wholly random – like winning the lottery – and exposure to its possibility requires negligible effort, like buying a ticket. But there is another type of luck characterised by French microbiologist Louis Pasteur: “in the fields of observation, chance favours the prepared mind.”

I think this is a reasonable compromise. Several of the investors profiled made huge gains in the late 1990s stock market bubble, for instance, and held on to them. They were lucky to be in the right place at the right time, and then to buy the right stocks, and perhaps even lucky to get out before the crash (as opposed to prescient). But it was no accident that they were invested.

Inevitably, survivorship bias looms large. This is a book about 12 investors who – leaving aside a couple of very distinct outliers – reinvested savings from their salaries into strategies that paid off big time. They’ve made themselves ISA millionaires. Given the short time ISAs have been in existence, that’s something that can only happen by compounding very strong gains.

It isn’t a book about the losers who tried to do the same.

On the subject of losers, I’m not surprised to see these self made millionaires didn’t get there by relying on financial advisors, or even fund managers. Trying to beat the market may be a quixotic goal, but doing so while also paying for a bunch of hangers-on is an even harder one, unless you’re rich to start with!

Whether you go active or passive, it pays to read obsessively, take responsibility, and do it yourself.

I’m not going to write much more about the lessons, such as they are, in the book: Most are lifestyle orientated, as opposed to general investing ones, anyway. Virtually all the mainly 40-somethings featured (all male) are living reasonably modestly compared to their net worth, many are childless, and the few who risked getting married often got expensively divorced. Most seem introverted, and a couple borderline Aspergic.

All useful traits for accruing self-invested wealth, but if you want something different out of life, you’d be a fool to copy them for money. As for me, while I’m not quite the shy bookworm of my teens, I’m still your basic introvert, a natural long-term thinker, a marriage-a-phobe, a dedicated follower of business and the markets, and living well below my means. I’m also on a path that could put me in this book in a decade’s time. (Well, with luck!)

I heartily recommend the book if this sounds like you, too.

[continue reading…]

Note: What follows contains lots of speculation and fantasy finance. It is not a prediction. It is a reminder to keep our eyes on the horizon.

I had a dream which was not all a dream.
– Lord Byron

So here we are in April 2020. It’s a strange date to type out – it reminds me of when I was both a kid and a bookworm, and so I dreaded the arrival of 1984. For the first two or three months of that year I felt like someone was watching over my shoulder as I wrote the infamous date into my schoolbook each morning.

Now it’s 2020, and I can’t help looking back with 2020 vision.

Bear necessities of an investor’s life

As a Monevator reader, you don’t need me to tell you it’s been another good year for the stock market.

Strange to think that when I started writing this blog back in 2007, the memory of the Dotcom crash and the slump that followed had barely been expunged by a timid march towards the pre-crash highs, before we ran into the sub-prime crisis and another plunge in stock markets around the world.

I used to believe that investors of my generation would one day be grateful for a chance to get into equities at reasonable levels, but I don’t think many of them actually did. Going on Monevator traffic, it wasn’t until 2015 or 2016 that people really started taking an interest in shares in a big way again.

As a still-anonymous blogger – barely – the long years in the wilderness with just a loyal band of readers suited me fine. Having the Daily Mail camped outside my front door in 2018 after Time Warner tried to buy Monevator was infinitely scarier than seeing shares plunge in 2008.

And in case you’re still wondering, no I’m not Richard Branson, King William, Toby Young, Lady Gaga, or that Australian from the old show, Dragon’s Den.

Things could only get better

Anyway, I’m rambling – an increasing foible as you age, they say, but long-suffering readers will know it’s always been my vice!

Back to today’s stock market, and it seems fitting that the FTSE 100 finally broke through the 14,000-barrier this month. Round numbers don’t mean anything to computers, but thanks to behavioural economics we know they have an impact on us sentimental investors.

I’d love to have a time machine to go back to 2009, when other bloggers ridiculed me for writing about the potential for a great decade to come for equities.

Not because I would like to take them an iPad 11 to show them a screenshot of the FTSE 100 at 14,000 – if they ignored the evidence of historical asset class returns in favour of Doomsday scenarios, then I don’t see why they’d listen to a salt-and-pepper haired blogger from the future in a blue jumpsuit.

No, I’d simply use my time machine to go back and invest more money.

Short of borrowing to invest, I threw most of my disposable income towards snapping up equities between 2008 and 2011. Yet who wouldn’t have invested even more knowing what we now know?

Then again, as I say the decent run for shares wasn’t entirely unpredictable.

Short-term returns from equities are fiendishly volatile, as any investors who lived through that grim first decade of the 21st Century will attest. But over the longer-term, it tends to even out.

Indeed, by April 2011, the FTSE 100 had already soared like a phoenix from the flames (or like a bonfire of discarded share certificates heaped and set alight in a dumpster) to break back above 6,000.

14,000 and rising

Now, we know the long run nominal return from UK shares has been about 10%.

As well as inflation, that 10% return includes dividend income. Excluding the latter but not the former, we might have guessed the FTSE 100 would grow at about 7% for the nine years to 2020.

This would have taken the index to 11,000. But remember too that the decade from 2000 to 2010 was one of the worst on record for shares. Things were likely to do better than average, in turn.

True, much of the near-20% returns per annum that optimists predicted for the decade that followed were delivered in the early years of the recovery, as the market roared back from the March 2009 lows.

Yet valuations and sentiment had both become so thoroughly depressed by 2009 that equities have had a decent push beyond their long-run average for most of the past 11 years.

As it turned out, an investor who put £10,000 into the cheapest FTSE 100 index tracker in April 2011 and reinvested all her dividends should now have a nest egg worth approximately £30,000. And if she’d been even braver, and invested in the nadir of 2009, she’d have over £50,000.

Who says optimism never pays?

Bonds a bust, gold got sold

It hasn’t all been plane sailing. While we’ve seen none of the truly horrendous turmoil that scared that earlier generation of investors so silly that for a crazy moment in late 2008 they accepted negative returns on US Treasuries, we have had the usual lurches in confidence – along with the usual background noise of geopolitical posturing.

And needless to say, while equities are the biggest daredevils of any portfolio, they aren’t the only asset class that can give investors the willies.

The great bond rally of 1980 to 2010 finally broke down, for example, to the dismay of those who’d gorged on those 30-year issues that Central Banks pumped out in 2009 and 2010. But at least with bonds you get your money back if you hang around long enough.

Not that anyone seems to want to hold bonds these days. Nor cash, for that matter, despite 7% interest rates. We would have killed for that a decade ago!

Of course, back in April 2011 it was all about gold, which had just hit $1,500 an ounce – roughly where it sits today. Gold bugs were right that the price of gold would go higher, but wrong that we’d all eventually trade in our American Express credit cards for Krugerrands and shotguns. Eventually, gold fell. The yellow metal is a valuable diversifier, but there’s no comparison between backing it or human industry.

The same might be said about oil and the other commodities. Yes, they provided the early juice to the recovery, as countries like China and India took the accelerated steps that turned them into the top-tier powers we know today. But oddly enough, just like the British Empire and the American one that followed, China and India still haven’t consumed every last lump of whatever the Australians can dig up. Our energy use has changed, and we’re also changing how we make things, which ultimately put a lid on price rises.

Just ask anyone who bought into that insane IPO of 2015, which simply proposed an open-ended mandate to begin an “undertaking of great advantage” through mining operations in the last unexplored realm within our reach.

Back to the future

The flotation of Moonshot Mining PLC aside, most of the past decade has been largely free of the bubbles that blighted the previous ten years.

So has humanity finally learned its lesson? Hardly. I’m sure we’ll see bubbles again in my lifetime.

It’s true that 2000 to 2010 did leave a painful memory. But frankly, those same events also left the average Man on the Clapham Hoverbus without much money to pump up a new bubble – especially given the competing need to service those horrendously huge mortgages taken out on UK property as a result of the last one. (Even higher interest rates from 2012 haven’t really dented London property prices. Long-time Monevator readers will know I’m STILL renting as a result!)

Having said all that, there are some signs that shares are now getting frothy.

The rally over the past decade has been broad, with miners eventually giving way to leadership by the global consumer companies that rule our world, and to the eventually rehabilitated banking and housebuilding sector.

But technology shares have arguably become very overvalued, 20 years after the last tech bubble burst.

Also, while I’m his biggest fan, I do wonder whether Warren Buffett can really keep running the very expensive-looking Berkshire Hathaway from a life support machine.

Bond vigilante

Overall the market isn’t expensive, claim my critics, who call me a grizzly old bear. “Britain is booming!” they cry, adding that we can hardly have a recession when so much of what we used to call the emerging world is now living the middle-class dream.

It’s funny how things turn on their head if you wait long enough.

Maybe I am an old fuddy-duddy. From 2008-11 I was happy to run 90% equity exposure: I knew it would hurt me in a dip, but the opportunity was there for the taking and the odds seemed fair. Plus I had a crucial long-term perspective.

Now I’m 50% in cash and bonds, which is much more conservative than my share crazy doctor tells me I need to be. (He’s also more bullish that I’ll eventually reach my centenary, too, but then I can remember when even a 70-year old was considered ancient. Buy more GlaxoSmithKline-Zeneca, I say).

So why the shift in my portfolio? Joking aside, it’s partly an age thing – I’ve ten years fewer left now to ride out the vicissitudes of the stock market.

But there’s also the thorny matter of valuation.

Back in 2011, the FTSE 100 was on a forecast price-to-earnings ratio of roughly 10. The P/E ratio fell to less than 9.5 for 2012. These numbers suggested investors didn’t expect much growth to come.

Fast-forward to 2020, and I’m assured a P/E of 22 reflects the new reality of a world population that’s topped 8 billion hungry souls.

The next bear market

A new reality, eh? Now where have I heard that before?

Personally, I suspect a new bear may finally be preparing to emerge from the history books. Don’t ask me when it will strike – nobody ever knows, and markets can stay irrational far longer than you will want to wait. (Did I mention I’m STILL renting?)

I tell you this though: I am more fearful today given how everyone seems so gung-ho about equities, compared to when none of my friend’s cared less.

What should you do? Some will say stock up on gold and cans of tuna, but of course there’s no tuna left.

Instead I suggest you rebalance your portfolio a shade more conservatively, consider a few alternative assets, and don’t be afraid to hold cash.

I know, I know: you tripled your money by investing in shares over the last decade. But take it from an old codger – the good times won’t last forever.