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Are ETFs the next ‘financial weapons of mass destruction’?

Lothar Mentel - 24 June 2011

The Financial Services Authority (FSA) has again expressed its concerns over exchange traded funds and their use by retail investors. A few days ago FSA director Sheila Nicoll said: “We share many of the concerns that have been highlighted about whether marketing and promotional material adequately explains the differences between various types of ETFs.” Not that all retail investors appear to be sharing those concerns.

Today there are more than 2,500 ETFs in operation and AUM has reached $1.4 trillion. Last month BlackRock estimated that the global ETF industry would reach $2 trillion in assets under management. BlackRock itself has around £70bn in funds under management within its iShares ETF brand, and despite this success, BlackRock has noted that the market is becoming cluttered and increasingly confusing to investors.

In broad terms, ETFs can be divided into two main types. In the ‘plain vanilla’ corner you have ETFs that aim to physically replicate the return of an index of stocks or a commodity. With these ETFs, the funds own some of the underlying assets. But plain vanilla was never going to be exotic enough to satisfy the broad tastes of an investment world always looking to find new ways to make money.

In the other corner, therefore, you have the spicier ‘synthetic’ ETFs. These aim to mirror the replication produced by a physical ETF, through the use of over the counter (OTC) derivatives, meaning those that are privately traded between two parties rather than traded in a market or on an exchange. The ability of these ETFs to track markets is entirely dependent on the issuing investment bank, rather than the performance of a portfolio of physical and matching assets.

These synthetics include vehicles such as inverse or short ETFs (which offer a return if the asset falls in value) and leveraged ETFs, which use derivates and debt to increase their exposure and therefore multiply the level of returns available. It’s this second wave of more complex ETFs that has got regulators worried. Holding up a mirror to something that’s already a reproduction? That sounds like a layer of complexity, and potential distortion, that’s a step too far for most retail investors.

Of course words such as 'leverage', 'derivatives', 'complexity', and 'investment bank dependency' will likely set alarm bells ringing for anyone who remembers the causes of the global financial crisis. The FSA is therefore justifiably concerned that investors may once again be unwittingly piling into complicated financial products that carry the potential for large losses that they do not understand.

So what are the drawbacks that come with ETFs? First, for many new to investing, the term passive in itself can be misleading. Passive does not mean low risk, and neither is it necessarily a cheaper alternative to actively managed funds. Passive in this context simply means limited human intervention in the investment decision-making process. There will always be many different structures and approaches within the passive market, some more expensive than others, and some more complex than others.

Second, an investor who expects their index tracking ETF to deliver an outperformance, or the same return as the index will be disappointed. ETFs tend to marginally underperform the index they are mirroring as a result of their fees and necessary transaction charges.

But let’s not forget the reasons why ETFs, particularly physical ETFs, have grown so popular in the first place. They can be bought and sold at any time, just as individual stocks are, and for lower fees. They are relatively cheap, they are liquid and they can provide access and broad exposure to a range of markets and asset classes. In volatile times such as these, no wonder that investors are looking for products that can be traded effectively to exploit short market timing opportunities. Investors must remember though that they are buying the volatility of the index when they buy an ETF. Yes, they’ll gain full exposure to the upside but also to the downside.

The multi manager team at Octopus uses ETFs as part of our core investment strategy, and as the first building block when we look to create a position in a particular region or market. We choose to invest in physical, index based ETFs in areas where there is no competitive advantage from investing in actively managed alternatives, or where we wish to get broad access more specialist areas investment areas quickly. This helps to keep our cost base down, and our investors benefit through reduced costs of investment.

We wouldn’t, however, rely solely on ETFs, because our investors expect something more. They rely on us to deliver at least market returns, but with an additional level of outperformance, something that unleveraged ETFs on their own are not able to give you, but without the risk that leveraged ETFs entail. As multi managers, our job is to offer a balance of risk and return. Our advantage over passive alternatives is our ability to identify those managers that have proven skill and remain true to their investment style.

Can a fund manager consistently outperform their market year in year out? In most instances, the answer is no but that is not because they aren’t any good.  Every fund manager has their own approach: many will be rewarded at certain times of the market cycle and punished at others. Therefore, selecting the right manager, at the right part of the economic cycle, is what underpins long-term returns for an investment portfolio.

Investment products always look to evolve, so it is no surprise that the introduction of more complex ETFS has attracted the attention of regulators concerned about the next potentially toxic investment. From the perspective of the man in street, the old advice remains relevant: do not invest in something you do not understand.

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