Exchange Traded Funds have taken the investment world by storm over the last decade and are even proposed by Warren Buffet as the low-cost investment of choice for retail investors. The development of ETFs arose on the back of index tracker funds (which they are not). They are sold as a simple, safe, low cost alternative to a well-diversified portfolio of shares. However, frequently what is on the label is not what’s in the box. ETFs are being mis-sold and the risks of constructing, running, trading and holding them is not sufficiently understood. Many ETFs are synthetic, not holding the underlying assets they are meant to track, but rather holding derivatives of those assets, giving rise to counterparty risk. Many of these funds are leveraged and used by hedge funds and banks to short markets adding to volatility in markets. In certain illiquid sectors, the risk of not being able to buy or sell the underlying asset exists. The collateral matters and even if physically backed, often the stock is out on loan. Although being billed as low cost, they are also a most profitable product for the asset managers as the disclosed charge is only part of the cost, as they trade around the edge of the hedges.
The September 2011 UBS scandal, in which Kweku Adoboli was identified as the rogue trader (fall guy) and resulted in the firing of the CEO Oswald Grubel, was as a result of the trading of ETFs on the bank’s Delta One desk – a shadowy corner of the investment banking world. The “flash crash” of March 2010 was partly blamed on ETFs not being able to rebalance themselves as markets fell sharply.
ETFs now account for in excess of $ 1 trillion in assets under management and for roughly half the trade on the US stock market. When investments become mainstream, the easy money has been made, the first movers are looking for an exit and they start marketing to the man in the street – it’s time to be careful. What started with a single index tracker in SA, then split into resources, industrials, financials. This still made sense. Now there are 36 ETFs and 21 ETNs (Exchange traded notes) traded on the JSE. This volume ramps up exponentially internationally and what started as a simple solution has become very complex. (I went onto the iShares website to give you some statistics, but the offering is so vast I gave up). Fundamental indexation and other strategies move away from the passive theory of investing and introduce an active overlay. Anomalies are showing: 2004 saw the creation of Gold ETFs and from that date, the price of physical gold has risen dramatically. Gold mining shares however, no longer track the bullion price – there is an inexplicable disconnect; the largest constituent of the MSCI Global Equity Fund is the MSCI Japan Fund (not Apple as we would expect). It is becoming a fund of funds.
When we started investing offshore, we needed a quick, diversified exposure to global equity and bought into iShares MSCI Global Equity fund in London which trades in $. We specifically chose this index as we believed it to be the largest, most liquid index in the market. iShares, the largest provider of ETFs, was started by Barclays who sold it to BlackRock in the 2008 meltdown to raise cash to avoid a bail out. Our intention was to switch to individual shares over time when we had adequate conviction on our stock selection and markets had rallied a little. Upon starting to exit the MSCI we were horrified at the lack of liquidity (low trading volumes) in this stock. Another red flag. If any ETF runs into trouble, there is likely to be contagion and the effect will be felt in all ETFs and probably even index funds.
Having served their purpose, we are now largely out of this position and hold cash to invest into quality global direct shares as soon as the market retreats a little.