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ETFs are more difficult to use

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2:33 pm
July 14, 2011

mark.yamada.1

posts 2

In speaking with registered reps at ETF conferences across the country, it appears that product complexity is forcing some to pause in using ETFs in client portfolios. Is this a pervasive issue?

11:07 am
July 15, 2011

De Goey

posts 6

It's a red herring, IMHO.

The real reasons, in my experience, are twofold:

1. MFDA advisors aren't licensed to sell ETFs under any circumstances (but don't want to admit that restriction to their clients).

2. Many advisors are afraid to move to unbundled compensation, and so don't recommend products that don't offer embedded compensation. The same goes for mutual funds like Steadyhand, PH&N, Mawer, Chou, etc.

Puting through a trade for an ETF is every bit as easy as putting through a trade for a mutual fund or stock. The only legitimate problem, IMO, is that it is (usually) impossible to run PACs on (most) ETFs. That's an operational constraint; not a complexity issue.

6:42 pm
August 2, 2011

Mike H.

posts 8

Post edited 6:52 pm – August 2, 2011 by michaelsteven.hadford.7

John, I think you misunderstood the question. Mark said he was talking with "Registered Representatives" – which denotes IIROC licensing. He was speaking with people at ETF conferences – why would an MFDA licensed person go to an ETF conference?

ETF complexity is a real issue, and has nothing to do with pushing a button on a trading system, or how an advisor is compensated. In the good ol' days, the word ETF meant "low cost indexing", which can be a good thing. However, ETFs now are often actively managed and / or have high fees. Inverse ETFS and leveraged ETFs increase complexity, and many investors don't realize that often the only underlying asset is a counterparty's promise to pay. The Global Financial Crisis (<- imagine the creepy halloween font here) showed us that counterparty risk is very real.

Inverse ETFs promise to deliver the opposite return of the targeted asset class, then in the same breath disclose that they don't exactly do that, they don't do that over long periods of time, and they are not suitable as long term holdings anyway. If I have trouble grasping this concept, what hope do my clients have?

Q: How can Horizon's BetaPro offer an S&P 60 stock index fund for a cost of 0.07%?

A: They don't buy stocks. They buy a promise to pay (swap) from National Bank. All of a sudden, your client's investment is NOT diversified among 60 large corporations – it is 100% dependent on the solvency of a middling-sized bank rated by Moody's as B- for financial strength.

So buying this ETF is a bet that both the S&P 60 index will go up, and National Bank won't go under. Maybe it should be called the "Horizons BettingPro National Bank Promise to Pay the S&P60 Return if We Can After We Pay Our Depositors Bond Holders and Senior Creditors First ETF".

ETF managers commonly lend the securities in the underlying portfolio, and keep the revenue for themselves. At least Blackrock iShares gives 60% of the lending revenue to fund owners, and "only" keep 40%. Many give nothing. Let's assume that the combination of the lending fee / rebate / interest plus interest earned on collateral works out to 1.5%. If the ETF manager lends 50% of the portfolio, this is an extra .75% per year hidden fee. Suddenly the low MER of the ETF isn't so low, but the "low fee" ETF is very profitable to manage.

Most clients would be offended to learn that the securities they own are being lent out to third parties in order to short sell, or bet against the client. All without informed consent or compensation. There is a thin line between short selling being an expression of an opinion or bet on future security prices; and being a driver of future security prices. Wouldn't it be ironic if a client's portfolio was effectively used to drive down the value of the client's porfolio, and while the client loses, the fund manager gains?

If the short seller is correct and the security price falls, the client loses. If the short seller is wrong and the security price skyrockets, the client can still lose if the short seller defaults. Of course, this is also an issue with open-ended mutual funds

I think my clients might be a bit annoyed if I lent out all of the money that they've entrusted to me. But if I could get 1% on it, I would be tripling my income. I already collect a 1% fee, but half goes to overhead. Same deal with an ETF – they've already covered their expenses with the MER, so the lending revenue is pure gravy.

Just as bank lending increases the money supply, security lending artificially increases the security supply. Let's say I buy an ETF, and through this I own one share of a corporation's stock. The ETF can lend that share, and the borrower now owns it, then sells it into the market. Now a third person owns it, but I still think I own it. There are essentially two shares created from one. Since I bought my ETF in a broker / dealer nominee account, the dealer can lend out the shares of the ETF I own, and I still see the shares listed on my statement. Now there are 2 more artificial shares being traded in the market. You can imagine this process repeated many times at many levels, creating a complex house of cards, all betting against me. We know that increasing the money supply devalues currency. Doesn't it follow that increasing the security supply puts downward pressure on security prices?

A good discussion of the issue of ETF complexity and risk is here: http://www.economist.com/node/18864254

One ETF advocate said that ETFs need these devices if financial “artistry” and innovation are to survive. I would have thought after the Global Financial Crisis, the apetite for artistry, innovation and artifice would have been sated. But I guess the people who created credit default swaps, hybrid mortgage backed securities and asset backed commercial paper need new jobs now. With the explosion of new assets, I'm sure that ETFs are hiring.

5:56 pm
September 21, 2011

Mike H.

posts 8

$2.3B UBS loss linked to ETFs:

(Reuters)

Lucrative Delta One desks are one of the most profitable areas on trading floors, together with high-volume computer-driven program and electronic trading.

"If you look round the City at the sector swaps guys on the Delta One desks … it's safe to say that at least one or two are taking good-sized bets into the market on any given day," said a former Delta One trader at a large investment bank.

This is particularly the case in some of the more complex Exchange Traded Funds (ETF) positions which UBS said were at the heart of its trading debacle, where it is hard to find a position that exactly matches the exposure.

"You go for some sort of proxy hedge which adds a level of complexity which often the bank risk and compliance systems cannot handle," the trader said.

Translation: Bank creates and sells ETF, with return of ETF linked to 'something'. It's expensive and difficult for bank to get pure exposure to 'something' so instead it buys 'something else'. When performance of 'something' is very different from 'something else', bank loses $2.3B.

Next time this happens, the bank might not be able to suck up the loss, leaving ETF owners to take the loss, even if the return on 'something' is positive.

6:09 pm
September 21, 2011

Mike H.

posts 8

Post edited 6:20 pm – September 21, 2011 by Mike H.

This is from Terry Smith, CEO of Tullett Prebon:

ETFs – you were warned

The losses of $2bn incurred by an allegedly rogue trader on the Delta One desk at UBS have again raised the subject of the (lack of) risk controls by banks dealing in opaque instruments, the need to separate investment and retail banking and the risks inherent in ETFs.

I have written over the past year about the unappreciated risks in ETFs and it is probably time to bring these thoughts up to date.

ETFs are regarded by many investors as the same as index funds. They clearly are not:

1. Some ETFs do not hold physical assets of the sort they seek to track. They are "synthetic" and hold derivatives. This gives rise to a counterparty risk, and as we saw with the UBS incident, some interesting risks within the counterparties supplying the basket of derivatives. What if (when?) such ETF trades cause such a mammoth loss in a counterparty which does not have sufficient capital to bear the loss and pay out under the derivative contract? Answer-the ETF will fail.

2. ETFs do NOT always match the underlying in the way people expect. Because of daily rebalancing and compounding, you can own a leveraged long ETF and lose money over period when the market goes up but during which there are some sharp falls. Equally, you can own an inverse ETF (which provides a short exposure) during a period when the market goes down but there are some sharp rallies and lose money. This actually occurred with some inverse ETFs in 2008. I would strongly suggest that people would not expect to be leveraged long and lose money if the market goes up or short and lose it when it goes down.

3. Because you can exchange trade these funds, they are used by hedge funds and banks to take positions and they can short them. Because they can apparently rely upon creating the units to deliver on their short, there are examples of short interest in ETFs being up to 1000% short i.e. some market participant(s) are short 10 times the amount of the ETF. If the ETF is in an illiquid sector, can you really rely upon creating the units as you may not be able to buy (or sell) the underlying assets in a sector with limited liquidity? The danger of allowing short sales which are a multiple of the value of a fund in an area where it may not be possible to close the trades by buying back the stocks are clear, but amazingly, during the debate in which I have been engaged by various cheer leaders for ETFs, they have claimed that there is no such risk in shorting ETFs. They clearly do not understand the product they are peddling, and if they can't what chance has the retail investor got?

4. Although ETFs are billed as low cost they are also the most profitable asset management product for a number of providers. How can this apparent contradiction be so? The answer is that the charge for managing the ETF is only one part of he cost. There are also the hidden costs in the synthetic and derivative trades which the provider undertakes for the ETF.

As a result of all this I have long thought and written that there is a certainty that ETFs are being mis-sold to the retail market and that the risks that are being incurred in running, constructing, trading and holding them are not sufficiently understood. After the UBS incident I think this should be regarded as indisputable.

10:06 am
October 5, 2011

smelly

posts 28

Yay Mike.

(cue the crickets as we wait for a rebutal from "the Degoey")