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This story was originally published in December 2011.

Lesson 1 – Select the the right tools for the job

Derivatives offer useful and cost-effective ways for investors to manage risks. In the ETF world, derivatives have democratized investor access to asset classes like commodities and currencies, and to strategies like covered-call writing, use of leverage and short selling.

Derivatives were previously the sole domain of professional and sophisticated investors. Now accessible to the masses, this freedom has come with the expected consequences of misuse and plain ignorant use of some or all of these products.

Three questions arise from the increasing use of synthetic structures in retail products.

  1. Are the benefits and costs associated with these products adequately understood by users?
  2. Are there potential systemic risks arising from the growing popularity of these instruments?
  3. Who’s best equipped to determine if investors should have access: regulators, investment professionals, or investors?

The right tool for the job

Having a plan is as basic to portfolio construction as it is in the workshop.What will the portfolio have to do? What characteristics must it have?

Selecting the appropriate tools and materials and understanding the capabilities and inherent risks with each is simply common sense. While possible to drive a nail with a screwdriver, it isn’t always as effective as using a hammer. Selecting ETFs is no different.

Returns are difficult to predict, but costs are different. The ETF Screener on the TMX Money website offers two basic ETF classifications: those using passive strategies and those using embedded strategies and costs are behind each.

Passive

These are straightforward ETFs that replicate an index and hold the actual components or a stratified sampling of the index holdings.

Embedded strategies

All other ETFs fall into this category, suggesting additional analysis may be required. We have broken these into three subsets with additional costs associated with each.

Strategic:

Holding equal dollar amounts of index components is one example. Proponents claim reduced large capitalization company bias in an index allows smaller faster-growing companies to contribute equally. Whether or not you believe this (there is research supporting both sides), more frequent rebalancing incurs more trading costs. This holds true for so-called fundamentally weighted indexes and active ETFs. Investors must decide if the costs are justified by the strategy.

Exchange-traded derivatives:

These ETFs can involve options and futures and introduce time as a more critical investment factor. Covered-call ETFs, for example, alter risk over time; modestly for ETFs overwriting a small portion of underlying holdings (e.g. FXF) to those that overwrite all of the holdings (e.g. ZWB).

Commodity ETFs can hold the underlying commodity, but many use futures. This subjects these ETFs to liquidity, basis, contango and backwardation risk. ETFs using exchange-traded derivatives introduce some elements of additional cost from liquidity, basis, timing (backwardation/contango) in addition to possibly higher management costs. Leveraged-long and leveraged-short ETFs also fall into this category.

Over-the-counter derivatives:

OTC derivatives are based upon total return swaps. A dealer commits to pay the return of an index over a particular time period in exchange for collateral. This introduces a potential cost as credit risk because the dealer or counter-party is promising to pay. It also introduces potential liquidity risk related to the collateral.

Investors and advisors have a duty to understand the risks inherent in these products and their potential impact on broader markets. Do regulators know better than advisors or clients whether these products have a place in retail portfolios? We’ll address these issues in future columns.

Types of ETFs

PASSIVE TICKER MER
BMO Aggregate ZAG 0.50%
Claymore S&P/TSX Canadian Dividend CDZ 0.60%
Claymore Gold Bullion CGL 0.50%
iShares S&P/TSX 60 Index XIU 0.17%
iShares S&P/TSX Capped Energy XEG 0.55%
iShares S&P 500 XPS 0.24%
PowerShares Canadian Dividend Index PDC 0.50%
PowerShares QQQ (CDN Hedged) QQC 0.32%
PowerShares Ultra DLux Long Term Government Bond PGL 0.25%
RBC 2013 Target Corporate Bond RQA 0.30%
RBC 2014 Target Corporate Bond RQB 0.30%
RBC 2020 Target Corporate Bond RQH 0.30%
EMBEDDED STRATEGIES – STRATEGIC TICKER MER
BMO S&P/TSX Equal Weight Oil & Gas ZEO 0.55%
Claymore Canadian Fundamental CRQ 0.65%
Horizons Dividend HAL 0.70%
EMBEDDED STRATEGIES – EXCHANGE-TRADED DERIVATIVES TICKER MER
BMO Covered Call Canadian Banks ZWB 0.65%
Horizons S&P/TSX 60 Bull HXU 1.15%
XTF Can 60 Covered Call LXF 0.65%
XTF Can Financial Covered Call FXF 0.65%
XTF Tech Giants Covered Call TXF 0.65%
EMBEDDED STRATEGIES – OVER-THE-COUNTER DERIVATIVES TICKER MER
Horizons S&P/TSX 60 Index (swap fee 0.0%) HXT 0.07%
Horizons S&P 500 (swap fee 0.30%) HXS 0.15%

Mark Yamada is President of PÜR Investing Inc., a registered portfolio manager specializing in risk management using exchange-traded funds.

Originally published in Advisor's Edge Report

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