Exchange-Traded Products: If You Don't Get Them, Don't Get Them

by: PensionWag

Could it be death by a thousand cuts? One wouldn’t think so initially. To a butcher, a knife is a tool to cut meat to a customer’s specifications; to a hoodlum, it is something else, indeed. A product just out of adolescence, the exchange traded fund would appear to offer cheap and easy access to beta for the retail investor by replicating various stock and bond indices and enabling one to take directional views on the fate of these myriad markets in quantities large and small alike (e.g. the ability to go short as well as long and employ leverage).

But with speed comes risk of centripetal forces that could throw Mr. and Mrs. Investor clear off the track. Recall that these types of funds may be traded freely like shares of stock, rather than through the process of redemption, as is the case with mutual funds. Note as well that these vehicles often index a particular market, meaning that the fund itself holds a representative sampling, but often not all of the shares of the particular index whose behavior it seeks to replicate. This leads to a mismatch or ‘tracking error’ of varying degree, depending upon the market in question. For the more illiquid markets being replicated, a change in investor sentiment en masse could result in potential difficulty unwinding positions. Finally, their use in high frequency trading is something to ponder.

The road has become more tortuous still. ETFs and their siblings have been moving into the active space, employing derivative strategies, in common parlance, to “juice” returns in a low rate environment or to create synthetic exposure in markets that lack sufficient depth for a full-on replicative approach. Whilst the more complex and arcane of these vehicles have appeared on other shores, the world of finance is made smaller still through the expedient of technology with a mouse click moving capital outré mer. The run-of-the-mill investor will in all likelihood not take the time to read the finer points or footnotes in the prospectus, if she or he reads it at all. Therein lie the the arcana of exposures, hedging and the concomitant risks. Do investors in these more recent ‘releases’ know what they're getting? Are they facile in navigating the circuitry? Probably infrequently. The hue and cry of overseers and regulators should be heeded. Indeed, the Financial Stability Board, the Bank of England and the Bank for International Settlements have all weighed in on not so apparent risks in some of these products. So, too have various trade associations representing the fund management industry both here and in Europe issued rejoinders. While curiosity invites a broader treatment of these tools, it is beyond the scope of this article, meriting book length research. Herewith is a brief taxonomy of products with their trade-offs. This list is by no means meant to be exhaustive and innovation is most likely adding to it.

Exchange-Traded Furor

Product

Description

Trade-Offs

Exchange-Traded Fund –physical or “plain vanilla” variety.

Fund that trades intraday like shares of stock, may be purchased on margin and sold short. The garden variety replicates or tracks the index on which it is based.

Because it is a passive investment, the product is low cost, may be purchased in small quantities and settled easily during the day due to its liquidity.. Tracking error exists and may be greater for products based upon a market segment with less depth (liquidity, opacity). Use is roughly equal between individual and institutional investors.

Synthetic Exchange-Traded Funds

Fund pursues return through asset swap with a counterparty rather than through index replication.

Counterparty risk. The party charged with the delivery of the OTC derivative or other vehicle may not fulfill its obligation. Oftentimes this counterparty is the bank doubling as ETF provider. Its potential default is a risk consideration. Collateral not required to match assets of index tracked and may be much less liquid. May be problematic in event of wholesale redemption. Strategy is low cost. Comprise almost half the ETF market in Europe where their use by institutions dominates.

Exchange-Traded Notes (falls under the rubric of exchange traded product)

A debt product that is listed like an ETF and holds various types of fixed income.

Seek to replicate debt markets which may be more opaque. Are also not subject to investment company requirements such as diversification rules.

Exchange-Traded Vehicle (falls under the rubric of exchange traded product)

Akin to an ETN, but issued through a Special Purpose Vehicle (SPV)

Offers opportunities in less accessible markets, but with greater counterparty risk.

Leveraged Exchange-Traded Funds

Borrow to deliver inflated performance of an index

Leverage can cut both ways, delivering disastrous results.

Inverse (short) Exchange-Traded Funds

Track the opposite performance of an index

Contrarian in nature, the directional trades may end in grief.

Click to enlarge

What offers a transparent product now offers an opaque one in need of more rigorous analysis of which the garden variety investor is often incapable. Caveat emptor: if you don’t get it, don’t get it. The funny thing about shallow water is how easy it is to touch bottom.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.